Few words better characterize today’s financial markets than uncertainty. We believe investors need to adjust their expectations in order to adapt to the road ahead. It seems to be the nature of today’s markets to subject investors to sharp price fluctuations and confusing global events that test emotional fortitude at every turn. Experience has taught us that successful investing requires discipline and the patient execution of a long-term strategy, most especially when it is emotionally difficult; in fact, that is usually the time when opportunities are greatest.
In order to help our clients chart a course in uncertain waters, we’ve compiled a list of critical mistakes investors should avoid:
Mistake #1: Expecting a Smooth Ride
You probably remember the heydays of the 90’s when many investors felt like they were on an elevator heading for the top floor. Today’s markets are not like that, and it’s a mistake to think that we will return to those conditions any time soon. In this “new normal” economy, big swings in the markets have many people scared stiff. However, even in a choppy market, with the appropriate mix of investments, there is money that could be made. In order to help navigate the turbulent markets of today, it is critically important to structure your portfolio to seek to minimize declines in down markets. This definitely does not mean to cash out when you lose confidence and re-invest when you begin to feel better about the markets (See Mistake #2 about the perils of trying to time the market). This means that during periods of market turbulence, you may need to adjust your mix of investments.
Mistake #2: Trying to Time the Market
When markets are rallying or pulling back, it’s often very tempting to try and seek out the top to sell, or the bottom to buy. The problem is that investors usually guess wrong, missing out on the best market plays. Does the cost of trying to time the market make a big difference in your returns? You bet it can.
For example, between 1986 and 2005, the S&P 500* compounded at an annual rate of 11.9 percent –even while weathering Black Monday, the dotcom bust, 9/11, and various booms and busts. Over that period, $10,000 invested in 1986 would have grown to over $94,000. However, according to a recent Dalbar report, the average investor’s return during that period was just 3.9 percent, meaning that same $10,000 grew to just over $21,000. Why? Trying to time the market. The average investor misses out because their money tends to come in near the top and come out at the bottom.
Mistake #3: Taking Too Much Risk
Not only do many investors pay the timing penalty, they also pay a penalty for having too much risk in their portfolios. During the bull market days of the late 1990s and early 2000s, money poured into equities, mostly into risky tech and internet stocks. The boring “value” stocks trading at low earnings multiples saw many of their investors fleeing towards higher returns. However, during the terrible bear market that followed 9/11, many of those “boring” value stocks weathered the storm well, while the bottom fell out of the tech industry. Investors who took on too much risk, afraid to miss out on the dotcom boom, saw their portfolios take a severe beating. One of the major differences between amateurs and investment professionals is that the professionals seek to understand and manage portfolio risk. Prudent investors consider the risks contained in an investment position and cut down their position and market exposure if they determine that their portfolio contains too much risk. Future markets may still be volatile, and holding too much risk can spell disaster for your financial future.
Mistake #4: Taking Too Little Risk
Today’s markets are highly volatile and investors are playing it safe, fearful of losing portfolio value. However, a portfolio containing too little risk can leave you feeling safe but sorry as you miss out on the important market rallies. With so much turbulence in the markets, many investors are flocking to so-called safe haven investments like U.S. Treasuries and cash. This aversion to risk can have serious adverse effects on long-term investments, as too many fixed-rate investments put a cap on your portfolio’s upside. Inflation is a serious concern in long-term investing and too little growth in your investments can leave you with a shortfall in your retirement years. In a reaction to 2012’s turbulent markets, investors pulled more than $28 billion from U.S. stock investments, even as the S&P 500 rallied more than 18 percent. It’s not hard to see why wary investors want to take a more cautious approach, given economic turmoil and the cloud of uncertainty surrounding taxes. However, by trying to reduce the chances that their portfolios will suffer large losses, investors may be trading one type of risk for others, including inflation risk, high valuations, and greater-than-expected volatility. While it is true that equities have greater loss potential than short-term fixed-rate investments, they also have a greater potential for gain. For many investors, hunkering down in safe haven investments is a luxury they simply can’t afford. With inflation eating away at cash every year, most investors need at least some growth-oriented investments.
Mistake #5: Making Emotional Investment Decisions
Emotional decision-making can wreak havoc on the most carefully designed investment plan when markets swing. The vast majority of investors lost money in the mortgage-meltdown crash of 2008. Many cashed out near the bottom, fearing that the markets themselves were collapsing, and, even as markets have experienced rally, many investors still have their money sitting on the sidelines. The scars of the crash, when the markets experienced serious intra-day swings, run deep. A 2011 study by benefits company, Aon Hewitt, showed that boomers are especially at risk of making emotional investment decisions. Study results showed that those nearing retirement become very loss averse, and are prone to bailing on the market during declines. The problem is that these are the investors who may have the most to lose by making poor investment decisions.
