How To
Avoid
The Worst Mistakes
Investors Make
By Paul Merriman, editor
FundAdvice.com
Investing
is about taking risks, and when you do that, you're entitled
to expect a return that's commensurate with the level of risk
you take. But if you're not careful, your own mistakes can prevent
you from achieving the return that should be yours.
In my all-day seminars
I always discuss these traps, and I want to share them here.
I have identified 18 examples, and I hope they will let you learn
from other peoples' mistakes so you won't have to learn them
yourselfthe hard way.
Mistake
No. 1:
No written plan.
It
always puzzles me why people who spend days planning a two-week
vacation will make five-figure investment decisions seemingly
on a whim.
A Fortune Magazine
article published in 1999 says people with written plans governing
their investments on average wind up with five times as much
money during retirement as those without written plans.
Obviously, the act
of writing a plan doesn't put money in your pocket.
But people who are
methodical enough to put their plans in writing are also likely
to do many of the other things that lead to successful investing.
And of course, even the most brilliant plan is worthless if it
just collects dust on a shelf.
With a plan, you can
get back on course when you go astray. But without a plan, you
can't even know you're off course.
If you don't have an
investment plan that's right for you, developing one should be
your top priority. If you're a do-it-yourself type, visit our
Web site at FundAdvice.com and look in the Basics of Investing
section of our newsletter archives for an article called "Don't
Have an Investment Plan? Start Here." Or get professional
help from someone who does not sell financial products.
Mistake
No. 2:
Procrastination.
Waiting
for the right time can ruin your results over a lifetime. Procrastination
takes many forms. You don't start saving for retirement until
it's nearly on top of you. You "know" you should review
your investments but other things always seem more pressing.
You think you'll catch up later when the market is better, when
you're making more money, when you have more time.
And there's the irony, because the longer you wait, the less
time you have. Every day you delay is a day of opportunity that
you can never, ever get back.
Mistake
No. 3:
Taking too much risk.
Investment
risk is not a theoretical concept. It is the very real possibility,
experienced earlier this year by many aggressive investors, that
you will lose money.
Investing requires
taking some risk, but many people take too much. They probably
know that higher returns go hand in hand with higher risks. But
they may believe they are immune from losses or that they'll
somehow know when it's time to sell. The problem is that by that
time, it's usually too late. Their desire for high returns simply
puts the blinders on.
Far too few investors
understand the risks they are taking. Most don't understand what
could go wrong with an investment when they make it, and they
have no plan for what they will do if things go wrong.
People who take too
much risk often wind up being speculators instead of investors.
But those who are savvy about risk invest instead of speculate.
They never forget the importance of limiting and managing their
risks. If they gamble, they do it with money they know they can
afford to lose.
Mistake
No. 4:
Taking too little risk.
Some
people are paranoid about the thought of losing any money at
all. They want everything nailed down, secure, guaranteed. The
sad truth is that absolute security is only an illusion, it doesn't
exist anywhere in nature and it certainly doesn't exist anywhere
in the financial markets.
Very low risk almost
always equates with low return. If you put your emergency money
in a bank account and earn 1 percent, you may think you're taking
no risk. But in fact you are taking the very real risk that inflation
will rob your money of its purchasing power.
If you put your life savings in very low-risk investments, you
are giving up an enormous opportunity. A few years ago my wife
and I made $10,000 gifts to each of our three grandchildren for
their retirement years.
When my grandson, Aaron,
was six months old, we put the money into a variable annuity
that will compound until he's 65 years old. We did not choose
the annuity's money-market fund option, which at a compound rate
of return of 5 percent would turn that $10,000 into $238,399
after 65 years.
Instead, we chose to
invest the money all in equities, split equally between U.S.
and international stocks. If I assume this combination can make
a 12 percent return, by the time Aaron is 65 the account will
be worth $15.8 million.
Had I gone for the
no-risk option, I could have short-changed Aaron out of $15.6
million, or about 98.5 percent of his retirement.
Mistake No. 5: Paying too much money to others.
Mutual
fund investors essentially throw some of their money away by
buying load funds instead of no-load funds. In addition, far
too many investors pay far too little attention to annual expenses.
Otherwise, they'd almost never buy annuities inside IRA accounts.
