Not having an investment plan.
Let's kick it off with our first investment mistake that many individuals make. That first mistake is not having an investment plan. Let's break that down. You may think that you have an investment plan, because you're simply investing.
The question is, is your investment plan written down, documented, where you can go back and reference that plan, and determine if your current investment strategy is in sync with the original, written, investment plan?
In your original investment plan, you should have a number of items in there. The first item you should have is what are your goals. What are your investment goals? What are you trying to accomplish by investing?
As we talked about in our prior podcast, in episode number one, we talk about the concept of investing should not take place unless you have investment goals. Don't invest without investment goals. That's a roadmap for investment disaster.
The first thing you should have in your investment plan is what is your investment goals. For a lot of folks, those investment goals are a big one. That's typically retirement. What amount of money they may need at retirement. What kind of income they need at retirement.
The next area of your investment plan should focus on what asset allocation is your account going to be managed at. In other words, how much do you need in stocks, and how much do you need in bonds. The overall risk of the portfolio is what we're talking about here.
Once that's determined, then that's documented in the plan. Then you can get into breaking down that level of risk between stocks and bonds. More granular, what we call sub asset classes, where you may have exposure to US stocks and international stocks.
On the bond side, a variety of different bond asset classes. You would put target asset allocation percentages for each of those broad asset classes between stocks and bonds, and the different sub asset classes in the portfolio. That will get documented in an investment plan.
Then also the next step is, putting down how the accounts are going to be managed. How are you going to rebalance the portfolio? Is the portfolio going to be rebalanced annually, based on an upper or lower limit, based on a certain anniversary date there's a whole bunch of different ways you can rebalance a portfolio, but the most important concept is actually getting the rebalancing done.
Those are some key areas of an investment plan. In a future episode or blog, we may discuss in more detail all the different ways of rebalancing a portfolio, and also designing an asset allocation, setting investment goals, and a number of other topics.
Today, we'll keep it pretty simple, give a little summary for each of the mistakes that we typically see investors make.
Focusing on past performance.
So the first one is not having an investment plan. Number two is focusing on past performance. Past performance is exactly what the name implies. It's past.
That's not performance that you had, or that you will have going forward. That's performance that the fund or the stock or the bond that you're looking at had performed.
What is the correct way to look at performance? Well unfortunately, there's not a great way to look at performance, because all the performance, whether you look at annualized performance, or you look at annual performance (calendar year performance), and we can talk briefly about the difference between the two of those, that's performance, again, that you would not have had.
If you must look at some level of performance, the best level of performance to look at is annual performance, not annualized, annual.
What does that mean? Annual performance is year by year. You're looking at what was the performance last year, 2016. What was the performance in 2015?
You're looking at each year in isolation. That's more relevant to the immediate past performance of the particular investment that you're looking at.
When you look at annualized performance, that's looking at a period of time, and annualizing that return out over that period. If you're looking at annualized return for the last 5 years or 10 years or 15 years, that's assuming that you were invested in that fund on day 1 of that 5 year period, and held that fund or investment for that entire time period. That would have been your return.
Unfortunately, when you look at past performance, and you look at annualized performance, those are often not the returns that you would've had even if you're in the fund, because the fund could have had a great streak of performance for a short period of time, maybe early on or midway through that annualized performance period.
If you weren't invested during that time, you may not have had anywhere close to the actual performance of that fund.
I guess in summary, in looking at performance, all of the performance, whether it's annualized for various periods of time or it's on an annual basis, where you're looking at each year separately, it's, again, past performance.
This performance should not be looked at to indicate what type of performance you're going to have going forward. Your performance is your future performance. It's not the past performance of the investment.
Don't overly diversify your portfolio.
We'll move on to item number three here. The third mistake that investors make is they overly diversify. What does this mean when everybody out there is talking about diversifying your portfolio? What that means is that typically, investors buy a number of different investments.
Let's just keep this conversation pretty simple today, and talk about mutual funds or exchange traded funds, more specifically probably on the mutual fund side.
On the mutual fund side, a lot of investors, they look at a lineup of mutual funds. Typically, they have mutual funds on a 401(k), and then certainly investing them outside of their 401K.
They look at what are my fund choices. When they look at funds, they're typically looking at what are the names of the funds, how is the fund performing, and not really looking at what is the fund investing in, unfortunately.
What often happens is individuals, investors, they over-diversify in their portfolio. They end up buying some of the same exposures with multiple funds.
For instance, if they bought a large cap US stock mutual fund, they don't need to buy two or three or four large cap stock mutual funds, because you're doubling up, you're tripling up, you're quadrupling up on your exposure to the same exact segment of the market, or a country, or an asset class.
