When it comes to making investment decisions, sometimes our emotions take over for common sense. While we usually rely on our knowledge and experience to point us in the right direction, investing doesn’t always work that way.
Fortunately, there are things you can do to keep on the right track. While you can’t control the markets, you can control your own behavior and how you respond. When making investment decisions, it’s essential to take into account a few potential pitfalls.
What’s considered a bad investment?
When it comes to investing, there can be a big difference between investment returns vs. investor returns. Why’s that? Because we’re all human and we make decisions based on emotions even though we think we’re following logic or common sense.
Investment decisions are not made in a vacuum - no one has a crystal ball. Making investing mistakes is to be expected since no one can be right all the time. However, some are worse than others.
When it comes to bad investments, there are some habits that can contribute to subpar returns. Those types of behaviors often result in undue stress and potential financial losses. The good news is that they are easily corrected as long as you are aware of them and take the necessary steps.
Why do bad investments matter?
Making a bad investment or following bad investment habits can result in losing a lot of money. Even if you don’t see an immediate result, bad investments can mean losing out on years of compound interest.
On the flip side, making a good investment or following good investing habits can mean long-term gains and overall portfolio health. If your returns are not what the data suggests, chances are that bad investing habits are the reason for the difference.
Bad investing habits to avoid
According to a study published in the Journal of Behavioral Science, people are less likely to be affected by market volatility if they feel in control of their finances. Avoiding bad investing habits and forming good ones will make you feel more in control of your money and your market returns.
In most cases, human behavior is our worst enemy. We often know what we should be doing but tend to react to market fluctuations in an emotional way or ignore red flags. Those types of behaviors result in added stress and usually cause you to lose money in the long run.
1. Not automating contributions
No one can predict market conditions at any given moment but many people think they have the inside scoop. Putting your money in an investment all at once thinking it will only go up is a can be a risky idea.
Don’t make the mistake of trying to time the market and focus on having a plan for making regular contributions. Making those contributions automatic means that no matter what the market is doing, you will be buying more stocks and building your portfolio regardless.
This is called dollar cost averaging and it’s a powerful way to take emotion and fear out of investing. It minimizes the focus on short-term market conditions and shifts it to long-term gains. If a recession hits and your investment falls in value, making regular contributions means that you’ll end up buying more shares at a lower price.
Making automatic contributions reduces market risk and helps you build your investments over time. It’s best suited for investors with a lower risk tolerance and long-term investment horizon. Keep in mind that investing does involve risk so do your own due diligence and only pick investments that you understand.
2. Lack of planning for the future
If you don’t know where you want to go, how are you going to get there? Making a plan is your roadmap for the future and will help you determine how much risk you’re willing to take with your investments.
You can either do this on your own or enlist the help of a qualified financial planner who can help you figure out your long-term goals and offer suggestions on how to invest. Either way, it’s important to make a plan for how you’re going to invest your hard-earned cash.
You should never invest based on rumors, hot tips, new stories, future predictions, expectations of market directions and so on. Make a plan and stick to it. If you take the time to make an investment outline and are disciplined about the implementation, you’ll come out as a winner in the end.
3. Lack of diversification
Throwing all of your money into one investment or a few similar investments is just asking for trouble. For example, investors who were heavily leveraged in the real estate market in 2007 saw their investments quickly devalued during the Great Recession. Those who were heavily skewed toward the hot tech stocks in 2000 suffered heavy losses when the tech bubble burst.
While it’s ok to own real estate investments and tech stocks, don’t make one investment or stock the hallmark of your portfolio. You may consider owning a variety of investments, including small-cap and large-cap stocks, international funds, gold, real estate, bonds, and so on.
4. Not planning for taxes
Taxes are never a fun subject, however, it’s imperative to have a plan in place to minimize how much you pay Uncle Sam. Since the objective of investing is to maximize profits, taxes and fees are a critical component of the equation.
The tax implications of a transaction largely depend on its impact on investment performance minus fees and taxes. For example, if you had sold your tech stocks prior to the tech bubble bursting in 2000, you probably would have paid a large tax bill on the gains. However, if you held on to the stocks to avoid the tax bill, you would have lost a much larger amount of money once the market tanked.
It’s important to take a balanced approach to each transaction and consider the tax implications and fees as a part of the overall picture. Oversimplifying the decision can lead to expensive mistakes in the long run.
5. Picking Stocks
Even the pros struggle at outperforming the market. According to a 2010 study titled, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas,” by Laurent Barras, Oliver Scaillet, and Russ Wermers, stock-picking expertise is elusive. It analyzed the performance of 2,076 mutual fund managers over a 32-year period and couldn’t find evidence of stock-picking expertise in 99.4 percent of those managers.
