How To Avoid These 4 Investing Mistakes
Investing isn’t rocket science, but our irrational behaviour often leads to poor returns. For the 20 years ending December 2010, the S&P 500 Index averaged 9.14% a year, but the average equity fund investor earned only 3.83% a year.
This happens because we tend to buy after the stock market goes up, and bail when it goes down. We chase the latest trends, and pay too much attention to what’s happening in the economy today, without keeping an eye on the long term.
Related: Stock Market Corrections – Buy, Sell or Ignore?
Here are 4 investing mistakes that newbies and seasoned investors make, and how to avoid them:
High MER Mutual Funds
The majority of individual investors are sold high MER mutual funds from their bank or financial institution. These expensive products end up generating big commissions for your advisor, but do little to add to your bottom line.
Over the last decade, index funds beat the returns of the equivalent high MER equity funds by a wide margin. That’s because equity mutual funds charged up to 2.42% MER, while the index funds cost as little as 0.33% MER.
Index funds like TD e-Series, and low cost index ETFs have yielded superior returns when adjusted for investment risk.
Related: Using ETFs Inside Your RRSP
Lowering your investment costs by just 1% per year with a $10,000 portfolio will save you $100 a year. With a $100,000 portfolio, you’ll save $1,000 a year. Over a few decades, the savings can add up to some serious wealth.
Trading Too Often
Part of your overall investing costs, in addition to MER, comes from trading fees and commissions. Whether each trade costs you $29, or $5, trading too often can erode your average cost base and eat into your portfolio over time.
One problem is dollar cost averaging, where you invest small amounts each month to help smooth out the volatility of buying at extreme highs and lows.
Dollar cost averaging works great when you start investing in mutual funds, or index funds. That’s because you can set up a pre-authorized purchase plan to buy mutual funds with as little as $25 a month. Best of all, there’s no trading commissions.
Related: How To Get The Most Out Of Your Savings
Unfortunately, dollar cost averaging with small amounts doesn’t work so well when you buy ETFs and individual stocks. You’ll pay up to $29 a trade, so you’ll want to buy enough to keep your costs below 1% per transaction.
For ETFs, that means re-balancing and adding new money once or twice a year to keep costs low. With individual stocks, you’ll want to enter a new position with at least $1,000 to $3,000, depending on your cost per trade.
Investing In ‘Story’ Stocks and IPO’s
Dividend stocks and index funds are dull and boring, so it’s easy to get led astray by story stocks and new IPO’s. Take Facebook, for example. How many of you were caught up in the excitement surrounding the Facebook IPO? It’s now trading at half its initial price.
Related: Contrary Financial Decisions
Retail investors don’t stand a chance against the issuer and underwriter, who have access to much more information and actually set the price. Avoid investing in new issues and stick to companies with a proven track record.
Gambling with a portion of your portfolio
Some investors like to use a portion of their portfolio – say 10% – to gamble on penny stocks or tech stocks. You’re trying to hit a homerun by finding the next Apple or Microsoft in the early stages. And because this makes up only a small portion of your portfolio, you convince yourself this is a reasonable bet you can afford to lose.
In reality, you’re sure to lose most, if not all of your ‘fun money’. Finding the next great stock is next to impossible for even the most skilled investors. How much research is involved in your penny stock selections? It’s likely you’re taking a shot in the dark on some news you’ve read about uranium, or about the latest medical breakthrough.
Related: Market Efficiency – A Glaring Oversight In Passive Strategies
Surprisingly, index investors often make this mistake. 90% of their portfolio is geared toward accepting market returns, minus a small fee. But some can’t resist the temptation to buy individual stocks, so they dedicate 10% of their portfolio to try and beat the market.
This makes no sense when you consider index investors often go to great lengths to lower their overall investing costs by a few hundred dollars a year, but they seem willing to lose up to 10% of their portfolio ‘playing’ the market.
Final Thoughts
There are a lot of things you can do to make good investment decisions. Set aside a percentage of your income for investments, and find a strategy that you can stick with for the long term. Keep your costs down and don’t get carried away with risky investments.