The best course of action here is to buy one fund, or one investment that covers each asset class in a portfolio. Again, our preference is to use index funds to do that, because you know then you're getting the returns of the market you're investing in, or the country you're investing in, or the asset class in the portfolio that you're investing in.
At the end of the day, the idea and concept is not to overly diversity. You don't need, as I mentioned, four different US large cap stock funds, or three different US small cap value funds.
One fund in each category or each asset class is appropriate. Too many funds end up costing too much money, too many potential tax issues, especially in taxable accounts.
Keep it simple. Keep one fund for each exposure, each asset class in the portfolio. Obviously, look at funds that if you have three or four funds that have the same exposure, for let's say large cap US stocks, or small cap value stocks you probably want to look at the cheapest fund, because that exposure's the same in all the funds, for the most part.
That's why we're not doubling up or tripling up on the different fund exposures for each asset class.
Not controlling the things that you can control.
Now we'll move on to the next mistake that investors make. That mistake is not controlling the things that you can control when investing. What do I mean by this? I mean that at the end of the day, you can control a number of things. Obviously, you can't control what the markets are going to do.
No one knows what the markets are going to do. We're not fortune tellers here. You're not a fortune teller, but you can control many things in your portfolio and the investment process that can lead you to potential investment success down the road.
Those things are what is your asset allocation? What investments did you select in the portfolio? Are you using active funds? Are you using index funds? You certainly can control your costs.
If you're using an adviser, you can control somewhat what your adviser fees are, either by negotiating with your adviser, or looking at a number of different advisers and comparing adviser-to-adviser. Then tax is another aspect of this. Let's briefly touch on each one of these things.
At asset allocation, you can control what is the appropriate amount of risk that you should be taking in your portfolio, and then don't take risk beyond that.
You're exposing yourself to risk that you don't need to potentially be taking. It's maybe risk you want to be taking and knowing what that difference is between want and need.
The next thing that we just mentioned was that investment selection. Again, are you using index funds to get exposure in your portfolio, which generally are low cost, compared to active mutual funds? Also, they're intended to capture a certain segment of the market, or the market, or an asset class.
The next area is costs. You can control the cost of the portfolio somewhat. What custodian are you using to hold your account? Is it a low cost custodian? Are the transaction fees that the custodian charges reasonable?
Next area is adviser fees. Adviser fees come in many shapes, sizes, and forms. It's much too lengthy to get into this discussion today about adviser fees, but what you need to do is know what you're paying in total cost to your adviser.
There are a lot of advisers out there that kind of like to answer the question based on the way that you're asking the question.
If you ask them what their fees are, they may tell you that I don't charge fees, because they charge commission, but then they don't tell you what they charge in commission, because that wasn't the question you asked them. These are the types of games that are played in the advisory business. What the key question is what is the total fees you would be paying to an adviser.
Most of the time, if you are working with a fiduciary adviser, you're going to be paying them somewhere in the market rate of 1% or less or more, but kind of the average out there is about 1%.
(That does not mean that I agree that you should be paying 1% in adviser fees. In fact, I feel the complete opposite. There are many advisers out there that will charge significantly less in fees, such as Firstmetric, that charges a fixed flat quarterly advisor fee of $875 regardless of account or portfolio size, NOT a percentage of your assets. Shop around!)
The next area that you can control is taxes. Let's just back up one minute before we get into taxes, and go back to adviser fees. I thought of another aspect to this. There's also a lot of advisers out there that are charging low fees. That's one thing that you need to look at is what fees that you're really paying to an adviser.
Are the fees low or if they're not low, are you getting the value that you should be getting for the fees that you're paying? A lot of advisers like to bake into their fee financial planning, ongoing advise, preparing your will, preparing your trust, a number of different things that you don't need done all the time.
You shouldn't be paying for those on an ongoing basis as a percentage of your assets. Really, looking at separating all those different fees out that an adviser may be paying you in an all-encompassing 1% fee, and asking them, what does it cost just to manage the portfolio? What does it cost just to prepare a financial plan?
What does it cost to prepare just a will or trust, if they happen to be an attorney. What does it cost to prepare your taxes if they're a CPA or an accountant. Those are some things you want to be aware of when you look at adviser fees.
Quickly going back to taxes. Taxes is another expense to the portfolio. These are things, again, that you can control somewhat. Are you taking unnecessary short term capital gains in the portfolio? Can you wait another month or two or rebalance? Is the portfolio of a great amount where you can convert a short term potential capital gain into long term capital gains?
