‘My Two Cents’ on 12 Investing Mistakes and How You Can Learn From Them

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On Wednesday December 12th, Pinyo over at Moolanomy re-published a guest post he originally wrote for Get Rich Slowly late last year. In the post Pinyo talks about 12 investing mistakes he’s made, and how you can learn from them.

I found the post very interesting because I think many of the points he made were spot on. He addressed many of the issues that investors face. I thought this would be a good opportunity for me to highlight the different sections of his post and add my two cents to each.

1. Not investing soon enough — I have been working part-time since my first year at college in 1991. If I had known what I know today, I would have invested my money in an IRA from day one. But like many other young adults, I was thrilled to have money and to spend it all on things that I enjoyed — movies, games, electronics, etc. If I had invested just $2,000 per year while I was in college, that $8,000 invested in an S&P 500 index fund would be worth about $36,000 today.

#1 - I think many are aware of the compounding power of money, especially in a tax protected account like an IRA. It’s amazing how by delaying your investment in an IRA, for just 5 years, how much it can impact the ending balance when you’re ready to retire.

On this site, I have 6 financial calculators (that you are free to use at anytime). I ran my own little test using the Don’t Delay Your Savings Calculator, and if you were to contribute $200 a month ($2,400 a year) for 5 years into an IRA account (preferably a Roth IRA) and it grew at 9%, you’d have $15,054 in 5 years.

This, I’m sure, jives with the numbers that Pinyo used in his example, although we’re talking about different time frames. That’s not a bad little nestegg for a $2,400 a year contribution that you’d probably not miss in the least bit.

By the way, if you took $15,054 and grew it out over a 33 year period (right around the time Pinyo and I would be scheduled to collect social security) at a rate of 9% it would be worth $258,658. That’s the potential cost of procrastinating 5 years!

2. Not knowing the basics— When I finally began investing, my first move was to give my money to a full brokerage firm to invest for me. I didn’t know anything about stocks or mutual funds. I just knew I should invest money to make more money. This was a big mistake since each trade executed by my broker cost a lot of money. Also, the mutual funds they picked weren’t good, and were very expensive.

#2 - Giving your money to a broker to trade for you is a foolish man’s game. That is the way things used to work way back when. You might as well trade it yourself and lose your money without the heavy commissions attached.

Either, educate yourself and go at it alone or find a trustworthy advisor that can build you a solid investment allocation for the longterm. And believe you me, it’s not that easy to find a capable, caring, honest advisor. I believe that’s the biggest problem that continues to plague my industry.

3. Chasing past performances — Once I got smart enough to switch to a discount broker, I committed another mistake. I chose mutual funds based on their past performance and Morningstar rating. I picked several loaded / high expense-ratio funds that lagged the general market in the subsequent years.

#3 - Many investors chase performance. They read about a hot fund (or stock) and dump their money into it. As they say, past results are no indication of the future. I say it on this blog all the time, all you can do, as an investor, is find cost effective investments and let the performance take care of itself.

You have to look under the hood and run various tests to make sure you’re not purchasing a lemon, especially when dealing with mutual funds.

The Skilled Investor has a lot more to say on the topic with The Fund Authority Score.

4. Experimenting with my IRA — Back then I had tons of ideas. Unfortunately most of my money was in IRA, so I experimented using my retirement money — big mistake! First, money lost in an IRA cannot be replenished. I was allowed to deposit $2,000 per year and that was the limit. Second, I could not claim my losses as tax deductions. Since the IRA was tax-sheltered, the loss was simply a loss. [Learn more about IRAs.]

#4 - In an IRA account you need to build a solid allocation for the longterm. Think about it logically. The IRA account was created for you to supplement your retirement income needs. Would you want to jeopardize your retirement by making wild investments? Ofcourse not.

I’m not saying buy Treasury bonds, but build a well diversified portfolio and if you want to get creative make sure you’re doing it with a small percentage of your IRA capital. Like Pinyo said, there is only a finite amount of capital you can put into an IRA, it’s important to make prudent decisions.

