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.
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.
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.
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.
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.