1. Taking Excessive Risk
Many investors gravitate toward investments offering the highest potential returns while ignoring the associated risks. If your investment loses 50% of its value during a bear market, it will take a gain of 100% just to return to break-even status.
The goal of a well-diversified, balanced portfolio is to reduce market risk while earning steady, consistent returns over a long time horizon. Minimizing losses during downturns generally produces higher average compounded returns in the long run.
2. Using Stocks to Meet Short-Term Cash Needs
Funds needed to meet a specific financial goal in less than a three-year period, and perhaps longer, should not be heavily invested in stocks or stock funds. Examples of goals are a car replacement, the down payment on the purchase of a home or even plans for a major vacation.
The logic behind this is simple. Stocks are quite capable of losing 30% of their value or even much more in a rather short period of time. When these periods of volatility occur, the odds are that you will not escape the carnage. Based on historical data, it often takes two to four years and sometimes longer to recover from a major market setback. When your goal is short-term, it is more important to protect your resources than to reach for higher returns.
3. Lack of Diversification
Diversification is the key to managing total portfolio risk and volatility. Reallocating funds moderately between asset classes that have a low correlation relative to the U.S. stock market can potentially reduce portfolio volatility without significantly sacrificing long-term portfolio returns.
4. Keeping Most of Your Eggs in One Basket
A concentrated investment strategy is the quickest way to accumulate wealth as long as you make the correct investment decision. It is also the quickest way to lose wealth if you make a poor investment choice.
A general guideline is to limit any individual stock to 5% or less of the stock portion of your total portfolio. An allocation above 5%, while carrying significant risk, could be justified if you are knowledgeable about the specific investment and are confident that this particular investment can outperform the broad market or other alternatives.
5. Stretching for High Yield at the Expense of Quality and Stability
Income-oriented investors frequently are attracted to the promise of high-yielding investments. It is important to mention that investment returns are composed of two factors. One factor is the income or yield that is generated in the form of interest or dividends. The second factor is capital appreciation or depreciation (loss).
Total return, the sum of these two factors, is the bottom line and all that counts. If an investment advertises a yield that seems too good to be true, it probably is. Interest rate or yield is irrelevant if you lose your investment.
6. Keeping Too Much Capital Tied Up in Low-Return Assets
It is quite common for many investors to gradually accumulate large sums of cash in low-return bank checking, savings and money market accounts. Invest some of the excess cash or permanent cash portion of your portfolio in high-quality, short-term or low-duration bond funds with low expense ratios to enhance returns.
7. Avoiding Paying the Government at All Costs
A common investment mistake is to focus on tax-advantaged investments instead of after-tax returns. Investors often become obsessed with trying to avoid paying taxes. A tax-exempt investment must be analyzed on a case-by-case basis to determine whether or not it makes sense in a particular situation. The best way to do this is convert all returns to after-tax dollars.
For the average investor, it may be possible to net more after tax by investing in a comparable taxable investment rather than the tax-exempt investment. You have to run the numbers to find out.
8. Investing Based on Hot Tips and Rumors
Following this investment strategy is the quickest way to accumulate a “shoe box” portfolio. There are several problems with this approach. First of all, is the source of the advice reputable?
The second problem is that of placing individual security selection as the highest priority ahead of your personal goals, time horizon, tolerance for risk and all the other critical investment factors that make up a personal investment policy statement. Individual security selection is actually the least important investment decision to be addressed.
9. Failing to Think Globally
Academic studies consistently demonstrate that a 15–25% allocation to international funds in the stock portion of a portfolio (not 15–25% of the total portfolio) can actually reduce portfolio risk and sometimes enhance returns.
10. Taking More Risk Than Necessary to Meet Your Goals
As wealth increases, it becomes more important to protect what you have while earning a reasonable return rather than focusing on achieving the greatest absolute return and taking excessive risk.
Christopher Parr, CFP, is president of Parr Financial Solutions, of Columbia. He can be reached at 410-740-9011 and via www.ParrFinancialSolutions.com.