Are you tax loss harvesting in your portfolio to capture tax losses today that you can offset in future years, or even in the current tax year, with any realized capital gains that you may need to take in rebalancing your portfolio?
In summary, on item number four of mistakes that investors make, again, control the things that you can control. Of course, the one thing you can't control is the markets.
If you control the other things that we just talked about, you're setting yourself up for at least a better chance of succeeding with investing.
Paying too much in total investment costs.
Mistake number five. Mistake number five is paying too much in investment costs. What does that mean? We talked about costs in the prior mistake, but we talked about costs just as overall costs to the portfolio.
Let's break that down a little now. You have expense ratios of mutual funds or exchange traded funds and you have transaction fees that are being paid to a custodian.
Then obviously, the 1% fee or more or less, depending on the adviser that you're working with, if you're working with an adviser.
Again, I encourage you to negotiate any fees that you may be paying to your adviser if they're towards that 1% range, because that's a market rate that's typical that most advisers end up charging.
It's a rate that may not be appropriate for the level of service that you're actually getting in managing your portfolio.
Look for expense ratios in mutual funds or exchange traded funds that are low, especially if you're using index funds. These will be low.
Transaction costs should be very low if you're working with a discount brokerage custodian, such as Charles Schwab, Fidelity, TD Ameritrade, Scottrade. I mean the list goes on. No preference on any of those. Just compare one to another, and what their total transaction costs are.
I'm not going to spend too much time here, because we covered that in the prior mistake, but again, be aware paying too much in investment cost is a direct hit on the portfolio in the short term and the long term. Investment costs add up.
Again, whether those are expense ratios you’re paying on mutual funds, transaction fees, advisor fees. When you begin to add all of those fees together, these are pretty substantial fees that individual investors could end up paying that could cost you some significant money in the long run, and cause you potentially not to meet your goals at the time that you're expecting to reach those goals.
Again, be aware, and monitor fees. I can't stress that enough.
Hiring multiple investment advisers.
Number six is splitting up your investments among multiple investment advisers, if you're using an investment adviser. Investment advisers, by design, are supposed to be advising you on your investment portfolio, and then even managing your portfolio, depending on what kind of relationship you have with your adviser.
Now this is assuming that if you're listening, you're working with an adviser. Some people who listen here are not working with an adviser. I apologize for covering this a little bit in depth here.
If you're working with an adviser, what I've seen over the years is that individual investors think they're doing the right thing by diversifying advisers, like they diversify their investments in their portfolio.
Diversifying advisers is actually not a good idea for many reasons. First and foremost, most of the time, when you diversify and have multiple investment advisers, one adviser doesn't know what the other adviser's doing.
What you have effectively done is you have now siloed multiple investment advisers doing their own thing, with certain portions of your total investment portfolio.
When you do this, it kind of defeats the purpose of hiring an adviser in the first place, because now, you have to manage these multiple advisers that you have hired and make sure that overall, all of the advisers are working together to accomplish your overall investment plan, that you're now responsible for, because as I mentioned, one adviser doesn't know what the other adviser's doing.
Even if those advisers end up talking to one another, because you give them permission to do so, my experience has been it's not usually at the level that needs to be where everybody’s always working cohesively.
This also gets very complicated when you're dealing with taxable money and you hire multiple advisers, because what ends up happening is one adviser may be taking capital gains.
Some are taking short term. Some are taking long term. Another adviser's taking tax losses in your taxable accounts. Another adviser's managing one portfolio at one allocation. Another adviser's managing a portfolio at another allocation.
Again, this puts the onus on you, because it's your money. You have diversified amongst advisers to manage your money and provide advice, that now you have to manage the overall investment plan, which is maybe what you're trying to get away from doing by hiring an adviser.
In my opinion, working with individual investors over the years, hiring multiple investment advisers is never a good idea. That's different than diversifying investments.
It's even different than diversifying custodians that may be holding your portfolio assets in safekeeping.
Dollar-cost averaging into the market.
Item number seven, and this is kind of an interesting topic that I want to talk about, where investors make mistakes that I see, is dollar-cost averaging.
Especially right now, where investors may have some cash laying around, or they just received an inheritance, or they received a bonus, maybe, towards the end of the year, they're going to receive a bonus.
What do you do with new cash that you want to put into the market if you don't put that money in a one lump-sum?
Typically, the best course of action is to put that in in one lump-sum. If the investor wants the dollar-cost average into the market, then develop a plan to do that.
Most people that develop an investment plan, also, if they're going to invest cash and they know they are over a period of time, they also develop a dollar-cost averaging plan.
