Investment Mistakes

Investment Mistake #1: Chasing "hot" funds or asset classes

Investors tend to chase recent performance. Whether it's the performance of a particular mutual fund, an asset class (like real estate), a country (like China), or a commodity (like oil), this investment behavior, which projects recent returns into the future, is responsible for the low returns that many investors experience over the long term.

Poor investments usually have very compelling stories. Investors love stories that explain why a particular investment has been a wonderful place to be for the past several years. These stories, which are constructed with the benefit of hindsight, never get it wrong. They are logical, backed up by historical experience, and portray growth of the same magnitude extending into the distant future.

Yet common sense tells us that nothing goes on forever in the same way. Research has shown that mutual funds with the best recent track records tend to fall from grace and descend into the basement of fund rankings in the future. In the overwhelming majority of cases, the high recent returns were caused by some temporary condition which favored the particular style of the fund. As these temporary conditions faded, so did the spectacular returns of the fund.

Investors who chase hot funds or hot ideas have no investment discipline. They are led from one idea to the next by the "news" and by promotional stories which never attempt to explain what could go wrong. The old adage "buy low, sell high" means "buy when the story is terrible and sell when the story is great". Chasing hot funds is exactly the opposite.

Investment Mistake #2: Timing the market based on "news"

If it were possible to consistently "time" the stock market based on current news, there would be dozens of mutual funds in existence with great long-term track records doing it.

Problem is ... there aren't any ... none. So, if the best minds in the investment world can't do it, why do you think you can?

The truth is that current investment news is one of the worst indicators of where the market is heading over the next year or two. Professional investors know that the market "looks ahead and through" the current environment to things as they should be six to twelve months out. Inexperienced investors often are confused as to why the market is going up when the economic news is bad. There is an old Wall Street saying, "A bull market climbs a wall of worry", which reflects the fact that savvy investors are unfazed by the current news environment which reflects the past, not the future. Remember, market tops occur when the "news" is uniformly good and investors in general are feeling confident and safe.

Investment Mistake #3: Playing it too safe - guaranteed returns

You pay for "guarantees". In the investment world, you pay dearly because almost all financial instruments which guarantee a return have little appreciation power. The reason for this is inflation.

If the inflation rate is 3% and you are "guaranteed" a 4% return, your net gain is just 1%. During the 1970's, when inflation was high, investors in "guaranteed" investments like CD's, short-term treasury bills, and money market funds scrambled from year to year to "catch up" with rising interest rates. They never did.

Your retirement account needs to grow at a "real" rate of 6%-8% annually over time. No guaranteed vehicle can do this for you. Conservative bond funds, with an average maturity of 3-5 years in the bond portfolio, do a better job over time of growing assets. In high inflation periods, these funds will capture higher rates as older bonds mature and are replaced by higher yielding new bonds. Owning these funds means giving up the certainty of year to year returns, but the longer-term outcome will be well worth it. When the inflationary period ends, these "intermediate" bonds can deliver substantial capital gains.

Holding a substantial portion of your 401(k) in a stable value fund is akin to stuffing cash under the mattress. It probably means that you don't have a long-term game plan you believe in, so you're not going to take any risk. This is a sure-fire way to a meager retirement later on when everything costs twice as much as today. The 401(k) Formula^TM can be blended with bonds to provide a superior risk-management discipline without sacrificing the possibility of inflation-beating, long-term returns.

Investment Mistake #4: Too much company stock

Many 401(k) investors are offered the option of holding company stock in their account. Research has shown that when this option is available, participants tend to go overboard. This is understandable. Participants know their own company well and as loyal employees have a high degree of faith in the company's future.

Yet this over reliance on company stock suffers from two big investment defects. The first is that "good companies" does not equal "good stocks". The stock market is not so simple. Your company stock may be overvalued and, after a long stretch of superior gains, may be ready to undergo a multiple-year decline or a long period of stagnation. This puts your funds at risk of low-to-negative returns over time. Second, you may not know your company as well as you think you do. Most employees cannot see the "big picture" which includes the economy, the competition, the changing marketplace for products and services, etc. You need to remember that half the companies in the S&P 500 were not there 15 years ago. The fortunes of companies wax and wane in unexpected and unpredictable ways, which is why diversification across many companies - even the entire stock market - is one of the primary rules of investment.

Enron Corporation employees, who had their 401(k)s' heavily invested in company stock, believed in their company and they lost it all. It can happen to you, too. Our recommendation is that no more than 10% of your 401(k) account should be invested in company stock.

Investment Mistake #5: Holding stocks through thick and thin

Conventional investment advice is dangerous to your financial security. Conventional 401(k) accounts allocate a percentage of assets to bonds and a percentage to stocks, usually with stocks claiming the lion's share. This is because participants are told that stocks do better than bonds over "the long-term". Often, advisors quote 10% as the long-term return of the stock market. This advice is misleading at best and completely false at worst.

"Long-term" is a relative concept. It means perhaps five years to one person, twenty to another. When investment advisors use this term they mean more than 80 years, usually based on a starting point of 1926. What they don't tell you is that over that eight decade span, there were periods of 10-20 years when stocks delivered low-to-negative returns. They don't tell you that a lump-sum investment in the S&P 500 in 1968 lost purchasing power until 1991 because of rampant inflation and flat stock prices from 1968-1982.

As a long-term investor, you should know that the stock market goes through long cycles of high annual returns followed by equally long cycles of low-to-negative annual returns. The last positive cycle began in 1982 and ran until 2000. It was the greatest bull market in history. Today, we are still suffering the "hangover" from the excesses that were created during the market "boom". This hangover could last another ten years.

If you hold most of your 401(k) assets continuously in the stock market, you are betting that stocks are not in the "hangover" stage but in the "boom" stage. If you are wrong, you're sacrificing your financial future on a bad long-term bet. Not smart.