5. Not paying attention to expense ratios — Not until recently did I realize how badly expense ratios can affect investment performance. I always thought “it’s only 1%, what’s the difference,” and went for the investment with better performance. I finally ran some numbers and I was shocked to learn that a difference of 1% can lower my investment performance by 25% over the course of 30 years. Instead of ending up with $1 million, for example, I might only have $750,000.

#5 - I spent nearly 3 weeks writing posts addressing the expenses ratios of mutual funds. I took it a few steps further and addressed the hidden fees associated with mutual funds, that Pinyo didn’t even touch on. You must be vigilant about choosing cost effective investments.

My motto, “When choosing your investments, you want to put a premium on tax efficient funds (including ETF’s) with low expenses. At the end of the day you can only play a part in controlling your costs, the performance will have to take care of itself.”

6. Not paying attention to distributions — This is another number that I did not pay attention to back then. I held some funds in my IRA and some in my regular account. For a couple years, I thought high distribution was really cool because I was making more money. How silly was that? Now I realize that I am paying other people’s taxes when I get mutual fund distributions. Now with my regular account, I invest either in low distribution funds or in ETFs. (Distributions do not affect IRAs.)

#6 - I’m glad to see Pinyo has moved to tax efficient mutual funds and ETF’s in his regular accounts, that’s very smart. Although capital gains distributions have no tax ramifications in your IRA, they may be a harbinger of investments with above average costs.

To be sure, I’d check to make sure nothing’s rotten in Denmark. A few weeks ago I offered up an ETF Tax Swap Idea for the Holidays that deals with mutual fund capital gains distributions.

7. Not paying attention to asset allocation — Way back when, my investment was mainly in large-capitalization U.S. stocks and funds. I did not know about asset allocation as a risk management and performance enhancement tool. It wasn’t until 1999 — when I became eligible for a 401k — that I started giving asset allocation serious thought.

8. Ignoring diversification — Again, with little experience and little money to invest, I was going after high-flying stocks (at least I thought they were) and did not pay any attention to diversification. Like asset allocation, it took me a long time to realize how diversification helps to reduce risk and enhance performance. The value of diversification became apparent to me at about the same time that asset allocation did.

#7 and #8 - Asset allocation and portfolio re-balancing are the keys to investing success over the longterm. A well diversified portfolio, with different, non correlated asset classes is the ticket. Why? Because it provides the kind of emotional journey that most humans can deal with.

When markets become ugly, investors tend to panic, overreact and make poor decisions. A well diversified portfolio insulates you (to some degree) from being victimized by these emotions. This is especially true in retirement accounts, where people tend to not watch as closely (a wonderful side benefit of having an account you can’t touch for 25 years+.)

Sure, you can try and brave it by putting all your money into small caps, which have had the best equity returns historically (over the past 100 years). But I guarantee you, the average investor won’t be able to deal with the volatility swings during the bad times (which always come) and the small cap market will chew you up and spit you out at some point.

Having a solid asset allocation and portfolio diversification greatly diminish the severity of these swings, making it possible for the average investor to remain focused on longterm goals. Last week, I wrote about how adding managed futures can further reduce portfolio swings.

9. Selling winners and keeping losers — This was my all time weakness. I knew the concept of “buy low and sell high.” So with little experience, I ended up selling a lot of my winners like Staples (SPLS), Ameritrade (AMTD), and Microsoft (MSFT) to lock in the gain; but held on to my losers like Flemings (FLMIQ) and eToys (ETYS).

#9 - In my opinion he might want to re-visit this one, because the assumption is he knows which stocks are going to continue doing well and which are going to stall out.

If he was writing this post about trading, as opposed to investing, I could understand the point he is making. (With trading there is a certain methodology that you must adhere to when dealing with winning and losing positions, but that is a very different game then investing for your future.)

I firmly believe most investors should not own individual stocks (or a small percentage). Either, let the professionals do their jobs (via mutual funds) or better yet own ETF’s. That way you don’t have to worry about whether or not you made the right buy/sell decisions.

