This is a guest post by Brendan Erne, Research Analyst at Personal Capital.
Every investor makes mistakes. While some are relatively harmless, others have the potential to be disastrous. There�s a good chance you are in better financial shape than you realize, but failure to correct one of these sins could significantly impact your ability to reach financial goals. There is a lot at stake�having to work longer, the inability to pay for college, or having to ratchet down your overall standard of living. Avoid these seven mistakes and you�ll be well on your way to a healthier, more rewarding financial life.
Deadly Investor Sin #1: Inappropriate Asset Allocation
We cannot repeat this often enough: asset allocation is the most important investment decision you will make. But most investors don�t even know their true asset allocation�it�s one of the primary reasons we built our financial dashboard. It is imperative you understand where you are before determining where you need to be. This means having a firm grasp on your aggregate portfolio�s exposure to domestic and international stocks, domestic and international bonds, alternatives, and cash. Alternatives are categories such as real estate, commodities and gold. Only then can you formulate a path to your appropriate allocation.
Many investors suffer from two common allocation sins: being too conservative and/or poorly diversified. These are sometimes one and the same. Being too conservative often comes in the form of too much cash and bonds and not enough stocks (more on cash in the next section). It can occur at retirement where there is a misguided belief that portfolios should largely consist of bonds and �safe� investments, or during key working and saving years. The consequence of being too conservative too soon could be running out of money.
The appropriate asset allocation should be tailored to your personal financial situation, accounting for your risk tolerance, time horizon, expected withdrawals, and legacy wishes, among other factors. It should be a diversified mix of lowly or uncorrelated asset classes. In every scenario, investors should seek the highest return for the right level of risk. The right level of risk is a factor of both ability and willingness to accept risk.
But even with a proper asset allocation in place, a portfolio can still be poorly diversified. Unnecessary risk can occur in one or many of the following areas:
- Style & size (e.g. small cap growth)
- Economic sector (e.g. technology stocks)
- Singular holding (e.g. Facebook stock, GE corporate bond, etc.)
A properly diversified stock portfolio, for instance, should have exposure to all economic sectors. The reason is simple: stocks in the same sector tend to behave more similarly to each other than to stocks in other sectors. So if technology blows up, your exposure to energy, health care, or utilities is there to act as a counterweight. Think about it. If you were entirely invested in technology in 1999, or financials in 2006, you would have lost over 80% of your portfolio value in the subsequent downturns.
You should also aim for exposure across different styles, sizes, regions, and to the extent possible, sub-industries. Spread out your risk. Doing this reduces portfolio volatility and can actually improve expected return. Greater return with less risk is the Holy Grail of investing. Ideally, each stock should only represent a small percentage of the aggregate portfolio. When positions get much greater than 5-7%, a portfolio begins to take on meaningful concentration risk.
Deadly Investor Sin #2: Too Much Cash
Another deadly investor sin: holding too much cash. And this isn�t a problem concentrated amongst retirees�it is rife across all ages and demographics. Much of it is driven by fear following the 2008 financial crisis. The severity of this downturn created a lingering psychological impact, whereby investors still don�t feel �good� about the stock market or economy. As a result, they leave significant portions of their portfolios sitting in cash, often in excess of 20%. And with yields at next to nothing, this is akin to stuffing cash in a mattress.
Why is this a sin? It significantly hinders your long-term return potential. Historically, cash has generated the lowest annual returns out of the six major asset classes. And 2012 was a prime example of its inherent risk. After accounting for inflation, it was the only asset class to produce a negative real return. This means those with cash heavy portfolios technically paid a fee to avoid other asset classes.
The impact can be even more severe over longer time horizons. Most investors sit on the sidelines waiting for the �all clear� signal to jump back into stocks. Unfortunately, such a signal doesn�t exist. And by the time they finally feel �good� about the market, they�ve already missed most of the upside. The S&P 500, for instance, is already up +125% since the March 2009 bottom. Many and more have missed a substantial amount of this bull market run.
Of course, there are times when holding larger cash balances make sense. The key is making sure it fits into your overall asset allocation.
Deadly Investor Sin #3: Paying Excessive Fees
Most people don�t actually know how much they pay for investment management or fund fees, and unfortunately it is often much more than they realize. Not all fees are easily understood, and many are embedded deep within investment products making them difficult to see. Over time they can be a significant drag on investment returns. Always know what you pay in fees. Aggregating your accounts on our financial dashboard can help.
Professionals. Investors who choose to hire a professional often pay annual fees based on assets under management. Amounts vary wildly, but typically range from below 1% of assets on the low end to 3% on the high end. Some advisors directly pick stocks, while others pick mutual funds (often called wrap accounts or fund of funds). Paying anything near the high end of that range is almost never warranted, particularly for those picking mutual funds which come with their own set of fees. And if you use a broker, you could be paying sizeable commissions on each and every investment you make. Annuities and some other life insurance products are notorious for such commissions, which is why brokers are so quick to recommend them. So when hiring a professional, make sure you clearly understand what they charge, as well as any commissions you might be responsible for.
Fund Fees. According to the Investment Company Institute and Lipper, the average expense ratio of equity funds is 1.43%. And expense ratios are just the beginning. Mutual funds carry several additional costs�some visible and some hidden. These can include sales loads, which are paid to the selling broker, as well as similar fees paid to the fund company. There are also embedded costs associated with trading, research, and potential market impact (hidden fees). Add these up and the real cost of owning mutual funds is often 2% to 3%, or more. These are huge hurdles to overcome considering most funds don�t outperform their respective benchmarks. And this doesn�t even include the impact of taxes. The best way to avoid excessive mutual fund fees is to avoid mutual funds altogether (at least active mutual funds). ETFs are often cheaper, more tax efficient alternatives.
Deadly Investor Sin #4: Poor Tax Management
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