This is not an article about different investment strategies, but rather more fundamental laws related to the topic of investing. Investors can be counted on to make the same mistakes over and over again. Knowing what they are and how to avoid them can help you keep the long-term value of your savings intact instead of following the pack toward financial self-destruction.
Mistake #1 – Not adhering to a written investment policy.
Successful investors follow a consistent and well-designed investment policy.
This is a statement of how it will be invested, regardless of short-term changes in the markets. It is written and signed after extensive discussion with your financial advisor to determine your investment objectives, risk tolerance and level of sophistication. It is then implemented and maintained throughout its life.
When an investor continually seeks to change an investment strategy, they will inevitably make the wrong decision at the wrong time because there is no overriding policy to direct the investor’s actions in times of hardship. The markets are volatile, but one’s approach to investing in them should not be. Untold wealth is lost through knee-jerk reactions like selling at market lows.
For example, when a catastrophic market event occurs, many investors and investment professionals will look for some solution to the confusion created by the event. These solutions will be “alternative investments” or attitude changes towards well-proven long-term strategies like “buy and hold is dead”.
Having a proper and rational investment policy can help an investor avoid mistakes during market turmoil.
Mistake #2 – Chasing return on investment.
A sure sign of a novice investor is one who makes investment decisions based primarily on past performance.
This is crazy, as the future is not the same as the past, as much as we want to use it to try to predict the future. Even the Securities and Exchange Commission requires that each prospectus (a document that explains the nature of the proposed investment) must state that “past performance is not an indicator of future results.” So why do people insist that it’s true anyway?
Many mutual funds use past performance almost exclusively for you to invest in your fund. Just check the financial pages of any newspaper or magazine and the ad touts “x% return in 3 years” as if that means anything to you. The only way it would affect your life is if you actually invested in that fund for the last 3 years. Otherwise it is irrelevant. In fact, most funds that have such great short-term returns will generally underperform for years to come, right after you invest your money.
Past performance is just one factor among many in determining the right investment strategy.
Mistake #3: Not determining the ultimate goal of an investment before you make it.
Money is only invested so that it can grow in value (or, more importantly, RETAIN its value) so that something can be purchased at a future date. Every investment must have a clear and decisive purpose for which that money is accumulated. The purpose can be anything you want: retirement income, a new car, a college education for the kids, a dream vacation, you name it.
There are thousands of different investments and each has an appropriate use, depending on the reason the money was set aside in the first place.
Example: If you want to save for a new car, then speculative stocks that will go up and down a lot in value will not be a smart choice. The chances of you having to cash it out at the wrong time are too high. Also, if you want to invest for retirement income in 20 years, keeping the money in a savings account at the bank won’t earn enough interest to outpace inflation.
The reason it is so important to know the ultimate purpose of an investment account is so that it is invested to achieve the best risk-adjusted results. The only time a person gets into trouble is when the purpose of the account changes.
Example: A person puts money into an IRA in stock and bond funds. After a couple of years, the person overspent and now wants to cash out the IRA to pay the bills. The account balance is down (which it will be in any speculative investment) and the person has a loss.
The moral here is to determine the ultimate reason for making an investment and not change your mind midway through. Otherwise, you expose yourself to unnecessary losses.
Mistake #4 – Not taking risk into account.
Probably the biggest problem an investor faces is that they don’t understand risk.
Risk comes in many forms and the most successful investment strategies will mitigate most risks.
The higher the return you want to generate from an investment, the higher the risk you must take. This is an investment law. Irrefutable. However, the idea that “higher risk, higher return” is not really true. There are countless examples where people take a high degree of risk and receive low returns. Why? Because the issue of risk is not understood.
What constitutes risk?
In general, risk is the “chance of loss” or the “probability of loss”. It is the problem of using the money for some future purpose and the possibility of incurring some degree of loss on that investment.
Many investors think that the only risks are related to the market, such as the fact that the market may go down or the value of the stock may go down.
But there are many more risks that people don’t usually think about. These risks include:
or inflation
o Taxes (on investment earnings)
o Exposure of creditors (incorrect titling of investment accounts)
o Herd mentality (doing what everyone else is doing, which is almost always bad)
or lack of knowledge
or and many others
The truth of the matter is that you really need to understand the risks you are taking with every investment you own. There are many other risks to consider besides the volatility of a particular stock, bond, or real estate investment. Some of these risks can kill your entire investment plan if not managed wisely.
In my experience, these are the 4 critical mistakes most investors make. If you avoid these mistakes, you will ultimately succeed. If you violate these rules, sooner or later you will be killed.
Happy investing!