Investing is a great way to build a retirement nest egg and meet other financial goals. But the road to investment success is littered with numerous potholes.
In addition to misinterpreting solid financial principles, such as diversification, many investors let fear and other emotions guide their investing rather than relying on time-tested strategies for success. Here are some common investing mistakes that can cost you big money over the long run.
One of the reasons that it’s hard to be an investor is that human psychology works against successful investing. When markets are making all-time highs, investors are naturally euphoric. Those with existing profits tend to put more money in their winning positions, while “fear of missing out” kicks in for those who have been on the sidelines. As a result, stock market inflows tend to be highest right before the market peaks.
According to Bloomberg, even professional money managers struggle with “FOMO” when the markets are booming. Pouring money into an overextended market is one of the most expensive investing mistakes that many investors make.
There’s no doubt about it — when the market is crashing, it’s an emotionally tough time to stay invested. Fear is a compelling emotion, and when you see your portfolio drop by 20%, 30% or even more, it’s easy to feel like cashing out and avoiding further losses. The problem is, just like investors tend to buy in at market highs, they usually feel like selling right when the market is approaching its lows. As explained by Prosperion Financial Advisors, “Investors tend to buy when times are good and sell when troubles in the market arise. They often don’t get back into the market in time to capture much of the later upturn in stock prices, and as a result are always behind the curve.”
As a result, many investors miss out on the oftentimes dramatic recoveries the market makes after hitting its lows. In March 2020, the market sold off dramatically, falling 30% in just 22 trading days; however, it had completely recovered just 33 days later, leaving those who sold low missing out on huge gains.
Short-term trading is something that every investor thinks they’re good at, but many lose money trying. But even if you’re successful at short-term trading, you might be overlooking an expensive part of your success: taxes.
Short-term stock profits are taxed at your ordinary income tax rate, which could be as high as 37% at the federal level alone. If you could instead hold your positions for longer than one year, your tax rate may be just 15%, or perhaps even as low as 0% depending on your tax bracket. In other words, you’ll need to be extremely successful as a short-term trader to overcome the effects of taxation on your profits as compared to a long-term investor.
Reaching For Yield
There’s an expression on Wall Street known as “reaching for yield,” and it can often prove costly. When investors reach for yield, they buy the highest-yielding securities just because they pay high dividends, often without researching the underlying fundamentals of the company paying the dividend. Certainly, a security paying a 9% dividend is attractive when the current yield of the S&P 500 is just 1.47%.
But usually when companies pay well above-average yields, it’s due to uncertain fundamentals. Remember, as a company’s stock price declines, its yield increases. Thus, stocks that have sold off dramatically often sport high yields. However, high dividends are often unsustainable and can lead to cuts.
Oil company Occidental Petroleum, for example, cut its quarterly dividend from 79 cents per share to just one penny per share in 2020. Investors that bought the stock for the high dividend no doubt learned an expensive lesson. No less than billionaire investor Warren Buffet told CNBC in 2020 that “Reaching for yield is very stupid. But it is very human.”
Piling Into Hot Stocks
Chasing hot stocks can turn into an expensive endeavor for investors who are left holding the bag. In early 2021, for example, GameStop stock skyrocketed after investors on message boards pumped up the stock and forced short sellers to cover their positions. After jumping an astonishing 400% in the last week of January 2021, GameStop shares fell 30% on the first day of February alone. There are countless other examples of stocks that shot up and then just as rapidly fell back to Earth, burning investors in the process. Piling into hot stocks like this often turns out to be an expensive gamble for investors.
Buying Low-Dollar Stocks
Some investors feel that stocks priced under $10 are “cheap” and therefore can generate dramatic price appreciation more rapidly than high-priced stocks. After all, the thinking goes, a $5 stock only has to move $0.50 to generate a 10% return, whereas a $1,000 stock must jump by $100.
However, this is fallacious thinking. Most stocks trading below $10 per share are there for a reason, and it’s often related to poor company fundamentals. Especially now, when many brokers allow investors to buy fractional shares, there is no reason to avoid buying high-dollar stocks. In fact, to reach their high-dollar prices, most high-dollar stocks have had a long track record of success.
Timing the Market
Trying to time the market has always been a fool’s game, and it can end up being an expensive mistake for many investors.
In March 2020, for example, the fourth-best day in the last 20 years came just one day after the second-worst day in 20 years, according to JPMorgan Asset Management. In other words, if you sold out during the market selloff to avoid further losses, you missed out on one of the best days in market history. There’s almost no way for the average investor to be able to time these huge market swings, and missing even 10 of the best recovery days in the market would dramatically slash your long-term returns. For most investors, timing the market proves extremely costly in the long run.
You may have heard that diversification is a good way to get the best possible risk-adjusted return for your portfolio. While this is true, there is such a thing as too much of a good thing.
If you over-diversify your portfolio, you’re destined to achieve a near-market return. The more stocks you add to your portfolio, the less impact each position can have. Thus, even if you pick a big winner — like Tesla and its 740% return in 2020 — if you own 500 other stocks, the effect of Tesla on your overall portfolio would be minimal.
As quoted in Forbes, a study by academics E.J. Elton and M.J. Gruber demonstrated that the benefits of diversification vanish somewhere between 20 and 30 securities. While you should own enough stocks to tamper down your risk, you shouldn’t own so many that your big winners can’t help you achieve an above-average return.
Projecting Future Returns Based on Past Performance
There’s a phenomenon on Wall Street known as “recency bias,” in which investors assume that the current trend of a stock will continue endlessly into the future. This can be a dangerous supposition, as business conditions, even at the most successful companies, are constantly changing. A large number of external factors can also change the course of a stock, from rising interest rates to growing unemployment. You’ll often see the disclaimer that “past performance is not a guarantee of future results” on mutual fund and other investment literature, and it’s there for good reason — because it’s true. Investors who assume that winning stocks will continue to gain endlessly can often learn an expensive lesson.
One expensive mistake many investors make is being too conservative with their investments. While your investments must match your investment objectives and risk tolerance, if you’re too conservative, you may never meet your savings goals.
Imagine if you put all of your retirement savings into a simple savings account. According to the St. Louis Federal Reserve Bank, the current average savings account rate is a measly 0.04%. At that rate, even a $1 million account will earn an unbelievably minuscule $400 per year. Let’s imagine instead that you had just $10,000 to invest, but you earned 8% per year investing in the stock market. That translates to $800 per year, or exactly double what you’d earn with $1 million in a savings account.
The point is that if you invest too conservatively, you could be missing out on significant additional returns. Sure, market volatility can be scary at times, but check this out — the stock market has never lost money over any 20-year rolling period. Turns out that over the long run, the stock market is actually a less-risky investment than many people imagine. As noted by the experts at Buckingham Strategic Wealth, “risk is more than volatility.”
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