With the stock market reaching new all time highs, the temptation will be strong to believe that the rules that govern sensible and long-term investing no longer apply to you. Suddenly the 60/40 asset allocation that has served you well over the years will feel too conservative.
That strong pull you feel egging you on to take on more risk, that voice in your head saying go for it, that familiar feeling of adrenaline rushing through your body as you throw caution to the wind and gamble your nest egg away, all this and more poses unpredictable risk to your long term financial security.
Here are 3 investing mistakes to avoid in 2014.
1. Chasing Performance
Probably the most common mistake investors make is chasing performance. Come January, the usual suspects will publish their list of the 10, 20 or 50 biggest mutual fund winners from 2013. More common now is to slice and dice the winners into more categories than one can imagine.
These mutual fund winners from last year, if chasing performance is your thing, soon replace the core funds in your portfolio as you chase after returns. It’s a temptation many investors find too hard to resist. If they performed so well last year, surely they’ll perform as well if not better in 2014, right? Not always and many times, not even close.
One way to avoid making this mistake is to do what more seasoned investment managers, including myself, do, which is to analyze not just last year’s performance, but instead look at a funds 5-year and preferably 10-year track record. This is a much better way to analyze and judge performance then strictly looking at a one year snap shot.
Keep in mind, mutual fund managers do get lucky sometimes. Looking at last year’s performance only when making a serious investment decision is not doing your proper due diligence. Always check out the 10 year track record if that’s possible as that will be a much better indicator of future performance than last year’s performance. Here’s a link to Vanguard’s mutual fund performance to better illustrate this point: Note the disparity between year-to-date returns and 10-year returns. That’s what you’ll want to pay attention to overall.
“John Bogle, the founder of The Vanguard Group and a longtime champion of investing in index funds said recently that America’s retirement system “is almost rigged against human psychology that says [if] something has done well in the past, it will do well in the future,” “That is not true. That is categorically false.” source: bogleheads.org
2. Throwing Your Diversified Portfolio Under the Bus
With bond funds continuing to see record redemptions, the overwhelming impulse for many investors seeking long term growth will be to avoid bond funds all together in 2014 and put 100% of their portfolio into the stock market. With the S&P 500 looking like it’s going to have a record year, this strategy, on the surface at least, seems logical. But don’t fool yourself, doing this is risky business.
What many investors too easily forget is the sound reason and basis for developing and maintaining a broad diversified portfolio. What did well last year may underperform the following year. Large cap growth may have outperformed large cap value, small caps may have out performed emerging markets, short-term bonds may have out performed long-term bonds, etc.
Regardless of which asset class we’re talking about, it's much better to construct and maintain a well diversified portfolio than making the mistake of thinking you can outsmart or time the market.
3. Buying Investments on Margin
Before the market crash in 2008, buying stocks on margin, meaning you borrow money from your broker to purchase more stock than you have the cash to do, using your current investments as collateral, also known as utilizing leverage, was very common. Some brokerage firms even enabled their customers to purchase 3X the amount of stock they owned. So if you had a portfolio of $500k for example, you were able to leverage that portfolio and purchase up to $1.5 million of other investments.
The rules since the crash are no longer that loose, but it’s only a matter of time before we’re back to the bad old days of 2 to 3X leverage of your portfolio. Yes, of course, borrowing money against your portfolio provides you the opportunity to double or triple your profits. But as many investors found out the hard way in 2008, when the market turns south quickly, the ‘opportunity’ to lose 2 to 3X your portfolio value, (check out the movie Margin Call) happens as well. Call this what it is - gambling or speculating, but don’t call it long-term investing.
If you have a high propensity for risk, this temptation will be one of your biggest challenges to overcome. The thought of doubling, perhaps even tripling your returns feeds into your emotion of greed, and in this case, unlike the movie Wall Street, greed is not good.
To avoid this mistake, pay attention to what’s driving your emotional need to take on this type of high risk. With a stock market that seems to be headed in only one direction, up, it’s easy to forget how quickly global events can turn a market around on a dime.
Finally, do yourself a favor. Please bookmark this website: Bogleheads Investment Philosophy So when you’re feeling tempted to do something risky with your investment strategy, go back and read these investing pearls of wisdom as many times as needed and get back on track to being a smart and savvy long-term investor.