8 Investment Strategy Mistakes to Avoid
When was the last time you truly forgave someone?
I’m talking about a time when someone did wrong to you with no explanation — leaving you bewildered as to why you were treated that way. And, unfortunately, you had no real recourse, except to pick yourself up and move on. But before you could truly do that, you had to forgive that person.
It was unfair, it was unjust, and it was simply not right to think that you, who had been wronged in such a terrible way, now had to forgive someone who had shown no remorse, no concern, and certainly no effort to get you back on your feet.
I know I’m asking you to dig up a bad memory, but I don’t want you to dwell on the bad. Instead, think about how it made you feel when you finally forgave them. The burden of carrying the wrongdoing (which was probably much worse than the actual event itself) finally lifted, and you could move on.
Now, think about a time when you did wrong by you.
Have you forgiven yourself for that?
If you have, I’ll bet dollars to doughnuts that you learned a lot about whatever decision was poorly made. And I’ll bet you don’t let it happen again.
Let me introduce you to an area where you may have done yourself wrong in the past, but have yet to even realize it.
The BIG investment mistakes.
Investors Underperform Investments
First, I’d like to share why I think you (and everyone else) have fallen victim to one of these mistakes in the past.
DALBAR, a market research firm, updates a study of how investors performed versus their investments. At first, this statement may seem nonsensical, until we understand that the data they are showing demonstrates how much money flows in and out of funds, and when.
What they do is look at the money flowing each way and translate that as investors buy and sell the funds. This way, they can estimate how an “average” investor performed, which will be different than the way that investor’s funds performed.
It turns out – and this study has been updated each year for 25 years with similar results – that people are buying high and selling low. In other words, cash is coming into the funds after they’ve gone up and going out after they’ve gone down.
In fact, over the last 20 years, stock market investors have earned just 5.29% per year when the underlying funds have increased by 7.20%. This means a “set it and forget it” strategy would have added almost 2% per year to the average investor’s experience.
We, as an investing community who are trying to fund our life’s expenses with an investment portfolio, are doing it wrong.
Eight BIG Mistakes That Tempt Us All
I believe there are at least eight BIG mistakes that we are tempted to make at various times. While we are not susceptible to all of them at once, we may see ourselves at different times in our investing history as having made these mistakes in the past.
1. Over-diversification – This is when we find that we own several different strategies. Now, all of these strategies made sense to us at one point in time. However, they have now combined themselves into one big strange Frankenstein portfolio.
Perhaps we started with five core funds, and then we read an article or had a conversation that convinced us to add a specialty fund or two. We didn’t track or adjust these holdings over time, and when another tip came to us, we found the cash and added that new piece of the not-so-fitting puzzle. Ultimately, this leaves us not really knowing what we own, with the possibility of duplicate holdings, and perhaps even fees on top of fees across our portfolio.
In reality, “over-diversification” does lead our portfolio to a concentrated position of some sort, but we didn’t get there on purpose. Instead, we got there piece by piece. This, in turn, may leave us feeling trapped, not wanting to adjust any of our mini strategies for fear their time has just now come.
2. Under-diversification – This one is really tough because it feels very logical but ends up hurting us. It stems from a propensity to keep narrowing down our strategy by only continuing with “what’s working.” The problem is that what is working today will not work in the future tomorrow. And, if by the time we’ve entirely shrunk down to a single idea, then watch out!
In 1999, I heard a lot of people say they were diversified because they owned tech, telecom, and dot com companies! We all know how that ended.
Today, I hear people say they are diversified because they own two or three rental properties. In the Bay Area, in the same price range, sometimes even in the same neighborhood. Eek!
3. Euphoria – You can also call this one “greed” if you’d like. This is when rising investment prices convince us that the risk of a decline is getting lower. It happens when people feel like they are “missing out” and want to be sure they get at least as high of a return as their neighbor.
One might think that after nearly ten years of rising stock prices, we are in that state today. However, I hear more people worrying about a decline in markets rather than worrying about missing out. I take this as a sign that the markets have a lot of strength behind them, but there will be a day when euphoria is more frequent again.
4. Panic – Just like all of these mistakes, panic will rationalize itself – it does not come from a place of irrationality. It comes with phrases like, “I have to get out of the markets until the election is over/we get the deficit in control/the trade wars are finished/deflation/inflation/OPEC/Watergate/Any-other-gate/etc.”
There’s always a reason, and it’s usually some “crisis” that is being discussed in the news.
Don’t get me wrong, there are many things we should be concerned about, but they aren’t things we can actually do something about. It’s ok to feel fear and even panic, but it’s another thing to risk your entire life’s spending plan based on those feelings alone.
5. Speculating Instead of Investing – In a recent blog post, we discussed what makes up an investment versus speculation. Speculation is a bet on a continuing price trend, which by definition, forces you to buy high. We can speculate for fun, like buying a lottery ticket, but we don’t bet our family’s financial success on speculations.
6. Investing for Yield Instead of Total Return – Pretend for a minute that you own a well, and you depend on that well to gather water for your survival. Does it really matter if the water comes from snowfall vs. rain?
Investments earn their way either by providing income payments (dividends or interest) or by gaining in value (like the world’s great companies always do over long periods). Getting too focused on either of these makes us miss the point of gathering as much value over time as we can to fund our planned expenses.
7. Letting Your Cost Basis Determine Your Portfolio – Technically, this is called anchoring, and it happens when we are unwilling to sell simply because of some figure where we transacted in the past.
This can be stock awards that may have dropped since vesting, and we now don’t want to sell them at a “loss.” Or, maybe it’s an inheritance whose value has fallen since we received it.
A requirement for this to be a BIG mistake is that these investments represent a large portion of your wealth, leaving you under-diversified and needing to sell.
8. Leverage – Often tied to great overconfidence in the markets, this is when we borrow to invest more in our portfolio. It is a particularly seductive mistake because, in some way, it makes sense to do this.
If you can borrow at 4% and invest in stocks at, say 6%, shouldn’t you do this as much as possible? No, and here’s why. Stocks don’t go up in a straight line at 6% per year. And, the year they drop 50% or more will leave you feeling, well, not so good.
More to the point, the temptation to bail out of an investment strategy that “isn’t working” will be way too strong, leaving you with total losses of 50% or more of your wealth.
Here on planet Earth, I don’t know anyone who can or would want to withstand such an experience. We don’t borrow specifically to invest in the markets, ever.
What Gets In The Way?
It’s obvious – we do.
As humans, we have tendencies to want to control things around us, and not everything can be controlled. On top of that, we don’t want to feel like we are “missing out” or that our neighbors are doing something better than we are.
Instead, we want to feel respected and be seen as savvy, especially when it comes to our money.
It’s this emotional roller-coaster that we all must ride that drives us to make all of the above mistakes and many more.
Besides, we have no help.
We don’t speak well about our money challenges or decisions. We don’t want to share the whole picture with friends or family and, even with our spouses. We want to be seen as having everything under control – even when we don’t.
Here’s the Good News
You can forgive yourself for your past mistakes and move forward with confidence.
In fact, there is a new field known as Behavioral Economics, which has been growing as a serious area of study. Many well-published authors and studies in this area suggest there is a lot more to learn.
This growth in awareness is making it more acceptable to admit the “faults” we have – which are really just human traits.
And, sharing our fears out loud is a great step toward addressing them, even if doing nothing is the best course of action – as so often it is.
Additionally, and I admit this is a shameless plug, a good financial planner who is experienced in addressing and helping with behavior challenges in investing can be a savior for your lifetime spending plan!