As emotional human beings, we tend to be our own worst enemy when it comes to making investment decisions. Below are five common ways in which investors slip up, and suggestions on how best to avoid these mistakes:
1. Letting Anxiety Rule Your Head
Back in 2006 you might have been feeling nervous about the stock market, with equities at all time highs, and pondering whether it might be time to get out and move into the ‘safe haven’ of a share-free portfolio. Again, in early 2009, you may have found yourself thinking that markets couldn’t go much lower and it was time to plunge your funds back into equities. The chances, however, that you actually managed to accurately pick—and act on—these two turning points are very slim. Furthermore, miscalculating these points could have had a seriously detrimental impact on the value of your portfolio.
Of course we understand that it’s difficult to ignore your emotions completely but the statistics prove that stock performances over time tend to improve and come back. If you’d been fully invested in bonds between 2000 and 2003, you might have been rubbing your hands with glee as you watched equities tumble amid the bursting of the tech bubble. But that same portfolio today would have substantially underperformed a mixed stocks and bond portfolio, even taking into account the stock market crash of 2008.
The key message here is threefold: taking a long-term view is important because it reduces the impact of volatility; trying to time the market leads to slip-ups; and diversification is very helpful for spreading risk.
Read this article for tips on how to minimise human error.
2. Trying to Time the Market
As alluded to above, timing the market is a lot easier with hindsight. Sure, we all now know that if you’d invested fully in large-cap UK equities around March 3, 2009, you would have seen your portfolio add half its value again over the ensuing six months and hold up this performance going into 2012. But accurately timing the markets is pretty difficult, and many would argue it's impossible. Did you invest on March 3, 2009? The answer is probably "no".
Simply admit that timing the market is not going to happen, and instead focus on setting your investment goals, picking your investment strategy and spreading your investment risk, which will ultimately lead to steady returns—returns that would have been substantially reduced if you’d tried to time the markets and missed, say, the best-performing month of each year. Trying to guess market movements is a risky and fraught investment style.
One particularly effective method of investing is pound cost averaging, which is when you invest equal amounts of money on a regular basis into your portfolio. This allows you to bypass the risk of making poor investment decisions during tumultuous times. Pound-cost averaging can help investors limit losses, while also instilling a sense of investment discipline and ensuring that they're buying shares at ever-lower prices in down markets. Numerous studies have confirmed that it also results in better returns than strategies that involve trying to time the markets.
3. Misunderstanding Diversification
A common mistake to make is to think that because your portfolio contains 15 different funds, you’re well diversified. But diversification isn’t about the quantity of holdings. Use our Instant X-ray tool and you may be surprised at the overlap within your portfolio. Good funds combined in the wrong way can make a bad portfolio: diversification means spreading your investments across assets, regions, sectors, and investment styles. This table perfectly illustrates how one year’s ‘hot topic’ can become the next year’s dud. Anyone invested fully in one area, such as UK small-caps, would have watched their portfolio swing violently between notable gains and substantial losses over the ten years to 2006, but a savvy investor who had spread their money across a range of assets, sectors and regions would have achieved much smoother returns over the decade.
4. ‘Old Age’ Means Time to Pull Out of Stocks
By all means, as your investment time frame shortens you may want to move from a more aggressive investment style to a more conservative one, perhaps shifting assets into bonds and cash and out of more volatile equities. But just because you’re broaching retirement age doesn’t necessarily mean it’s time to focus your portfolio fully on fixed income.
There are three key points to take into consideration here: Firstly, retirement income horizons are increasing—if you can afford to retire early then congratulations but for the majority, the State-set retirement age keeps being pushed back. Secondly, we’re living longer these days—in fact a couple aged 65 at present have more than a 25% chance that one of them will live into their late 90s so that’s more than three decades of living costs they need to have saved and invested for. Thirdly, inflation erodes purchasing power. The value of a portfolio invested solely in fixed income will decrease over time, even at the current low rates of inflation, and increasingly so as inflation rises, as many expect it will do given the vast quantity of money injected into the system by way of the government’s economic stimulus programmes. Keeping a portion of your portfolio in other assets such as equities can help protect again inflation-erosion.
For more on this topic, read this article by Brook Sweeney, Investment Consultant with Morningstar Associates Europe.
5. Procrastination or Inertia
“I can’t afford to invest right now, I’ll do it next year once the company reinstates bonuses.” Sound familiar? The problem with delaying is that it reduces the amount of time your money has to work for you and also reduces the long-term advantage of pound cost averaging. If you had invested £2,000 per year over the ten years to 2006, the value of your investments at the end of the time period would be far greater than had you started investing £4,000 per year halfway through that period.
An additional benefit of long-term investing is compound interest, exemplified by the oft-quoted trick question of whether you would rather have £1,000 per day for 30 days or a penny that doubled in value every day for 30 days. The savvy investor would pick the doubling penny and be looking at £5 million at the end of 30 days versus £30,000 if they opted for the £1,000 per day.
Hopefully you’ve noticed that these investor mistakes all lead to the same few suggested solutions: take a long-term view, understand that market corrections do happen, stay the course rather than attempting to time the market, taking advantage of pound-cost averaging and compound interest, diversify your portfolio and, last but not least, act rather than delay.
Additional articles on all these topics can be found by searching our article archive.
A version of this article was originally published in December 2009.
