When it comes to investing, your worst enemy may be the person in the mirror. It’s a hard truth that almost everyone who invests money has to face at one time or another. Understanding that we all make common investment mistakes — and learning to avoid them — is one of the keys to getting consistent returns.
The good news is, with a little effort, you can learn to avoid the big killers of returns that leave you with a meager one or two percent at the end of five years. Like Captain Renault in Casablanca, let’s round up the usual suspects that are lowering your investment returns.
Making Emotional Decisions
Investments are a tool, nothing more, and they’re all governed by three relatively simple concepts: time, risk and returns. Risk can be mitigated by either a longer investment window, which will average out the ups and downs, or by accepting lower returns. Returns can be increased by accepting more risk, or investing over a longer time horizon. The time you have before you’ll need to access your money will determine what investment classes make the most sense. Weighing those three factors is all there is to it.
Not Rebalancing Your Portfolio
In a diversified portfolio, some funds will do well, some won’t. Over time, the winning funds will comprise a larger percentage of your portfolio, and most people want to stick with the winners. If that goes on long enough, your portfolio gets lopsided — and the most unnatural act in the world is selling off some of the winners, and putting that money into the losers to even out those percentages. No one wants to reward poor performance, yet that’s exactly what you need to do at least once a year. Rebalancing works because no investment style or sector stays in fashion indefinitely, and you can’t know which sectors are going to be hot next year.
Borrowing From an IRA or 401(k)
This is the silent, deadly killer of 401(k) returns. Borrowing from your retirement plan is a double hit; first you pay a penalty to the IRS, and then your investment money becomes a liability that you have to pay back. Borrowing money for a life-saving operation is one thing, but too many people are tapping retirement savings for vacations or a down payment on a house — and crippling their investment returns for decades.
Giving in to Confirmation Bias
Today we have such a broad range of media options, we can pick the ones with beliefs most similar to our own. That is not an accident: people are more than twice as likely to select information resources that confirm what they already believe. That’s human nature, and it leads to systematic flaws in our judgement. Confirmation bias in investing is a disaster waiting to happen. You should not only seek out diverse news sources, you should deliberately seek out those that see the market and investing differently than you do.
Following the Herd
In 2008 the herd was stampeding for the exits, selling at a loss just to try and stem the flow of red ink and salvage some of their money. The people who held on eventually recovered. My wife thought I was crazy because I was buying stocks and funds all through the crash like a kid in a candy store. I quit buying when the market hit bottom in 2009, not because I’m some genius investor who can time the market, but because I was literally out of free cash to invest by then. If you follow the herd you’re going to sell low and buy high; not a winning strategy. While it sounds easy to say you’ll be a contrarian, your gut will be screaming RUN when the market crashes and it takes a lot of fortitude to go against the tide of herd behavior.
Parroting Conventional Wisdom
Conventional investing wisdom says the percentage of money you should have invested in the stock market is 100% minus your age. Conventional wisdom says your home is the best investment you can make, and you should only withdraw 4% of your investments during retirement. The problem with conventional wisdom is that hardly anyone is conventional.
My dad, who has been retired longer than most people alive today have been investing, made 28% last year. Most financial advisers and conventional wisdom would say he has far too much money in the stock market for someone his age. He takes out more than 4% some years, less most of the time; it depends on whether he needs the money, or if the IRS says he has to take more out of his IRA to avoid penalties. His biggest problem isn’t having enough money for retirement, it’s estate planning. We should all have such problems — and he got there by consistently ignoring conventional wisdom. Dad didn’t put money into a house; instead he invested it, and later bought a house when he could pay cash. Every situation is different, and conventional wisdom conveniently tends to serve the interests of the financial industry rather than the individual.
Being a successful investor is not rocket science; it means picking low-cost, high-quality investments and sticking with them. It means rebalancing your portfolio at least once a year, and seeking out a wide spectrum of financial advice. It means hanging in when the financial news is bad, and putting more down when the news is bleakest. Mainly being a successful investor means doing what’s right for you — instead of what’s right for your investment adviser.