by Ramy Majouji
An old Wall Street adage states that two emotions move the market: fear and greed. Indeed short-term investors are affected by these emotions. Acting on strong emotions may lead to some investment mistakes.
Common Investment Mistakes
In recent years, S&P 500 index funds have outperformed about 75% of the actively managed mutual funds each year. The following are the reasons:
- Index funds charge small operating fees.
- Actively managed funds often trade stocks faster, leading to high brokerage costs. Thus, high expenses significantly reduce the returns of these actively managed funds.
- People are generally overconfident in their ability to pick mutual funds or stocks that will outperform the market. Overconfidence increase turnover, which lead to lower performance after brokerage costs are taken out of the returns.
- Optimism encourages investors to continue active trading, which incur far too many fees, rather than pursuing wiser, time-saving investments in index funds.
- People tend to deny that random events are random, and find patterns where none exist. The past is not an accurate predictor of the future.
- With gains, investors tend to be risk averse and tend to sell earlier to guarantee the gain. With losses, investors tend to be risk seeking and tend to hold on the loser longer in the hoping of becoming a winner.
Personal Investment Strategy
It is not easy to outperform the market from a short-term perspective unless you do your homework diligently. The decision that benefits investors over the long term is usually made in the absence of strong emotions. Experts suggest that you invest from a long-term perspective. The basic strategies should include the following:
Safe money—put aside an emergency fund equal to six months’ living expenses. Money is put in a safe money-market account.
Reason: To meet unexpected emergency needs.
Diversification strategy—spread the money among various sorts of investments and among both domestic and international securities. Diversification breaks down into three different categories—stocks, bonds, and some forms of cash such as money market accounts, savings accounts and money market funds.
- To take advantage of growth potential through stock holdings while offsetting stocks’ risk through more stable bonds and cash holdings.
- To reduce risk.
Invest in S&P 500 index funds and adopt low-cost investing.
Reason: They outperform 75% of managed funds due to low operating fees.
Invest a fixed amount on a regular basis (every payday)—from a long-term perspective.
Reason: To buy more shares when prices are low, and fewer when prices are high—this tends to reduce the price in the long run.
Buy and hold strategy–invest from a long-term perspective. Research and buy the index funds and hold.
Regularly review, recheck, and readjust the asset allocation to guard against the status quo.
Reason: To meet objectives through evaluating individual portfolio, time horizon and risk tolerance as time goes by.
Maximize investment in a 401k, 403b, IRA, or Keogh plan.
- To take advantage of the tax deferred rate.
- To get the maximum match offered by some companies.
Buy a second home as an investment. Set aside a certain amount of money for mortgage payments and rent it out to help with the payments.
Reason: A home in an attractive and convenient location is worth the money put in. When time comes to sell, you should be able to get a reasonable return on your money.
Set up an automatic transfer of some money every month to be deposited in your savings account from your paycheck. A portion of the savings is for vacations, a new car, etc.
- To enjoy life, spend time with your family.
- To motivate and reward yourself and your family.
If you have extra money, invest in a Roth IRA even though there is no tax deductibility.
- Tax-free growth.
- Tax-free withdrawal.
- No mandatory withdrawal. Participants may wait as long as they wish to withdraw from their accounts.
- No cutoff to contributions.