In fact, if you owned ETF’s, it makes a lot of sense to trim your winning and add to the lagging parts of your allocation. A concept known as re-balancing. And to me, second only to diversification in importance, when it comes to the keys to investing success.

“Buy low and sell high” works with well diversified portfolios but it may not work with the stocks that Pinyo mentions. With individual positions you have to deal with a whole different set of decision making variables that can stall any methodology.

The advice I would offer is… do yourself a favor and re-diversify those monies into correlated ETF’s, re-balance the portfolio periodically and never worry again, whether or not your adding to a stock that’s a dud or whether or not you sold a winning position too soon.

These are mistakes investors make far too often, exacerbated by the Jim Cramer’s of the world. When in doubt always keep it simple, especially if you’re not a CFA. I heard Warren Buffett say just this week, ‘I invest in what I understand, if I don’t understand it than I put it in the hands of others.’

10. Cost averaging down — This was another “buy low and sell high” mistake. Not only did I hold on to my losers, I bought more shares in hope of lowering my cost basis and reducing my losses. I did this blindly without additional research to find out why these losing stocks went south.

#10 - there’s nothing wrong with this approach, if it’s part of an ETF or mutual fund re-balancing strategy. There’s obviously nothing wrong with putting new money to work in under performing sectors. Like I said in the last section, where you run into trouble, is when dealing with individual stocks.

In that case, all bets are off, it becomes more feel, gut instincts, art, luck. As opposed to science, math, systematic, unemotional. When it comes to investing success over the long haul I’ll take the second set of adjectives over the first.

11. Investing without a goal — Not until recently did I define a real goal for my investment — among other things, one of my investment goals today is to build a $1 million investment portfolio by 2017. This is my main retirement portfolio. Other goals, which I am still defining, are investing to subsidize my kid’s college expenses and my parents’ retirement expenses. Without a clear goal, I was chasing short-term performance and was prone to act on market swings.

#11 - My entire business is built on the premise of setting goals. By having a financial plan you define all of your goals and can take the necessary steps to achieve them. Here’s a sailing analogy I used to drive home the point.

For many of my clients, the sweetspot, those not in the accumulation phase of their lives, it should be mandatory to derive your asset allocation from a formal financial plan. For the majority of Americans in their 30’s and 40’s, a ‘formal’ plan is not a necessity.

(One of these days, I’m going to introduce a series of ‘informal’ financial planning steps (Down Home planning) that should satisfy the planning element for most GenXer’s)

For anyone my age (and Pinyo’s) what is key now is properly assessing your risk tolerance and building a properly diversified portfolio around it. For the overwhelming majority of you, a growth oriented allocation will make sense. How you build that portfolio and with what investments is the key!

12. Selling on corrections & buying at the top of the market — These are symptoms of not having a clear goal. Since I was chasing short-term performance with the objective of making more money. I occasionally gave in to my emotion and sold my investments during corrections to protect my gains. Occasionally, I did come out ahead, but most of the time I ended up rushing to reinvest my money as the market invariably rose after these corrections.

#12 - Trying to time the market never works. Instead, (once again) focus on building a strong allocation that dampens the volatility the market throws at you. Once you have something firmly in place, you’re going to have a renewed sense of confidence and will view market troughs as an opportunity to add to your existing investments (if possible). This is the beauty of systematic investing or Dollar cost averaging, but I’ll save that for another day.

In conclusion

It’s great to see Pinyo learned from his mistakes. Unfortunately, the way we learn in life is through experience, which often means the hard way. It doesn’t have to be that way when planning your future, or when it comes to investing. You can avoid some of these mistake if you can take your ego out of the equation.

Do some reading, ask questions, stay humble, and you’ll get the answers you’re looking for…

Let me know about any investing mistakes you may have made…

This post was featured in the 132nd Carnival of Personal Finance over on The Digerati Life. A great job was done putting together this carnival during a very hectic time of year. Kudos to the Digerati Life for the great work.

Tags: investing 101, My Two Cents