7 Common Investing Mistakes
The unknown
In 1973, Burton G. Malkiel wrote a book that has since become one of the most popular and often-cited publications about investing. The book, “A Random Walk Down Wall Street,” galvanized and popularized what Malkiel called the “random walk theory.” In short, the random walk theory states that stock prices are random and are nearly impossible to predict. It states that, to seek returns in the stock market, you are as good picking random stocks as you are smartly curating a list of “favored” ones. In other words, a random walk down Wall Street is every bit as good as a well-planned route.
It’s hard to imagine Malkiel was right. After all, smart investing experts were lecturing about investing long before 1973 and haven’t stopped since. In fact, this financial noise may be even louder today. If you seek investment advice on how to get ahead in the market, you’ll surely find it (likely followed closely with a sales pitch on the investment too!). There is no shortage of investment professionals who think they can beat the random walk theory.
But what if he was right? What if investing is a random roll of the dice? One of my favorite stories supporting this idea is the hilarious findings from a Fidelity study looking into their most successful retail investors. Fidelity found that their most prolific investors were not who they expected. They weren’t the investors with the most skill in investing or those who worked in finance. They found that their best clients were those who had completely forgotten they had an account.
What not to do
I happen to believe Malkiel was right, and still is. Aside from trading on inside information (which is a felony), beating the market is nearly impossible. I can’t do it, you can’t do it, even professional fund managers can’t do it. If you believe you have a sure-fire tactic to beat the market or know the best fund manager that believes they can, please let me know. I’ll take the short side of that bet every time (as will history).
While there’s probably nothing we can do to beat the market, it turns out there’s a WHOLE LOT we can do to lose to it. There are limitless foolish things people can do with their money in the stock market. If they want to lose even faster, there are options and leveraged investments to help do so. Funny enough, and very ironically, most of the things people do to lose money in the market are done so in a futile attempt to win.
The best we can honestly hope for is a draw. Take the market returns and live happily ever after. So, since there’s nothing we can do to beat the market, we should focus instead on what NOT to do to lose to it. In that spirit, here are the seven most common “don’ts” in today’s investing environment.
Don’t: own less than 10 stocks in your portfolio.
Risk is a part of investing. It is ubiquitous and unavoidable. The trick is avoiding as much of it as possible. That is, while you can’t get rid of it, you should lower risk to its absolute minimum relative to your required return.
Fortunately, you can eliminate unnecessary risk through diversification. Diversification is the idea of not putting all your eggs in one basket. If you’re someone who has all of your investments in one company, then you’re one corporate bankruptcy away from becoming bankrupt yourself. Choosing 10 to 40 good companies across different sectors and industries is what most professionals consider a properly diversified portfolio. Many, including me, prefer index funds for their hyper-diversified and self-cleansing features. Index funds are diversified because they contain every single security in the benchmark. If unnecessary risk can be diversified away with as few as 10-40 stocks, then surely it can be done with every stock in the market.
Don’t: pay high fees and expenses.
Remember when I said no one can beat the market? I really meant no one. Hundreds of studies have been done on which fund managers, if any, can consistently beat the market. These studies repeatedly show that the law of averages is undefeated. It pulls every successful investor and fund manager back to the mean. Sure, a few managers can beat the market over a few years. But, it’s impossible to know which managers are about to have their golden run. Typically investors find these managers after their successful stint, only to invest in a fund that is about to regress to the mean.
So what about fees and expenses? Well, investment management comes with a cost. The most common fees associated with mutual funds are reflected in their expense ratios. While most expense ratios have been dropping over the past 20 years or so, they still exist, siphoning precious returns off your portfolio. Ironically, the more actively managed the fund is, the higher the expense ratio. That is, if a fund manager does a lot of stock picking and trading within a fund, they demand a higher fee for their labor. And, as I’ve said, the more active a manager is, the less likely they are to beat the market (because they can’t). Bottom line: a lot of investors end up paying higher fees for increasingly substandard returns.
Don’t: forget to set goals.
In my recent article, “What Are You Saving For?” I talked about the importance of saving with a purpose in mind. Saving with purpose, or a goal, has two benefits. Not only are you more likely to stick to your savings plan, but it feels much different putting money towards an important savings goal than a general account with no reason behind it.
