Investing is a little like chess. The basic rules are relatively straightforward, but if you don’t know what you’re doing, it can get really complicated really quickly.
Here are 10 big mistakes to avoid if you decide to handle your own investments.
1. Not Having a Plan
It’s important to know why you’re investing. It’s easy to just throw money at your brokerage account, but without a target in mind, you won’t know if you’re successful. Are you building up your emergency fund? Are you saving for your children or grandchildren’s education? Are you saving for retirement? Each should be approached in different ways. Saving to save is good, but you can do better.
2. Taking the Wrong Amount of Risk
Risk and return are related. You can’t get higher returns without accepting more risk. Make sure that you’re taking the right amount of risk in your portfolio. The “right amount” has the potential to help you meet your goals while still allowing you to sleep at night. It’s easy to see why taking too much risk is bad, but you can also be too conservative. Investing isn’t about shooting for the high score – it’s about being able to do what’s important to you.
3. Planning for Average Returns
The S&P 500 Index has historically had an average return of just over 12%. However, “average” in this instance is a pretty rare occurrence. Since 1926, the average annual return was only between 10% and 14% during seven years. That means more than 92% of the time the S&P 500 Index’s annual return wasn’t very close to its average.
This is important. You’ll often hear people talking about these average returns as if they are something you can expect year in and year out. They’re not. These are very long term averages and you need to take that into consideration when building your portfolio.
4. Not using Tax-Advantaged Accounts
Everyone would agree it’s a bad idea to give up free money. But that’s what you’ll wind up doing if you don’t take full advantage of the tax advantaged accounts available to you. These include not only the traditional 401(k) and IRA accounts for retirement, but also 529 accounts for education. Even ignoring things like matching contributions to your 401(k), the government is still basically handing out free money by allowing you to shift your taxes around. You owe it to yourself to take advantage of that. And if you can get a 401(k) match from your employer, do it. That is literally free money.
5. Ignoring Asset Location
If you’re going to use tax-advantaged retirement accounts, you might as well make the most out of them. Using their unique tax setup, you can reduce your tax bill if you’re smart about which investments go in your different accounts. As a general rule, you’ll want to put the investments with the highest tax bills in your tax-deferred accounts, and the investments with the lowest tax bills in your regular investment accounts. If you want more information, you can take a look at our article on asset location.
6. Ignoring Costs (Especially Loads)
Investing costs money. When you buy a stock, or invest in a mutual fund, a lot of people will get a cut of your money. If you’re smart about how you do this, you can make sure you’re only paying people who are actually doing something for you, and that you’re paying them as little as possible. When you’re investing, take a close look at what you’re paying, and if it’s not clear, ask. You should be able to understand what you’re paying for, how they’ll be getting their money, and how much you’ll be paying them. To be clear – in finance, you don’t get what you pay for. Cheap investments are a good thing.
7. Active Management
It’s really tough to talk about costs without talking about investment management. There are basically two main branches – active and passive management. Active management is trying to pick winners and outguess everyone else in the market. Passive management is focused on allowing you to harvest the market return and delivering exactly the risk exposure that you want.
While it sounds like active management should get you better returns (especially considering they charge more for it to boot), there’s no evidence it helps you consistently beat the market. Every year, some group of managers happens to beat the market (not to mention the group that does worse than their benchmarks, but you don’t hear much about them…), but it’s a different group every year. There is no persistence in terms of “good” management – once you control for costs, it’s basically monkeys playing darts. The winners and losers are random.
Passive management doesn’t beat the market every year. But it does deliver the amount and type of risk you decide on. And as we mentioned earlier, getting the level of risk in your portfolio right is the most important thing in investing. (Can you guess which side we’re on?)
8. Trading Too Much
One of the investment sayings thrown around a lot is money is like soap. The more you touch it, the less you have. When you trade, you have direct costs like commissions and taxes and you have indirect costs, these are the most expensive ones. The more you trade, the more direct and indirect costs you get hit with. When you’re trading a lot, most of the time that means you’re on the fear and greed roller coaster. You buy when things are looking good and sell when things aren’t. In other words, you buy high and sell low. It turns out, this doesn’t work so well. Once you build your portfolio around the appropriate level of risk for you, let the market do it’s thing.
9. Trading Too Little
It’s possible to go too far the other way. You need to do some trading to keep things in line and take advantage of some things from a portfolio management perspective. Since the market is always moving, you’ll occasionally need to rebalance your portfolio to maintain the appropriate level of risk.
Some folks do this on a scheduled basis, others do it when their portfolio gets too far out of line. Either works, as long as you have a set policy in place. Rebalancing is not an opportunity to take a bet that this will do better than that or vice versa. Rebalancing is about keeping risk at the right level.
One other thing you may want to take advantage of is tax loss harvesting. This is a little more involved, but you can sell investments that have done poorly and use those losses to offset the gains from your investments that have done well. This is a tricky road to go down, so you may want to take a look at our article on the subject.
10. Not building a diversified portfolio
Diversification is the only free lunch in finance. Not having a fully diversified portfolio means you’re taking risk the market won’t compensate you for. Since building a diversified portfolio is cheap and easy now, there is no reason not to do so.
Want to discuss investing with a professional? Contact McLean today
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