Don’t make the mistake of trying to pick the next hot stock or a sector that is likely to outperform. According to Morningstar, the volatility of the average technology fund is almost twice the level of Standard & Poor’s 500 index. Instead, invest your hard-earned dollars in a broadly diversified stock fund, which will give you exposure to most major U.S. industries.
6. Going to extremes
One of the most important investment habits to cultivate is being balanced. Taking excessive risks with your investments or being too conservative will end up costing you in the long run. Going to extremes will diminish your returns and put your portfolio at risk.
Finding the right balance is critical for your investment success. Investing too heavily in the newest hot stock or sector is making the same mistake as the guy sitting on a large portfolio heavily skewed toward safe investments such as bonds or U.S. Treasury bills.
That is not to say that you shouldn't take risks, just make sure you have an exit strategy for every investment so you can preserve capital when things start going downhill. What goes up can come down so keep that in mind when making a risky bet. Invest aggressively only when the reward merits the risk.
7. Not investing in financial education
According to a 2017 time use survey by the Bureau of Labor Statistics, Americans spend an average of 2.8 hours per day watching TV. Yet, very few people spend any time learning about investing and managing their money.
When it comes to investing, our decisions are affected by a myriad of factors including previous experience, greed, fear, our values, expert opinions, and so on. Decisions are not made in a vacuum even if we think what we’re doing is perfectly rational and logical.
That’s why you should spend some time learning about investing, asset allocation, dividends, mutual funds, historical market returns, etc. Learning the basics will help you better evaluate potential investments and determine how they fit against your overall investment plan and long-term goals.
8. Confusing market conditions with personal skill
If you start investing in a bull market and watch your investments soar, you may mistakenly believe that it’s your skill causing your portfolio to increase in value. Don’t make the mistake of thinking you have the golden touch just because you happen to be in the right place at the right time and made some good money by getting lucky.
Conversely, investing in a bear market can make even the most confident investors question their decisions. One of the most important lessons you can learn as an investor is how to conserve capital and even prosper during adverse market conditions. This means having the discipline to manage losses at an acceptable level even in a down market.
Don’t take the short-term view when evaluating investment returns. A one-way market can skew results and lead you to make false conclusions. Evaluate the entire market cycle, both the ups and the downs, when looking at portfolio health and investment returns.
9. Not doing regular portfolio reviews
Make a note in your calendar to check on your portfolio regularly. Doing a portfolio review every quarter can help you verify that your investments are on track. This is a great time to spend a few minutes going over the funds and stocks you hold to determine if they still fit within your overall plan.
A quarterly portfolio review allows you to rebalance your asset allocation and do a fee analysis. It will help you form a better picture of how your current investments align with your long-term goals. When you have a full picture, you can make better decisions about future investments and adjust to market changes.
10. Listening to the noise
Every day, we’re bombarded with an avalanche of information on market conditions, the economy, the next big stock or the hottest sector to invest in today. Fortunately, the majority of information in mainstream media is mostly noise that you can ignore.
Experts usually sound very knowledgeable about a subject, make reference to relevant facts, and build a compelling logic for their case. However, a good expert is usually wrong. By looking for easy answers, we’re asking for trouble.
One of the best ways to cut through the noise is to remind yourself about your plan. Refer back to the target allocation for your portfolio and remind yourself why you made those choices.
Before you make any decisions based on a piece of information, check out the data behind the story. Many media outlets present only one side or one piece and don’t give the whole picture. Check out all the information or data thoroughly before making any investment decisions.
Be selective with your sources and try to figure out their agenda. Keep in mind that most experts or information sources have an agenda so you need to factor that into your decision process. It doesn’t mean that the information they present is incorrect but it may skew how much of the information they offer and how they frame it.
What to do next
Avoiding bad investments really comes down to making a plan, investing in your financial literacy, and sticking to your long-term goals. Take the time to sit down and review your finances so you can determine what’s important to you and plan accordingly.
If you’re not sure where to start, consult with a financial advisor who can help you clarify your goals and figure out how to get there. Spend some time learning about investing so you can make better investment decisions. At the end of the day, it’s your hard-earned money so it’s up to you to figure out how to manage and grow your capital.
Making money is much more fun than losing it. By learning to avoid the most common bad investing habits, you can enjoy the process and preserve your cash. It’s always best to learn from the mistakes of others than to lose money to bad investments. This can make the difference between wealth and poverty.
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This is a post from Clint Haynes, a Certified Financial Planner® and Financial Advisor in Kansas City, Missouri. He is also the founder and owner of NextGen Wealth. You can learn more about Clint at the website NextGen Wealth.