What does this mean? This means that you can invest money whenever you want, but if you're investing money kind of ad hoc, then you'll investing in it based usually on emotions and what the market is doing at the present time.
When you dollar-cost average into the market, and you want to do this over a period of time, because you think the market is overvalued, undervalued, it's going to keep going up or it's going to hit rock bottom.
I mean obviously you don't know that, but you want to be cautious with your cash. That's why you're thinking you want to dollar-cost average. When you do that, you need to come up with a plan, because all too often, what we end up seeing is we see that somebody puts money into the market, and then they stop putting money into the market, because they think, again, it's too high, too low.
It's going to crash. It's going to keep going up. They're going to wait until it pulls back. They're going to wait until it stabilizes. I mean there's all kinds of different buzz words that people may use and emotions for why they are changing their dollar cost averaging plan.
It really doesn't matter what the plan is. The plan can be you're going to invest money at the 1st every month, the 15th of every month, every other month, every quarter, semi-annually, annually.
There's a lot of different ways you can dollar cost average into the market. The key here and the mistake that people make is not sticking to the dollar-cost averaging plan.
Again, stick to the dollar-cost averaging plan if your dollar cost averaging.
Again, we typically advocate, if you have cash, and you're going to invest it, since nobody knows what the markets are going to be doing, typically just dollar-cost averaging or putting in a one lump-sum, the preference would be putting it in one lump-sum.
In bull markets everyone is a genius and has skill.
Item number eight mistake that investors make is bull markets. What does that mean? That means, first of all, we've been a bull market for the last eight and half years. It's been a good run.
Again, we don't know, and you don't know, and nobody knows, even if they're writing about it or talking about it in the news, what the markets are going to do tomorrow, next week, next month, three months from now. Nobody knows.
The fact that we've been in a bull market for the last eight and a half years, everybody is a genius. What does that mean? That means that you're investing money.
At the end of the day, you really don't know how your money may be doing other than your accounts are positive or they have gone up in value.
When you're investing, and you're investing without a plan especially, that's a big problem, not knowing how your investments are doing in a bull market, or even in a bear market. We're talking about a bull market, because we happen to be in that right now.
When you're looking into your investments and you're trying to determine how well you're doing with your money, you need to know what your benchmarks are to the investments that you bought.
What does that mean? That means if you're buying a mutual fund or an exchange traded fund (ETF), that invests in US large cap company stocks, then you should have a benchmark that you're benchmarking the performance of that investment to that is the same as how you're investing.
That way, you're knowing whether your investment is performing in-line with that aspect of the market, or asset class, or whatever area of the portfolio you are buying an investment in.
Without a benchmark, you really don't know how you're doing. Just because your portfolio or a fund or an investment has gone up in value, it doesn't mean that you're actually getting the returns that you should be getting for that given asset class or style of the portfolio.
That's why without benchmarks, you're kind of really flying blind. You may be making money. Your performance may be doing well, but you don't know, unless you compare it to a benchmark.
What we often hear in long bull markets, like we're in right now, is that when someone asks you how your portfolio is doing, especially if you're interviewing investment advisers, typically we'll hear that your investment portfolio is doing well.
It's doing good. I'm happy with it. But then when you dig a little bit further under the hood, you realize that they may not have a benchmark that the benchmark in the portfolio to, and it may not be performing as well as it should be performing in relation to how the market or an asset class or a style of the portfolio is performing.
Just be aware that in bull markets, everybody seems to be doing well, but are they really doing well, as well as they should be doing in relation to how the market is doing, again, how an asset class is doing, or style in a portfolio.
Take a look at your investments and dig out how they're being invested in each class, what mutual fund, exchange rated fund, or individual stocks that you're buying in the portfolio.
Then pull out some benchmarks that are typically on the websites of the different mutual fund companies if you're buying mutual funds, and different exchange traded fund websites if you're buying exchange traded funds.
Compare the performance of how your investment is doing to the actual benchmark itself to get a good indication of how it's performing.
Buying into year-end capital gains distributions.
Mistake number nine. This is a timely mistake, because we're getting into November, December now of 2017. Again, we've had a great run this year, and again, in this eight and a half year bull market.
There's a concept of buying into year-end capital gain distributions. What does this mean? This means that when you're buying investments and investing in mutual funds and exchange rated funds, but mostly mutual funds is what we're talking about here, there's a concept that you could be buying into a capital gain distribution.
At the end of every year, typically December, usually about mid-December to the third week of December, mutual fund companies will make capital gain distributions to shareholders of record in those funds at that point in time. Like I said, typically December, mid, to the third week of December.