Avoid the mistakes that tend to throw off well-intentioned investors who are otherwise taking the right steps toward building a solid investment portfolio.
Your choice of broker radically alters the transaction cost story. For example, Interactive Brokers has a $1 minimum per trade rather than $5 but there is a minimum level of activity below which they charge an extra inactivity fee for data services. So if you want to make many small trades and $5 per trade is killing you, they might be a better option.
Most discount brokers (E-Trade etc.) have a very weird fee structure that bears almost no resemblance to what the exchange charges them.
@W – I haven’t heard much about Interactive Brokers. Do you think their low costs encourage heavy trading?
IB user here. They’re practically designed for heavy traders. I don’t think they’re really a popular option among retirement investors/the typical group of retail investors because there’s a minimum monthly fee plus they have obscenely high account minimums (unless you’re under 25 years old).
Avoiding mistakes like those you have pointed out are crucial to successful investing. Good portfolio management is as much about avoiding losses as it is making money. Thanks for good list!
@Ken – sometimes it’s more about the things you don’t do, than about the things you do.
Any Canadian reading this should probably use Questrade for their brokerage account unless they’ve got a very high net worth. I still haven’t seen anybody definitively beat their commissions.
@Joe – I’ve heard mixed reviews on Questrade. Some readers have told me their service sucks and it takes forever for an in-kind transfer to go through.
I agree that as far as costs go, they’re tough to beat. But if you need a bit more hand holding then a full service broker can be worthwhile.
Their technology sucks, although their service (in my experience) is good. Example: they majorly screwed up by issuing tax slips way too late; as soon as their second self-imposed deadline passed, I called to complain and got $25 cash (not trade credit). Trades, for me, have been just as smooth as TD Waterhouse — but I’m not demanding much.
One other mistake that I see, but is never written about is cubicle copying. That’s where one employee sets up their 401k/retirement portfolio to look like the guy’s sitting next to them. Unfortunately, the guy sitting next to them is willing to let their neighbor copy.
I think #2 is the one that hurts a both longer term investors and more active day traders alike. While some brokers can lower the costs substantially, it seems some traders use those lower barriers as basically a free pass to take extra trades they might otherwise do additional research on. But a badly researched trade is still a bad trade, win or lose, and over the long haul it’s going to crush your account.
For what it’s worth, I’ve found Interactive Brokers in Canada to be quite good for many types of trading including forex, stocks and this like the ES and Crude. I would recommend them to anyone who wanted to actively trade their own portfolio with reasonable costs but who also had some time to understand the platform. It is FAR from the most user-friendly out there.
I am new to investing and a nervous investor at that. I often trade to often and end up kicking myself later. I recently thought to help ease this tendency I would put a portion of my investment money aside to “play” with. Essentially committing mistake number 4. So I guess I’m halfway there. Thanks for the list, I’m a little bit closer to getting the hang of it.
Like James said above, I’m relatively new too. I’ve been DIY investing for less than two years, and in that time the markets have gone mostly down, not to mentioned the mess in Europe. Sticking to my plan has been tricky when I see things moving down so much, combined with the fact that I don’t have 20 years experiece to reassure me it will go back up in time. But I’m sticking with it, and it’s great to see things starting to pick up again.
I have been using dollar cost averages to great success with smaller sums, as I build my positions through transfer agents (Computershare and CIBC Mellon, now Canada Stock Transfer) who don’t charge fees for optional purchases, then transfer them in-kind back into my TFSA in large chunks. I’ve been really happy with TD Waterhouse, but at $29 per trade it diffinitely wouldn’t work without the transfer agents.
@Rob, Being a relative newbie myself, I am intrigued to understand the benefits of using the process of acquiring stocks through transfer agents and transferring them in-kind back to your TFSA. I don’t understand how transacting through transfer agent (if possible for retail customers) could help while dealing with the $29 per trade at TD Waterhouse. Would love to read your understanding on it.
Thanks!
Hi James. Contact me here: http://dividendapprentice.com/contact-us/ and I’ll speak to you more about it.
Few investment mistakes:
1: Failure to Hold
2: Failure to Diversify
3: Failure to Capture Dividends
4: Failure to Place Stops
5: Failure to Research