Written by G. Thomas Watson, CFA, CFP®
In the words of Ben Graham, arguably one of the most successful investors of all time, "The investor's chief problem – even his worst enemy – is likely to be himself." As Graham and decades of research have uncovered, most investors fall victim to their own emotional and irrational behavior based largely on the short-term outcomes of their investment decisions. The failure to adhere to a long-term strategy steeped in sound principles and practices results in a haphazard approach to investing that invariably leads to costly mistakes.
Here are the most common blunders we often see investors make.
1. Holding Too Much Cash
Investors who sit on too much cash are making two significant mistakes. The first is that, well…they are sitting on too much cash. Is there such a thing? Of course! Especially in an inflationary environment. Cash that isn’t invested erodes every second it is sitting in a non-productive account, like a bank account or money market account with minimal return. The passage of time eats away at its own purchasing power. There is a fine line between having enough cash for your “rainy day” or emergency fund and holding more than is necessary. Consult with your advisor to find the amount that is appropriate for you.
2. Trying to Time the Market
The second mistake made by investors is that simply try to “time” the market. Many investors who were spooked out of the market by the spine-chilling crash in March 2020, believed they could limit their losses by pulling out. But instead of protect from loss, they incurred more! They effectively locked in their losses. Many of them proceeded to sit on their cash, waiting for the "right" time to reenter the market, thereby missing out on the quickest and most robust market recovery in history. Would you have wanted to miss out on the performance of this past year?
Trying to time the stock market, or guessing which direction it will move next, is impossible to do with any degree of consistency. Many investors fail to understand that, for every steep market downturn or bear market, a strong recovery or bull market follows. It's been that way for more than a hundred years. Trying to “time the market” can be a dangerous habit. Sometimes, investors think they can outsmart the market; other times, fear and greed push them to make emotional, rather than logical, well thought out decisions.
Investors who pull in and out of the market at moments of worry typically miss the rebound and suffer both short-term tax consequences and long-term wealth-building opportunities.
3. Where are My Crucial Asset Classes? Missing Out on a Piece of Each Pie
Most investors understand the importance of diversification for reducing market risk, but they fail to understand how it plays out in their own portfolios.
Proper diversification—the kind that actually works—requires having a range of asset classes in your portfolio with varying price movements and volatility patterns. If you exclude certain asset classes, you could actually be increasing your risk exposure while restricting your potential returns. Of course, this is the exact opposite of the goal.
For example, small-cap stocks can be more volatile than large-cap stocks, but they have outperformed large-cap stocks over time. Foreign stocks behave differently than U.S. stocks and represent half of the global market capitalization. If you leave one or more of these out of your portfolio, you would be objectively under-diversified. Proper diversification is about selecting the appropriate mix of assets and their weightings to conform to your objectives.
In fact, your mix of investments matter a whole lot more than you’d think. In a study conducted by Gary Brimson, called the Determinedness of Portfolio Performance, it was found that as much as 93 percent of the variation in volatility and returns is determined not by individual investments but by the structure of asset mix. That is to say, the actual mix of assets is far more critical than the selection of any particular investment.
Keep in mind, while the goal is to be diversified, it’s important that your portfolio is efficiently diversified. It happens all too often -- investors attempting to follow the sound principle of diversification will invest in several very similar funds or investments. The problem is, when you closely examine the underlying holdings, it is common to find that many of the securities, if not most, are closely correlated. That means their prices tend to move in the same direction. That could be great when the market is rallying. However, it can be devastating when the market becomes volatile and turns downward.
The idea of diversification is to mix different asset classes that are not correlated with each other. Different asset classes perform differently in different markets. When the stock market rallies, some assets will perform better than other assets, and vice versa. We really can't know when a particular asset class will outperform another, so by owning a mix of assets with low correlations, your portfolio can capture returns in any market environment with less overall volatility.
4. Improperly Aligned Risk
Risk is related to returns. The more risk you are willing to assume, the higher returns you should expect, and vice versa. Your goals should be aligned with your risk profile, so your portfolio reflects both the level of returns and risk required based on your time horizon. Otherwise, you could be taking on more risk than is necessary or less risk than is needed to achieve your goals.
The danger here? Basically, not living the life you want. Working hard to build and working harder to maintain. This, of course, makes the entire endeavor feel, well…a little too hard at times. That’s because the risks you’re taking in your portfolio may not be matched to your life goals.
If you invest too conservatively relative to your return objectives, you could fall short of your goals. Investing too aggressively could introduce more volatility into your portfolio than you are willing to tolerate. Working with your financial advisor, you can design a portfolio mix that can align your return objectives with your risk tolerance and bring you closer to where you need to be.
5. Ignoring Tax Considerations
Most investors are surprised to learn how they can dramatically improve their long-term investment returns by considering their investment decisions from a tax perspective. The less you pay in taxes on your investments, the more your returns can compound over time.
It starts with knowing the difference between short-term and long-term capital gains tax rates. Securities held less than one year are taxed at ordinary income tax rates, whereas securities held for longer than a year are taxed at the more favorable capital gains rate, ranging from 0% to 20%, depending on your taxable income. Holding securities for the long term is a highly effective tax deferral strategy. Selling securities for a gain in the short term can result in taxes eating a significant chunk of the gain.
Another shock investors experience is with their mutual fund investments. Many mutual funds turn their portfolio over more than 100% in a year. That can have severe tax implications for a fund's returns. It can be better to invest in low-turnover funds or index funds that experience little if any turnover at all.
Another big mistake investors make is buying a mutual fund at the end of the year, right before capital gains distributions are sent or reported. In essence, you didn't have the opportunity to participate in the fund's returns over the year, yet you are responsible for the capital gains taxes for that year. Not the wisest move!
Bonus Mistake: Trying to “DIY It”
Avoidable investor mistakes can result in the loss of tens of thousands of dollars over your lifetime. Working with a trusted financial advisor, you can create a long-term investment plan around sound investment principles that keep you out of trouble. After all, it’s those investors who have a long-term investment plan they can stick with that tend to outperform those who don't. Don’t be one of “those guys.” Get the guidance you need to align your wealth in your favor.
Diversification does not assure a profit or protect against loss in declining markets, and diversification cannot guarantee that any objective or goal will be achieved
Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.