When you're buying investments, especially into December, you want to make sure that you're beyond the period of capital gain distributions, so you're not buying into year-end capital gain distributions, where you end up paying taxes on capital gains into the portfolio that you could've avoided by buying that portfolio usually a day later, a week later, a couple of weeks later, and avoided paying any potential long term and short term capital gains on year end distributions. That's something you need to be aware of.
Usually all mutual fund companies, especially large mutual fund companies, like Vanguard, will publish this information on their website typically starting towards the end of November, and certainly in the first part of December what the estimated year-end capital gain distributions would be short term and long term for each mutual fund, and then also the important dates that you need to look at, the date of record, the ex-dividend date.
Those are all important to look at when determining when to buy into a fund to avoid buying into what they call a year-end capital gain distribution.
I just bought the S&P 500 Index, so I can sit back and relax.
The last one we want to cover today is another mistake that investors make. This is just concerning just index investing. A lot of people buy index investing.
Certainly, I'm a big proponent of indexing. That's how we manage money at Firstmetric, we're an investment management firm that I'm the CEO at. This is a concept that we get the question a lot of times about index investing, that's easy, right? I just go out and buy an S&P 500 fund, and sit back and relax.
Why do I need an adviser? Even if I'm going to do it on my own, why do I need to buy more than the S&P 500?
Well that's an important question. I think a question that we should spend a couple of minutes on talking about here, because investing in the S&P 500 is not a diversified portfolio even if you're buying index funds.
When you invest in the S&P 500, you're investing in large cap US stocks, 500 stocks give-or-take, US large cap stocks, depending on what fund you're buying the S&P in, some manage the fund by buying actual holdings. Some do sampling. There's different ways of replicating the index. We won't get into that today.
Assuming you're buying the S&P 500, you're buying a large cap US stock index fund. What does that mean? That means you don't have exposure to many, many different areas of the market as a whole.
You certainly don't have international exposure other than the companies that are US companies in there that are doing business internationally that you'll have that exposure, but you don't have any direct international companies in the portfolio that you have exposure to.
Then also you don't have exposure to different asset classes, such as small cap. You don't have exposure to different styles within other areas of the portfolio, like growth and value.
You have growth and value in the S&P 500, but that's typically about half growth and half value. You don't have a bend towards anything in the portfolio. Certainly you don't have any fixed income bonds in the portfolio if you're buying just the S&P 500.
Bonds play an important role in a portfolio to manage and help control what level of risk you need to have overall in your portfolio.
Simply buying an S&P 500 fund, sitting back and relaxing, you may think you're doing the right thing, because you're investing in an index fund, and it is low cost, but you're taking potentially unnecessary risk by not diversifying the equity side between international and US, and then further between different asset classes in the portfolio, and then certainly not having fixed income as a real crucial element in the portfolio, because typically, you want some level of fixed income.
Even if you're an aggressive investor, typically you want at least a position of around 20% equity in a portfolio, even if you're inclined to be very aggressive and have 100% equity portfolio.
(The preceding sentence should have stated 20% in bonds, not 20% in equity as mentioned in the audio podcast episode and show transcript.)
That's just something to think about that often we get the question of indexing is easy. I can just go buy an indexed fund, and then I'm all set. I don't need an adviser or I don't need to complicate this to go out and invest my portfolio.
Buying an index fund is one thing, but developing an overall global diversified portfolio using index funds and asset class funds is the correct way to manage an index-based passive investment philosophy and strategy.
Keep that in mind as you may or may not be inclined to use index funds. If you are, just buying the S&P 500 is not necessarily the ideal strategy in the portfolio.
In fact, we don't buy the S&P 500 in our clients' portfolios, because we want exposure to the entire US stock market, not just large cap US stocks. Something to think about. Just another mistake is individuals get into investing and designing a portfolio.
We've come up with 10 today. They're not necessarily the top 10 mistakes. We tried to develop the list around the concept that some of these, as we talked about, were timely, because getting towards the end of the year, with year-end capital gain distributions, dollar-cost averaging, potentially for year-end bonuses, and a number of things that we'd already talked about in today's show.
Again, it's not necessarily the top 10. In a future episode or maybe a future blog, we'll talk about more investing mistakes where investors make mistakes in their portfolio.
I hope you're able to walk away from today's show with at least one nugget of knowledge. Hopefully we can steer you in the right direction from making some of these mistakes that we see pretty regularly when we speak with clients and potential clients.
Again, thanks for listening to today's episode. Until next time. Be safe.