7 Common Investment Mistakes And How to Avoid Them
Successful investing is one of the cornerstones to prudent financial planning. Let’s assume that you do everything else well. Even so, there are several common investment mistakes that can derail your path to financial independence.
You spend less than you earn, and you save the rest. You don’t take on bad debts. You look for opportunities to minimize taxes. And you’re properly protected in case of financial emergency.
All of those are great financial habits. But they have one thing in common-they help you avoid losing what you already have.
On the other hand, the investment choices you make can help you grow what you have into something more. As long as you avoid making mistakes.
Here are 7 common investing mistakes and how to avoid making them.
1. Not having clear investment goals.
Not having clear investment goals is one of the most common investment mistakes.
When I was an investment advisor, I would see people make this investment mistake all the time. Prospective clients would talk with me and ask me what kind of performance they could expect to earn if they moved their investments over to my firm.
The only correct answer I could ever come up with is, “I don’t even know what your financial goals are. How am I supposed to tell you what type of performance you should expect?” Let me explain.
A prudent investment advisor will help their clients invest in the right investment, where the expected investment return is proportional to the amount of risk involved. And the expected investment return should be appropriate to the investment return assumptions in your financial plan.
And the financial plan should include estimate how much money you need to meet all of your expected financial goals.
Can’t we avoid all investment risk?
Not really. Every investment has some sort of risk.
If you invest in a stock, there’s a risk that the company goes out of business. That’s a higher risk than investing in the entire stock market. But there’s risk in that, too.
If you invest in bonds, there’s a risk that whoever issued the bonds might not be able to pay you back.
Even if you put all of your money under a mattress, there’s a risk that someone will break into your house and steal it. Or if you put it in a safety deposit box, there’s a risk that inflation will make your money worth less over time.
So the key isn’t to avoid risk. The key is to understand how much risk you have to take to meet your investment goals. And to make sure that the expected total return on your investments is proportional to that risk.
That should be part of your financial plan.
But if you don’t have a financial plan…
So if your financial plan is incomplete, or you don’t have a financial plan, then how do you know what your investment goals are?
That’s like getting in your car in New York City without a GPS or a map, and just driving west towards California. You might eventually get there. Or you might drive into the Mississippi River on the way, and never completing the trip.
You’d be better off with a plan. And a GPS.
Not having clear investment goals, in support of a financial plan. That’s the most critical investor mistake. Because it’s the root of most of the other investment mistakes.
People who have clear investment goals as part of a long-term strategy are less susceptible to making mistakes than those who don’t know what their goals are.
How to avoid this mistake:
Avoiding this common investing mistake is fairly simple. Don’t put the cart before the horse. But here are some tips.
Develop a financial plan.
Base your investment strategy and goals on the plan.
That financial plan should have reasonable assumptions. And one of those reasonable assumptions should be an investment performance goal, based on your risk profile.
Once you have established a reasonable investment performance goal, you can build an investment plan and determine an appropriate asset allocation for your investment portfolio.
At my investment advisory firm, we built an asset allocation after we helped a client determine their financial goals. In a standard portfolio, we would estimate the investment portfolio that we would need to reach that investment performance.
You don’t need to chase performance.
For example, if your retirement plan needed a 5% investment return over a 25 year period to meet you goals, our investment firm would design an investment portfolio with 5% as the long term goal. And we would hold ourselves accountable in ensuring that our investments were adequate to meet that goal.
Here is a rule of thumb we used to use in our investment advisory firm:
- 4% performance: 60% bonds, CDs, and cash, 40% stocks
- 5% performance: 50%/50%
- 6% performance: 40% bonds/60% stocks
In the short-term, especially the first year or two of a client relationship, we would see investment performance fluctuate. But for clients we served for at least 5 years, I never saw long-term performance drop below these numbers.
Most of the time, performance in a properly diversified portfolio was significantly higher in the long run. In turn, additional performance made their retirement plans that much more successful. We’ll discuss more of the details in the next section.
Do it on your own, or do it with a financial advisor.
It’s your choice whether you hire an investment advisor to do this, or you use your own financial institution’s software to do this for you. If you’re not confident, or don’t want to take the time, it’s a good idea to find a financial planner to help (more on that later).
