Top five investment mistakes
These five common investment mistakes can cost you, and the impact worsens over time unless they’re corrected. The fixes include making a plan, refining it over time while sticking to it, frequently reviewing investments, and taking a long-term view.
It has been a turbulent decade for financial markets, with boom followed by the bust of the financial crisis and the shaky recovery since. However, most investors should have hardly noticed this because they’re in it for the long term and aren’t influenced by the short-term fluctuations in the financial markets.
By following a simple set of rules and avoiding the common pitfalls, anyone can become a more successful investor.
So what are those pitfalls? Here are five common mistakes that investors make.
- No plan
A successful investor needs to have clear goals, and a plan for how they’re going to achieve these goals. Whether you want £25,000 for a new car in three years’ time, £100,000 to cover your child’s education over the next 20 years, or £1 million for retirement, you need to make your investments work for you.
The key is to be realistic and not to expect too much, and not to use someone else’s expectations. There are many tools out there to help you. Try IG Smart Portfolios calculator.
Your plan needs to take risk into account. Risk that you’re prepared to take in order to achieve your goal, and risk that asset underperformance undermines the path to your goals.
The further you are from the goal target date, the less you should be concerned about market volatility. The closer you get to hitting your goal, the more risk-adverse you should be. However, you should always be aware of the risks of inflation eroding your portfolio, the impact of fees on your portfolio, and the benefits that compounding interest or capital gains make.
- Focusing on the short term
This is about sticking to your investment plan. Investing is about spending time in the markets, not trying to time the rises and falls of individual markets.
Short-term movements in the markets, including seemingly severe stock market crashes, can send investors scurrying to move to assets that are performing better at that time. This is the wrong thing to do. The FTSE 100 fell 28% in 2008, but it is still up 9.4% over the past ten years. Remember, you’re an investor not a speculator. It’s about the long term. Emotion shouldn’t get in the way. Successful investors stay calm when everyone around them is panicking. One of the world’s most successful investors, Warren Buffett, puts his achievements down to his temperament and his ability to control the urges that get other investors into trouble.
This means not buying and selling too often, and not chasing trendy sectors. Doing this not only distracts an investor from the overall gains of his or her portfolio, but it can also be costly, pushing up the fees that eat into returns.
- Not rebalancing
You’ve selected your asset allocation as part of your investment plan. Over the course of a year, some assets have performed better than others. That means your portfolio is now overweight with the assets that performed well that year and underweight with those that didn’t. You need to rebalance your portfolio back to its original state.
This is not easy. The tendency will be to keep the assets that have performed well. However, over time this is changing the risk balance of the portfolio. When the outperforming assets start to underperform, it will have a proportionally bigger impact on your portfolio unless you’ve rebalanced. So check in and rebalance at least once a year.
The opposite of rebalancing is chasing performance. It’s hard not to do. The feeling that you’re missing out on a great performance can be very strong. Resist it. The smart money has probably already moved on. Rebalance your portfolio, don’t chase performance.
- Not considering the impact that fees and charges will have on your portfolio
Even a small difference in fees can have a huge impact on wealth over the longer term. Fees can be bewildering. There can be initial fees, annual management charges, ongoing charges and outperformance fees. The industry, under pressure from regulators, is becoming much more transparent about its fees and charges, but investors need to make sure they know what they’ll be paying and compare the fees from different providers.
Generally, actively managed investment funds tend to have higher fees, but do the returns justify those fees? Passive investment funds have much lower charges.
An apparently small difference in fees can make a huge difference to returns over the long term. For illustration purposes, let’s say a 30-year-old individual receives an inheritance and decides to invest £15,000 of it. He puts it in an actively managed large-cap UK equity fund in an ISA tax wrapper with an average annual return of 6% before tax. If left for 35 years, the investment pot should be worth £115,291. However, if the investor has been paying just 1% in fees and charges, these would have taken out a chunk worth £31,273, leaving just £84,018. If the investor instead put the money into an exchange traded fund (ETF) replicating the performance of the FTSE 100 with an ongoing charge of 0.1%, then the total cost of investing is just £3967, meaning the pot after 35 years is £111,324.
While the example is illustrative, it clearly demonstrates the difference fees and charges can make, and how that difference compounds over time. Investors should seek to keep fees and charges to a minimum.
- Overconfidence in the ability of fund managers to outperform
Fund managers levy high fees based on the premise that they’ll be able to provide investors with superior returns. However, many fund managers underperform their benchmarks, and it’s impossible to predict which of the fund managers will be able to outperform and for how long. Statistics show that managers operating in the same area can report vastly different performances over the same period. Fund managers also sometimes move firms, and this can have a big effect on the performance of the funds they’ve left and the ones they’ve now taken on. There are sites where you can compare and research fund manager and fund performance. It’s also important that you ensure the fund manager invests in the right areas for you. Remember, you have your own investment plan and asset allocation that you’re sticking to.
Passive investment choices generally offer lower fees, although you’ll only be able to match the performance of the underlying assets you’re investing in (before the fees). But that may be enough to achieve the targets of your investment plan. As we’ve described above, there’s no certainty that an active fund manager will achieve the outperformance you’re paying for, and that’s true in both a bull (rising) and bear (falling) market.
You may want to consider a mixture of active and passive funds, or decide that you can achieve the results you want by investing wholly in passive funds. Just remember to avoid the common mistakes that we’ve described above.