Expenses are like leaks
in a bucket. The bucket is filled with your money, and you want
the water level to grow. Everybody can understand what happens
if a bucket has too many leaks in it. It's a pity that investors
can't see that the same is true of expenses.
Mistake
No. 6:
Trusting institutions.
I
often ask participants in my seminars if they trust their banks.
Most of them are pretty emphatic in answering: No! But many of
us act as though we do trust banks. We believe the bank will
tell us if we should move our money somewhere else within the
bank to get a higher return.
You and your bank have
a classic conflict of interest. Your best interests are served
by accounts that pay the highest interest. Which at a bank is
usually in a money-market deposit account of a certificate of
deposit. But your bank's best interests are served by accounts
that pay you little or no interest on your money, like passbook
savings and checking accounts.
It's a mistake to rely
on a bank to tell you what's in your best interest. It's a mistake
to rely on a broker or a brokerage firm to tell you what's in
your best interest. The same is often true of insurance companies
and government agencies, but that's an entirely different topic.
Mistake
No. 7:
Believing publications.
"Best
Funds for 2001 and Beyond"
"The 100 Best
Mutual Funds"
"These Stocks
are Real Steals"
"Got These Funds?
Six Standouts You've Never Heard of"
Those are all real
headlines from the covers of a popular personal finance magazine.
Predictably, they prompt readers to grab the magazine and dive
in, even if just out of curiosity.
Study after study shows
that the majority of stocks and funds touted in such articles
fail to do better than the average of other stocks and funds.
But that doesn't matter to the magazines, Web sites, radio and
television shows and (I hate to admit it) newsletters that keep
cranking out articles, broadcasts, lists and tips for eager investors.
Serious investors need
textbooks more than hot ideas. But people don't want textbooks.
They want entertainment, and that's what publications and broadcast
outlets provide. Most of us don't spend lots of time reading
to educate ourselves. We prefer laughs, escape of relief from
the stresses of daily life.
The right way to read
financial articles that tout specific mutual funds and stocks
is to treat them as useful sources of interesting ideas. The
wrong way to treat such articles is to regard them as prescriptions
of what you should do with your money.
Writers, editors and
publications follow fads. They write about what's in favor and
in style. When the winds of popularity change, they are never
far behind. That's fine if you're looking for entertainment.
But it's a poor basis for making investment decisions.
Mistake
No. 8:
Failing to take little steps that can sometimes make a big difference.
Some examples:
- People fail to fund their IRA contributions
at the start of the year.
People fail to make their annual IRA contributions at all. - People leave money in taxable accounts when it could appropriately go into IRAs and 401(k) plans and save taxes.
- People have multiple small IRA accounts, paying an annual fee for each one instead of consolidating them into an account large enough to avoid a fee n the first place.
- People don't move their money from a checking account to a money-market deposit account at a bank.
- People don't move their money from a bank
money-market deposit account to a non-bank money-market fund.
Each of these little steps make a difference. And over a lifetime the little differences add up to big differences but only for people who take advantage of the opportunities they have.
Mistake
No. 9:
Buying illiquid financial products.
Liquidity
is the ability to get your money back quickly, to turn an investment
into cash. A stock is very liquid, because you can sell it whenever
the market is open, and you'll have your money three days later.
Mutual funds are even more liquid, letting you have your money
the next day.
But liquidity is severely
compromised when you invest in limited partnerships, for which
there is often no market. When limited partners want to sell
their units, they often find that everybody else wants out, too,
and there are few buyers at any price. In this garage-sale mentality,
the only buyers may be speculators who buy partnership interests
for pennies on the dollar.
Mistake
No. 10:
Requiring perfection in order to be satisfied.
We've
all known people whose attitude is that nothing is good enough
for them. People who can't stand to have anything but "the
best" are rarely successful at investing.
In fact, there will
always be something that's performing better than whatever you
have. If you happen to have the one fund that outperforms everything
else this month, you are practically guaranteed that some other
one will be ahead of yours next month.
Perfectionists often flit from one thing to the next, chasing
elusive performance. But in real life, you get a premium for
risk only if you stay the course. And if you demand perfect investments,
you'll never stay the course.
Mistake
No. 11:
Accepting investment advice and referrals from amateurs.