With so many financial planning tools out there, a determined investor absolutely can do this on their own. But this freedom of choice sometimes becomes a constraint. And many people feel more comfortable hiring someone to help them make those choices.
And to help avoid mistake #2.
2. Not having a consistent investment philosophy.
Having investment goals based on a long-term investment strategy is a good beginning. But it’s not enough.
You have to have an investment philosophy. An investment philosophy simply describes how you will invest. It states what you will invest in, and what you will not.
For example, at our firm, our investment philosophy was simple.
We only invested in low cost, tax-efficient mutual funds and exchange-traded funds. These were primarily index funds that only held stocks and fixed income instruments, like municipal bonds and CDs.
If we invested in any non-index funds, we personally researched that mutual fund or ETF. That way, if we were putting something in our portfolio, we could explain to our client why it deserved to be there.
We would periodically review client portfolios (usually 2-3 times per year) and rebalance as necessary. If a major event (like the COVID-19 pandemic) caused a severe stock market drop, then we would evaluate all portfolios. Then rebalance if necessary.
If there was a financial need within the next 5 years, we would ensure that money was in cash or individual bonds or CDs that would mature within that timeframe. Because cash is king.
Just as important, here’s what we did not do:
- Dabble in the stock market, buying and selling individual stocks
- Try to find the next hot stock
- Speculate in real estate
- Invest in alternative asset classes (like commodities or futures contracts)
Why? Because that wasn’t our expertise.
Warren Buffett is famous for never investing in a business he doesn’t understand. Whatever your investment philosophy is, it should be one that protects you from making tactical mistakes.
How to avoid this mistake:
Set clear boundaries for yourself.
What is it that you will do consistently? What won’t you do? If you’re not sure, then educate yourself.
If you’re a do-it yourselfer, find a group of like-minded people. If you think that low-cost index funds are the way to go, then find a group like the Bogleheads to talk shop. If you’re into real estate, focus on that.
If you’re looking to hire a financial planner, talk to several people. After a while, you can get a feel for who’s trying out a sales pitch, and who actually has an investment philosophy. And don’t stop until you find a financial adviser whose investment philosophy you believe in.
3. Not investing over the right time horizon.
Many of my clients used to ask,
“I’ve got $50,000. I won’t need it for at least 2 years. What should I invest the money in?”
Our answer was always simple. We simply told the client that we were not going to speculate with that money.
The best that we could do is find some highly-rated municipal bonds with a 1-2 year maturity date. And we’d take whatever interest rates were available. Because we wanted that money ready when the client needed it.
Consistent with our investment philosophy.
Many people make the mistake of not investing over the right time horizon. For example, the above approach wouldn’t make sense for someone who is saving for retirement in 20 years.
So how do you figure the right time horizon for a goal?
Make it part of your investment philosophy.
Here are two scenarios you should plan for.
1. If you have a certain amount of money set aside for a specific goal,
Then establish boundaries on what you’re going to do with it. Will you keep it in cash? Will you buy municipal bonds or CDs with it?
Will you dabble in the stock market? If so, what will you do if stock prices are down when you need that money?
Our philosophy was simple. If we had a short time horizon, we would focus on safety of principal. Because keeping 100% of the money we had in hand was better than taking on a short-term risk.
2. If you need a certain amount of money by a certain date in the future,
Then will you let yourself take the money from your investments? And how do you do this?
As our clients identified financial needs, we would simply incorporate that into our investment rebalancing.
For example, the Smiths normally keep $50,000 cash in their brokerage account as an emergency fund. Mrs. Smith tells us that they need an additional $50,000 for a new car purchase. During our next rebalancing, we would simply make the appropriate trades to ensure they had $100,000 available.
Because incorporating financial needs into our rebalancing decisions helps avoid irrational investment decisions.
4. Making irrational investment decisions.
Irrational investment decisions are usually emotional decisions made by people experiencing one of two things: fear and greed. Both emotions lead to some of the most costly investment mistakes.
Fear drives investment decisions when the stock market has gone down. Or the experts are fearful for the economy. Or interest rates. Or whatever people are afraid for during this news cycle.
Truth is, it’s never as as bad as people fear it to be.
