Investors are their own worst enemies sometimes. As market participants, we often struggle with the pitfalls of fear and greed. These two emotions have the potential to inflict more damage to a portfolio than anything found lurking in economic reports or quarterly conference calls. However, beginners can mitigate risk by avoiding some common mistakes.
The cost of having emotions play a role in your portfolio is expensive. According to DALBAR’s latest Quantitative Analysis of Investor Behavior, the average investor earns significantly less than major benchmarks. Over the past 10 years, investors in equity funds earned an average of 5.9% per year, compared to an average gain per year for the Standard & Poor’s 500 of 7.4%. The gap is even larger when looking at the previous 20 years. Sensible investing strategies, such as dollar-cost averaging, can contribute to this performance gap, but imprudent action is still far too common.
“Through QAIB, we have learned that the greatest losses occur after a market decline. Investors tend to sell after experiencing a paper loss and start investing only after the markets have recovered their value,” explained the report. “The devastating result of this behavior is participation in the downside while being out of the market during the rise.”
Let’s take a look at five rookie investing mistakes that should be avoided.
1. Investing before you are ready
Daily advertising tells us that we should start investing immediately in order to give our investments more time to grow. However, there are a few basic steps people should take before walking down Wall Street. You need to make sure you have saved up an emergency fund of at least a couple months of expenses. This should be kept in a readily accessible account, something boring like a savings account. The liquidity will help ensure you aren’t forced to conduct any unwelcome selling in your investment portfolio.
High-interest debt should also be paid off before you begin investing. If you’re carrying around credit card debt with an interest rate of 15%, the national average, you can essentially make a 15% return (risk free) by devoting your dollars to the debt, instead of stocks. The one exception that is widely agreed upon: If you have a 401(k) plan with an employer match, you should take advantage of the free money as soon as possible while you build your savings fund and pay down debt.
2. Not having a plan
You need to know why you are investing. In other words, what financial goals do you want to accomplish with your money? These vary among different people, but your financial goals should be clear, measurable, and attainable. They should also recognize constraints.
Without a plan, investors risk being lured into flavor-of-the-month investments. Far too often, investors will rush into funds with the highest rating — after the over-sized gains have already been realized. As the chart above shows, funds tend to underperform their benchmarks after receiving high ratings. In fact, five-star rated funds from Morningstar have the biggest gap over 36 months following the high rating.
Source: USA Today | Eric McWhinnie, Wall St. Cheat Sheet