If
you had a serious illness, I hope you'd consult a nurse or doctor,
not somebody on the street who had an opinion about what you
should do. And I hope you would treat you life savings and your
financial future with the same care as you would treat your health.
Yet too many people make big financial decision based on things
they hear. "I heard this hot tip." "I know somebody
in this company." "I've got an inside source about
this new product." My broker is making me a ton of money."
The lure of the hot
tip is all but irresistible to some investors eager to find a
shortcut to wealth. Unfortunately, many investors have to learn
the hard way that there are no safe shortcuts.
A client once told
me he had heard from friends about a woman who "made a lot
of money" for his friends. My client, normally very conservative,
cashed in $250,000 of his portfolio and turned it over to this
woman, who said she would invest it in "a conservative strategy."
Within two months, she had lost half of the $250,000. Only then
did my client learn she was not even licensed to do what she
was doing. The woman's compensation was to be 20 percent of whatever
profits he made, giving her an incentive to generate big gains
quickly. But he didn't understand that until it was much too
late.
Mistake No. 12: Letting emotions especially greed and fear drive investment decisions.
I
think the two most powerful forces driving Wall Street trends
are greed and fear. Think about these two emotions the next time
you listen to a radio or TV commentator explain what's happening
in the stock market. You'll hear fear and greed over and over.
There's fear of rising
interest rates, fear of inflation, fear of falling profits. You
name it, somebody's afraid of it. Fear is why so many investors
bail out of carefully planned investments when things look bleak
and since everybody seems to be selling at the same moment,
prices are down. That, in turn, reduces profits or increases
losses.
Greed blinds investors,
making them forget what they know. Last winter, greed prompted
many inexperienced investors and some experienced ones
too to stuff their portfolios with
high-flying technology stocks, which had just a terrific year.
In the spring, technology stocks, especially the most aggressive
ones, plunged without warning, leaving, many of these greedy
investors wondering what had hit them.
Investors obviously
want to make money. But this legitimate desire turns into greed
when it runs amok. Likewise, investors obviously should want
to avoid losing their money. But when a healthy respect for bear
markets leads to panic selling, it's out of hand and counterproductive.
Mistake
No. 13:
Putting too much faith in recent performance.
We
tend to think that whatever just happened will continue happening.
Sometimes that's true, but a great deal of the movement in the
stock market is random. And recent performance is a lousy predictor
of near-term future performance.
Ironically, recent
performance is at the heart of the mechanical market timing systems
we use and advocate.
Our systems don't predict
the markets; instead, they identify and follow existing trends,
on the presumption that those trends are likely to persist long
enough to take advantage of them.
Somebody asked me how
we can use recent performance while we advise investors that
it doesn't mean much. It's a good question.
When we use recent
performance in a mechanical timing system, we are using recent
history as a tool. We have no emotional attachment to any part
of that performance or our use of it, and we're ready at any
time to switch gears when our timing systems tell us to do.
Contrast that with
an investor who identifies the hottest performing mutual fund
over the past year and who therefore buys that fund because he
or she believes that hot performance means something (for instance
that the fund has a brilliant manager or the "right"
strategy) significant.
Many investors get
into trouble when they start believing in what they are doing.
This belief tends to make investors put too much of their money
into a single stock or one mutual fund. Such confidence takes
a while to build up, and investors tend to make their commitments
too late to fully participate in whatever it is that has impressed
them so much.
By this time, the investor's
emotional attachment has typically taken on a life of its own.
Then when their favored investment starts falling behind, the
investor's confidence persists. By the time the investor is finally
wiling to admit that things have changed, he or she will have
stayed much too long.
As you can surely see,
that is very different from the mechanical, unemotional way that
we use recent performance in our timing.
Mistake No. 14: Failing to resolve disagreements between spouses.
It's
not uncommon for members of a couple to have quite different
comfort levels and priorities for investing money. He may think
she's taking excessive risks; she may think he's hopelessly conservative.
Or of course it could be the other way around. When couples discuss
finances, including investments, there are often power struggles
going on under the surface. And when somebody is determined to
"win" or to "keep the peace," sound investment
decision often suffer.
One spouse will give
in or compromise, possibly with resentment. I'm reminded of a
line in a song from the musical "My Fair Lady" in which
Henry Higgins is complaining about the disruption a man feels
when he lets a woman into his life: "Making a plan and you
will find she has something else in mind, and so rather than
do either you do something else that neither likes at all."