Client example of fear:
In April 2020, one of our clients called us up and asked us to sell everything in her brokerage account. The stock market was down over 30% in about a month due to the coronavirus pandemic. The news was getting worse every day.
No matter how much we pleaded, we could not get her to reconsider. So finally, we executed those orders. And on the day we did, the stock market stopped trading. Again.
When it reopened, all of her ETF trades executed. At significantly lower prices than before the market halted. But prices kept going lower and lower throughout the end of the day.
And the mutual fund transactions hit after the market closed. At the statistical bottom of the market in 2020, my client sold everything. And had HUGE capital gains.
All of our other clients stayed put. Some put extra money into the market. But most of them kept dollar-cost averaging through their 401k plans at work.
Those clients were feeling pretty good by the end of the summer. And for the rest of the year as the market recovered. Let’s talk about the other emotion that drives rash decisions.
Remember 1999? Or 2007? Probably not as well as you remember the dot.com bubble burst of 2000 or the Great Recession in 2008.
Every stock market recovery has some period where the fear goes away. At first, it’s the smart money, coming off the sidelines and finding investment opportunities while everyone is still running scared.
Then it’s the news, telling investors everything is going to be okay. After a while, people realize that the stock market decline wasn’t as bad as it could have been.
But then there’s an inflection point. It’s hard to tell when newly found confidence turns into greed. Kind of like a frog in a boiling pot.
Maybe by the time you notice, it’s because the news channels are yelling at you that you’re missing out on opportunities. Get in before it’s too late!
Every burst bubble starts with irrational decisions based on greed. Then fear.
How to avoid this mistake:
If you’re following the first 3 recommendations, you’re mostly there. To recap:
- Have clear objective goals
- Have a solid investment philosophy, and
- Are investing over the appropriate time horizon and generating cash as needed when events arise
If you’ve done those three things, then you have taken most of the emotions out of your investment management. And that’s how you avoid some of the most costly investment mistakes. Like worrying about what you can’t control.
5. Worrying about what you cannot control.
Let me say this up front. In the long run, nothing exists that:
- Is out of your control, AND
- Worth worrying about.
And if you establish clear goals, have a solid philosophy, and have the right time horizons for your cash needs, then you’ve taken care of most of the big stuff.
So if the stock market is going to crash, don’t fret. What you do with your $100,000 (or a million, or 10 million) isn’t going to put a dent in a $40 trillion stock market.
If Jim Cramer’s yelling at you about losing investment opportunities, you might. But losing out on the next hot stock isn’t something you can control. Even Warren Buffett misses investment opportunities waiting for the right one.
But you do need to take time to make adjustments.
6. Not making adjustments over time.
Lots of people discuss the philosophy of, “Set it and forget it.” And that can get most folks through a working career.
Spend less than you earn. Save the rest in your 401k or Roth IRA. Pick 3-5 low-cost mutual funds or ETFs and ‘set it, then forget it.’
But things change over time. Like retirement. What do you do then?
That’s when most people get stuck, because ‘set it and forget it’ doesn’t get you through retirement. Not without some adjustments for losing that paycheck.
Saving for the kids’ college? What happens when they graduate? Paid off all your credit cards? Now what?
Take time to evaluate everything. Rebalance as necessary. Make those adjustments.
And if you can’t do that yourself, then be brave enough to admit that you might need help.
7. Not asking for professional help.
There are so many horror stories about advisor fraud that people overlook a basic principle about financial planning. Most financial planners (and other investment professionals) come into this industry to help people with their money.
And because they’re so distrustful, a lot of people do this on their own. Because they feel like they can do it better. At a lower cost.
Some folks do outperform their advisor. It’s not rocket science.
But maybe it’s also during a really bullish stock market, when a financial advisor would have been more prudent about their investment recommendations.
Are you willing to do the work?
To do it right, you have to stay on top of it. You have to be willing to educate yourself about finances. Continuously.
Things like tax planning, Roth conversions, estate planning-those are all services that financial planners help their clients with. And the vast majority of them are the good guys.
If you’re not willing to do the work, then look around for someone who will help you. Ask friends that you trust. Ask insightful questions during your prospect meetings.
And you’ll find the right fit for you.