Investing is no different. Many people are aware that they should be investing (you’re reading this aren’t you?). However, beyond obvious goals like retirement and education, it can feel like we’re just investing for the sake of investing itself. We’re just putting enough aside to get our 401k match (because we were told to) and throwing some in a 529 or brokerage account when we have it. The biggest problem with not creating goals is we have no idea if we’re on track or not. We could be on pace, we could be behind, and more surprisingly, we can also be wildly ahead of pace and taking on more risk than we need.
Just as with savings, investing with a goal in mind has many benefits. It gives us an idea of what type of portfolio we need, how much we need to set aside, and most importantly, what kind of lifestyle we can lead in the meantime. Lastly, it has the emotional benefits I mentioned above. Invest with a goal in mind and, not only will you be much more successful, but you’ll have a more positive and hopeful outlook on your future while you’re doing it.
Don’t: react to short-term news.
Outliers are exciting. There’s nothing exciting about normal. When you consume any form of news, entertainment, or other media, you’re likely being entertained by an extreme story or an outlier. Your attention is being held by something that doesn’t happen often or someone who defied the odds. Simply put, it’s interesting because it isn’t normal.
Financial news is no different. Part meant to inform, but mostly meant to entertain, financial news will always focus on some recent flash or outlier. The successful investor who scored big on a long shot. The microcap startup that no one knows about yet. The new crypto being launched by a movie star, and so on. The news usually focuses on extreme winners and losers, too. While it can be informative, it is meant to keep your attention and ultimately sell ad space.
It’s good to be informed about financial matters, but great caution should be taken before acting on any of it. The best way to avoid reacting to short term news is to build a portfolio around your individual goals, risk tolerance, and time frame. Then, stick with it. If you invest in a well-diversified portfolio built for your needs, you need not worry about a company's bankruptcy or a new computer chip. Chasing returns, as we’ve discussed, leads to losses and frustration.
Don’t: avoid necessary risk.
We’ve already talked about risk, but there is more to consider. Earlier, we talked about the importance of avoiding unnecessary risk. That is, the importance of diversifying your portfolio enough to avoid the impact of one bad investment in your portfolio.
Yet, while we should avoid unnecessary risk, we should be willing to accept necessary risk at the same time. Necessary risk, otherwise known as systematic risk, is the risk shared throughout the entire market. That is, it is the risk of investing in the market as a whole. When the stock market experiences losses on the day, that is a form of systematic risk. It is the chance of loss shared by every investment collectively.
If you’re risk-averse, you’re likely OK with the idea of avoiding unnecessary risk, but you should be careful not to avoid risk altogether. Remember, risk in an investment is usually tied to return. The higher return we expect in an investment, the more risk we should be willing to take. Someone who wants to avoid risk altogether will eventually find themselves avoiding return, too.
When a severely risk-averse investor focuses on minimizing risk, they turn to more stable investments. Bonds are the most typical and favored form of lower risk investments. When a risk-averse investor wants even less risk, they then turn to CDs and savings accounts as a safe harbor from the fear of loss. In the extreme form, they might choose cash stuffed in their mattress.
What our risk-averse investor fails to realize is that the value of money diminishes over time through inflation. While cash stored in a physical safe is free from most every type of risk, it faces a risk unique to low or no-return investments: loss due to inflation. To balance your portfolio's risk, focus first on the return you need. Don't fixate on the risk. Once you know the required return, you can focus on embracing the necessary risk associated with it. Read more on risk here.
Don’t: fall in love with your investments.
Investing can be emotional. It’s strange, but if you have ever bought stock in a company, a strange emotional connection can develop between you and the company you purchased. I’ve definitely felt this pull. When I was younger, I spent years trying my luck as a novice stock picker. Selecting stocks and watching their prices rise and fall. I would feel different about them each day, similar to how a sports fan feels about their beloved team. It’s a very strange connection that grows easily and can end up clouding your judgment.
This emotional connection can be amplified when your investments are tied to a goal that is important to you (and again, it should be tied to a goal). If you own Coca-cola stock in a retirement account, it's hard to separate your feelings about Coca-cola from your retirement. Coca-cola, its employees, its factories, and everything else about the company feels like part of your retirement journey.