Mistake No. 15: Focusing on the wrong things.
It's
generally agreed that asset allocation the choice of which
assets you invest in accounts for at least 90 percent of
investment returns. That leaves less than 10 percent for choosing
the best stocks and the best mutual funds. But most investors
focus at least 90 percent of their attention on choosing funds
and stocks. Their energy would usually be better spent on asset
allocation.
Some investors also
focus on small parts of their portfolios instead of the entire
package. They can become obsessed with some small investment
that seems to stubbornly refuse to do its part. Occasionally,
an enraged investor will overthrow an entire strategy because
of what happens to some small component of its.
Mistake
No. 16:
Not understanding
how investing works.
Many
people don't understand diversification; they just know that
it's supposed to be good for you. They would be better investors
if they learned how to put together non-correlated assets.
The entire point of
diversification is to always have some things in a portfolio
that "aren't working." That's because whatever is performing
well at any given time won't necessarily continue to do so. And
you want some other asset class waiting in the wings to find
its day in the sun, so to speak.
Mistake
No. 17:
Needing proof before making a decision.
The
ultimate stalling tactic for those who aren't ready to make an
investment is to require one more piece of information or evidence.
You can get evidence,
but not proof. You can prove what happened in the past. But there's
no way to prove anything about the future except to wait until
it happens.
I think it's ironic
that the main focus of mutual fund advertising is past performance
yet that's the one thing that the funds can't sell and
investors can't buy.
There are two track
records for any investment. The first one just came to an end,
and it includes all of history. It can tell you the range of
returns and risks that are reasonable to expect.
But it can't tell you anything about the future. The second track
record starts the moment you invest. It's the only track record
that matters to you, and it may or may not have any resemblance
to the track record of history.
If you really need
certainty, stick to Treasury bills and certificates of deposit.
But if you're seeking higher than you can get from those, you
will have to accept some uncertainty.
The only thing you
can be sure of about the future is that it won't look just like
the past. That's why savvy investors hedge their bets, so to
speak, by diversifying beyond what seems certain at any given
moment. To be successful, happy investor, you've got to somehow
learn to live with the ambiguity of an uncertain future.
How to overcome these common mistakes.
These mistakes are
very common. If you recognize any of them in your own investing
pattern, it doesn't mean there's anything wrong with you
just that you have room for improvement.
The cures for many
of these mistakes are obvious, though they're not always easy
to implement. They boil down to education, discipline and managing
your emotions. Try the following suggestions:
- Make sure you have written investment plan that outlines what you must do to achieve your long-term goals. Use specific, measurable goals so you can "keep score" on your progress.
- Educate yourself. Study the extensive article library at our Web site. Read a book or two from our site's recommended list. For a refresher on the basics, read either "Investing for Dummies" or "Mutual Funds for Dummies." Both are good.
- If you don't understand an investment, don't put your money into it. I believe this single step will prevent more grief than almost anything else you can do.
- Sometimes the best course is simply to slow down. Take a deep breath and apply a liberal dose of patience. Patience is probably the most under-rated virtue I know.
- When you notice emotions are driving your
decisions, substitute a discipline. If you have trouble doing
that, consider professional investment advice or professional
management.
Now let's have a little straight talk, just for the record. It might look as if I have a bit of a conflict of interest here because I manage money professionally for clients. That business provides the lion's share of my income. And here I am in a newsletter advising do-it-yourself investors to consider professional management.
My
highest priority in this newsletter is to give readers the best
information and advice I can possibly give them. I tell it like
it is, and if I ever have to stop doing that, this newsletter
will be history.
For the start, FundAdvice.com has never hesitated to tell investors
everything they need to know to do it themselves. If you can
successfully put into practice what you learn here, and thus
have no need for my management services, nobody will be happier
about that than I am.
But the plain truth
is that successful investing like successful dieting
is harder that it looks. I know this (on both counts) from plenty
of experience. Again and again we've pointed this out. This issue
is just one in a long succession of articles in which we have
told readers how to avoid the pitfalls and successfully leap
the hurdles.
But sometimes education
is not enough. Sometimes the smartest thing to do is hire a professional,
either to advise you or to take on the day-to-day discipline
of carrying out your strategy. If I didn't point this out, I'd
be doing you a disservice.