There are two emotions that you need to confront whenever you make financial or investment decisions: fear and greed. Fear can cause us to abandon an investment strategy when the outcome is not what we want. Greed can cause us to chase investment fads and take on too much risk. It’s impossible to avoid feeling these emotions when making important financial decisions; however, you can recognize them, and engage your rational mind to overcome them.
Mistake #6: Failing to Diversify
The first step of a diversification plan consists of diversifying between asset classes. This means maintaining a good mix of stocks, bonds, cash, and perhaps some other types of alternative investments like real estate, or other investments that are a good fit for your goals and investor profile. The problem is that many investors have a tendency to chase performance by aggressively investing in a single class of investment: stocks when the equity markets are rallying, and bonds or cash during a market decline. This lack of diversification can play havoc with a portfolio during times of market turbulence. The second part of a properly diversified portfolio is diversifying within an asset class. One of the most critical mistakes many working investors make is to have too much (more than 10-15 percent of their portfolio) in their company’s stock, which can spell disaster if it takes a turn for the worst – imagine, losing your job and your retirement savings in one fell swoop. For example, it’s important to have a good mix of small-cap, large-cap, international, and sector-diverse equities in a portfolio*. While a certain stock or sector might be affected by a market decline, a gain in another might offset it.
*Alternative investments may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio.
Mistake #7: Focusing More on Returns than Managing Risk
Chasing performance is one of the biggest errors made by investors. That feeling of, “I don’t want to miss out on this,” has probably led to more investment mistakes than any other single factor. If you take the time to study past performance, you will discover that it is not a reliable way to predict future winners. The growth stocks that were popular in the 90s had been churning out double-digit returns for several years, when they suddenly went south, taking many investors’ portfolios with them.
The lesson here is that if a particular asset class has outperformed for three or four years, you can know one thing with certainty: you should have invested three or four years ago. Often, by the time the average investor has decided to invest, the “smart money” has already gotten out while the not-so-savvy money continues to pour in.
Mistake #8: Ignoring the Impact of Taxes
When looking at investments, one of the key rules to keep in mind is that you should always be looking at the after-tax return of an investment. At first glance, a 5 percent return beats a 3 percent return any day of the week. However, if the 5 percent return were from taxable stock dividends and the 3 percent came from tax-free municipal bonds, then the situation changes. For example, a hypothetical $10,000 investment might be worth $17,908 after 10 years at a 6 percent annual return. However, after accounting for hypothetical state and federal taxes (5 percent and 25 percent, respectively), you would only take home $11,228, pushing your annual return down to just 1.2 percent. It never pays to ignore taxes. You should consider the impact of taxes whenever you buy or sell investments, develop a financial plan, discuss your estate or philanthropic plans, or give gifts. Remember that the federal government taxes investment income, like dividends, interest, and rent on real estate, as well as capital gains. This is why it’s critical to structure your investments in a tax-efficient manner to avoid having the taxman take a big bite out of your gains.
Mistake #9: Not Seeking Professional Advice
In a study conducted at Yale and Princeton, psychologists gave students questionnaires asking how they compare with their classmates in a variety of skills and tasks. For example, one question asked: “Are you a more skillful athlete than your average classmate?” The overwhelming majority of students responded that they are above-average athletes, drivers, dancers, students, and so on. Obviously, not all of them can be above average, but their self-perception led them to believe it was so. The same issue of over-confidence exists among investors. It was easy in 1999 and 2000 for investors to delude themselves about their investing skills when a few lucky stock picks quadrupled overnight. However, how many of these genius investors do you think were able to save their portfolios during the bear market that followed? Successful long-term investing requires the skill to position your portfolio for return potential in bull markets and the discipline to stay the course when markets decline. This is when it may be beneficial to have a professional money manager.
One of the greatest potential benefits of professional financial management comes when markets are declining. We educate our clients on the opportunities that market turbulence sends our way and keep them focused on their long-term goals, not on short-term gyrations. As financial advisors, we spend our careers charting courses through turbulent markets and help achieve results for our clients. As professionals, it’s our job to stay on top of ever-shifting economic, financial, and legal issues so that our clients don’t have to. Quite simply, the old days of achieving steady returns through cookie-cutter approaches appear to be over. We believe successfully navigating the turbulent investing world of today requires training, prudent management, and commitment to a long-term, active investing strategy.