Rookie mistakes, we've all made a few
Common errors that can sink a portfolio, from poor asset mixes to overly active investing
As in any endeavour, pitfalls lurk for the self-directed investor. Consider the experience of Gail Bebee, author of No Hype: The Straight Goods on Investing Your Money. Shortly after becoming a self-directed investor several years ago, she bought a labour-sponsored investment fund.
"What was I thinking?" she now asks herself. She had fallen for the hype surrounding the product and the lure of tax breaks. "There is so much information out there on financial products, much of it biased. Investors need to do their own research and understand what they are buying," she warns.
Succumbing to marketing bumpf is but one of the pitfalls self-directed investors can fall into. Here's a look at five others.
Not sticking with a long-term investment plan
During bear markets, many investors despondently jettison their stocks, unaware of the historical tendency of stocks to rise over the long run.
As Jeremy Siegel, a professor at the Wharton School of the University of Pennsylvania, has shown, U.S. stocks average 7 to 9 per cent annually over holding periods of 15 to 30 years.
Or, if investors are aware of the historical tendency of stocks, they fail to mentally prepare themselves to keep fear and pessimism at bay during the downturns.
"The main area where investors need some knowledge is asset allocation," notes Richard Deaves, a McMaster University professor of finance and author of What Kind of Investor Are You? Asset allocation is about selecting a combination of assets that maximizes return subject to an individual's risk preferences, time horizons, and other parameters.
The basic asset allocation decision involves spreading money over stocks and bonds. Risk-adverse individuals should go with a lower proportion of equities than people who are more tolerant of taking chances.
This makes is easier for them to ride out the short-term volatility, and assuage fears that future long-run returns will not be as high as past returns.
Some investors do not manage asset allocations well over time, however. They may become overconfident during bull markets and allow the equity proportion of their portfolio to rise, either by drift or overtrading.
When the downturn comes, they find their exposure to equities is in excess of their risk tolerance.
Similarly, neglecting to rebalance during the downturn leaves equity exposure too low when markets recover.
Another way you can trip up is to have too much weight in equities when saving for a short-term goal, such as buying a car in three years. Being volatile in the short term, equities could be in a loss position when the time to withdraw funds arrives.
Under-diversification is another hazard.
A 1995 research paper looked at the portfolios of more than 3,000 Americans and of those invested in stocks, the median number held was found to be just one. Only 5 per cent held more than 10 stocks.
Also, investors often fail to diversify with respect to non-financial wealth.
For example, as York University finance professor Moshe Milevsky writes in his book, Are You a Stock or a Bond?, investors employed in insecure lines of work should have less exposure to equities than persons with secure jobs.
Some people over-invest in the shares of their employer. A 2001 study found this excessive risk-taking arises due to "momentum chasing" - employees of companies in the top-performing quintile allocated 40 per cent of their discretionary funds to their employer's shares.
Overly active investing
Many investors spend a lot of time and energy researching stock picks and timing the market. But this doesn't necessarily contribute to portfolio performance, which experts say primarily derives from asset allocation.
Investors, especially those who are busy with family, friends, and career, may be better off designing their core portfolio around a passive investing approach based on index funds and exchange traded funds (ETFs) that track trends in assets. (One such example is the "couch potato portfolio" recommended by MoneySense Magazine.)
Financial planning missteps
Going without a financial adviser means you may miss some financial planning opportunities. For example, when it comes to retirement planning, many investors "do not begin saving until very late, and do not save enough once they start," notes Mr. Deaves. Other possible oversights include: not paying enough attention to tax breaks, overcontributing to your RRSP, and overlooking opportunities to tap into government programs, such as the RESPs.
Special to The Globe and Mail