So I'd like to leave
you with a few thoughts about how to choose an advisor or a manager.
Don't do it casually, because they (perhaps I should say "we")
are not all alike.
Choose a manager with
experience. The vigor, idealism and enthusiasm of youth is wonderful.
But there's something very valuable about the experience that
comes from having lived through good times and bad, having lived
through market crazes and fads and having learned from mistakes.
You are the one who will decide whether I'm merely promoting
myself by making this recommendation. But I believe my more that
three decades in this business makes me a better manager than
I was when I started out.
Choose a manager you can trust and with whom you are comfortable.
This is totally subjective, but you are a human being with emotions
that can derail you. Even if you find an advisor who is recommended
by the world's greatest authorities, unless this person wins
your trust and confidence, he or she isn't the right advisor
for you. Rarely do I tell investors to follow their gut feelings,
but this is an exception. This is not the only qualification
you should pay attention to. But it's an essential one. If you
leave your advisor's office feeling pressured to do something
you don't want to do, you probably have the wrong advisor for
you.
Choose a manager who
will put your interests first. Your best bet is somebody who
has no conflict of interest with you (because the manager doesn't
sell any products or have a financial stake in the specific choices
you make). But if for some reason you can't avoid a real or potential
conflict, choose somebody who, in advance, openly discusses the
situation to your satisfactions.
Choose somebody who
understands and is committed to whatever is important to you.
Part of this is finding somebody who can help you discover and
articulate the choices you will inevitably make. If the most
important thing to you is avoiding the loss of your capital,
don't settle for somebody whose attitude toward that objective
is only grudgingly lukewarm. And on the other hand, if what you
want is flat-out growth with no holds barred, don't go to somebody
whose passion is designing bond portfolios.
At the start of this
article I told you I had 18 examples of mistakes, but I've listed
only 17 so far. I have saved No. 18 as a "bonus" to
readers who made it all the way through this long article.
Mistake No. 18: Spending so much time focused on investments that "real life" gets crowded out.
I'd
like to repeat some thoughts from an article I wrote last winter
for winter Alaska Airlines Magazine on the subject of what smart
people do to prepare for retirement. (You'll find the entire
article on the Internet at http://www.fundadvice.com/press/alaskaairlines.html.)
I've seen over the
years that good retirement planning involves a lot more than
just managing your money properly. Smart people take care of
their health, both mental and physical. Smart people cultivate
new relationships and nurture established ones. The happiest
retired people I know are those who seem to have many favorite
people in their lives, including people who are younger than
they are.
Smart people have plenty
to live for. They have no trouble making a list of 100 things
they would love to do if they had the time. And smart people
don't wait for retirement to make their dreams come true. They
know life is uncertain, and all the tomorrows we assume are ours
can be snatched away in an instant. Whatever their age, smart
people find ways to make their dreams become reality, starting
now.
Editor's Note: Paul Merriman is founder and president of Merriman
Capital Management and publisher of FundAdvice.com, 1 year, 12
issues, $125. Mr. Merriman is considered one of America's top
experts on mutual fund investing. He manages over $300 million
using buy-and-hold and market timing strategies.
In 2000, he produced
a video called How to Build & Manage a Million Dollar Portfolio
Using No-Load Mutual Funds.
Here's everything you
need to know to be a successful mutual fund investor. You'll
learn how to design mutual fund portfolios like those used by
Nobel Prize winning economists. You'll also learn how to triple
the returns of the Standard & Poor's 500 Index at less
than half the risk. And much more!
To order this comprehensive
educational 3-tape, 4 hour investment video, just send check
or money order for $50 (plus $5.00 for shipping and handling)
to: 4-Hour Video, Merriman Capital Management, 1200 Westlake
Avenue North, Suite 700, Seattle, WA 98109. Or call toll-free
1-800-423-4893. Visa or MasterCard accepted. Make checks and
money orders payable to Merriman Capital Management and enclose
your name, address and phone number.
An invaluable resource
for investors, www.FundAdvice.com features high quality educational
content. This site is highly recommended for Bull & Bear
readers.
Mr. Merriman regularly
holds free workshops in the Seattle area. For times and dates
in July and August visit the Web site at www.FundAdvice.com.