When our investments do well, we can feel endeared to them; grateful for their contribution to our goals. When they perform poorly, we can likewise feel jilted they would interfere with our dreams. Ironically, outside of our shareholder’s rights, these companies don’t regard us at all. They don’t care if we’re saving for retirement or a boat. They are only focused on making the best product they can, doing it cheaper, and making a profit (for them and us).
Remember, it’s just business. If you own a company and their business model, growth strategy, or dividend share begins to fall outside your investment goals, you should seriously and dispassionately think about trading into a company who fits your investment needs. It isn’t personal and trust me, the company will regard your sale as much as they regarded your purchase of their company: not at all. An emotional connection to your investments is a one-way relationship. A relationship you should avoid.
Don’t: create inflexible goals.
I wrote an article earlier this year called “Risk Realized and the Goal Window.” The article was part of a series exploring risk and its various aspects. Included in this article was my idea of the “goal window.” It’s an idea I’ve had for years, but one I have grown more fond of over time.
Financial planners excel at number crunching. One of our best qualities is our ability to analyze your expenses. We can help you estimate them into the future, adjust for inflation, and more. We will curate a portfolio for your needs, create an investment plan, estimate returns, and forecast them into the future. “Boom, you can retire on your 65th birthday with $1,400,000 in your retirement accounts. You can live on $56,000 a year plus Social Security, spend every penny you make, and leave something for your kids.”
As impressive as retirement forecasting is, it can create a problem. If a client heard the above scenario, they probably heard one thing: I will retire on my 65th birthday and have $56,000 in income. While they might be very happy with this idea of retirement, they might end up anchored on this very specific scenario. The problem with such specific numbers, is that there is probably some danger lurking ahead. Perhaps the market underperforms. Perhaps inflation is higher than expected. Finally, perhaps the investor moves into overly conservative investments too soon to meet this narrow goal.
This is where a goal window could help. Let me explain how it works using the example of our client wishing to retire.
First, imagine a graph with an X/Y axis. The X-axis reflects the client’s age and the Y-axis reflects the amount in his account. Up in the quadrant is a dot that reflects our goal. It is placed right where age 65 and $1.4 million intersect.
Now instead of our dot, let’s imagine a horizontal line. It resides on the same $1,400,000 line, but begins at age 55 and ends at 67. If our client is only concerned with a $56,000 lifestyle, then perhaps all he needs to worry about is having enough money to do so. So, age 65 doesn’t matter as much as the $1,400,000 goal. In this case, he has a goal window of age 55-67 to reach his mark. This type of window might allow him to accept more risk and return than he otherwise might have avoided. Of course it might delay his retirement a few years, but it might also get him there sooner. Either way, the window allows him to be more accepting of retirement, whenever that might be.
What about the vertical? That’s another option for a window, too. Let’s say our client isn’t as concerned about the exact number he needs to retire. He wants to work until 65 and no further. No matter the number, he’ll make it work. For this, imagine a vertical line instead of a horizontal one. It is placed on the X-axis at age 65 and begins at $1,000,000. For obvious reasons, this line stretches up infinitely; there’s no such thing as having too much money to retire! Now our client has another form of flexibility. He has conditioned himself to accept unpredictable results in the market, but still retains some control over his fate. He’ll retire at 65, adjust his living expenses accordingly, and live the life afforded to him.
If the client is wise enough to accept some flexibility, he is much better prepared for retirement than if he narrowed in on a specific goal. After considering both options, he might consider the following: I’ll retire early if I get to $1.4 million, but by age 66 I’ll retire and make do with what I have. Now we have some flexibility to play with.
The thing I like most about the goal window, besides the emotional benefit of flexibility, is the ability to accept more risk and return. For instance, if our goals are inflexible, we have to be a lot more careful about the risk we take in our investments. If I know I have to have exactly $148.02 in 10 years, then I know I need $100 today and a 10 year CD paying 4%. What about putting it in the stock market? I could, but the exact nature of my goal dictates a much more conservative approach. It limits the type of investments I can consider, and most importantly the risk (and return) profile I’m able to accept.
The point is: don’t be inflexible with your goals. By remaining flexible, not only will you be able to accept more risk in your portfolio, but you’ll be more emotionally prepared for how they turn out.
