Whether you are going at it alone, or working together with a financial advisor, or robo-advisor, avoiding the investment pitfalls detailed below will help you invest your hard-earned cash wisely and maximize your returns.
#1: Investing from the Water-Cooler
Money personalities on TV love to talk—sometimes shout—about their latest hot stock tip.
Or maybe you have a friend or relative who always seems to brag about a "must-buy" company whose stock is poised to go through the roof.
If you think there may be something to the stock tip you picked up around the water cooler, don't rush to invest.
Instead, "research, research, research."
When you buy a house, you go check it out, right?
But when buying or selling shares, people often simply take someone else's word—be it a relative, friend, colleague or TV pundit.
Good places to start researching stocks
Do. Your. Research.
There you can view the fees associated with the investment, its historic returns, and the latest financial news associated with that company or fund.
You'll also want to review the company's latest financial reports to get a better sense of its profits and expenses.
Remember—investing solely based on rumors, conjectures, or hot tips is gambling, not investing.
#2: Having too short a time horizon
Financial experts suggest you only invest money you need for the long-term, say five or 10 years down the road.
That's because in the short-term, the stock market can drop multiple percentage points in a day—resulting in a panic-filled, bumpy roller-coaster ride.
So if you have $100,000 invested and lose 4%, that's $4,000—a significant chunk of change.
Over the long term, however, the stock market has a fairly steady upward trend.
Warren Buffet has been quoted as saying you should only buy stocks you feel so strongly about that you wouldn't care if the stock market took a two-year holiday.
Buy into something you believe in and then let it do its thing.
#3: Failing to rebalance
At least once a year, check in on your investment performance.
Since your investment portfolio is diversified, some investments likely performed better than others.
As a result, the original mix you wanted to maintain (such as 80 percent stocks and 20 percent bonds) may have morphed into 90 percent stocks and 10 percent bonds, for example.
Adjust your portfolio accordingly to maintain your desired mix.
This doesn't have to be difficult—your brokerage firm may even have a tool that will automatically rebalance your portfolio for you.
#4: Not diversifying your investments
You've probably heard the adage that you "shouldn't put all of your eggs in one basket."
In investment terms, that means that you should invest in a variety of types of investments, otherwise known as asset classes.
A balanced portfolio would be invested in a percentage of stocks (both domestic and international, and bigger, medium and smaller sized companies), as well as bonds, and some cash.
The goal is to lower the overall risk of the portfolio while hopefully also increasing the return.
When diversifying a U.S. stock portfolio, you may want to consider other markets like gold or real estate.
Too much can be a bad thing.
In fact, experts suggest investors don't have more than 20 mutual funds in their portfolio.
To be safe, diversify, diversify, diversify.
#5: Trying to pick the next hot stock
By definition, a diversified investment portfolio shouldn't be heavily weighted in one stock—it should be spread out among different types of investments to minimize risk and maximize returns.
A handy rule of thumb: Don't allocate more than 5 to 10 percent of your portfolio to any one investment.
This is especially true when it comes to your company's stock.
The last thing you want is to be unemployed and see your nest egg decimated at the same time if something happens to the company.
Still not convinced?
Just ask anyone who worked for an old company called, Enron.
The energy company's stock had an all-time high of $90.75 per share in mid-2000, but fell to less than $1 by 2001.
Employees whose retirement accounts were invested solely in Enron stock lost everything seemingly overnight. #Gasp
Still hankering to invest in individual stocks?
It's OK to set aside a small amount—say 5 percent of your non-retirement investment portfolio—to dabble in individual stocks, financial experts say.
Just be aware that this is more of a hobby than a sound investment strategy.
#6: Letting your pride take over your pocketbook
Often, when an investment begins to flounder, investors have a hard time selling the "loser" investment and cutting their losses.
"I'll just wait until it goes back to what I paid, and sell it then," they think to themselves.
That will just ensure that you lose any profit you could have made had you just stayed the course.
True, selling a stock that has decreased in value means you'll be locking in your losses.
But if the long-terms prospects for the investment aren't great, you risk losing even more money if it continues to decline in value.
Let's say you bought shares of Target at $35.
Now, they're valued at 20% less.
You could cut your losses and move on.
Or, you can stick it out and hope you didn't make a bad decision.
#7: Following the crowd
When the stock market crashed in 2008, and investors saw their portfolios drop more than 30 percent, on average, many sold their stocks and waited on the sidelines until the market rebounded enough that they felt safe wading their feet back into investments.
However, this is precisely the wrong approach.
In doing so, these investors sold off when stocks were low and bought when they were high (the opposite of "buy low, sell high").
When investing, fear will be your greatest enemy.
For example, you might decide to sell winning stocks when they rise or drop more than 15 percent in value.
Take the emotion out of it. Be logical. Make decisions based on strategy.
#8: Using too much margin
Margin is when you use borrowed money to purchase stocks. While buying stocks on margin can help you make more money, it can also exacerbate your losses.
That's because even small stock price changes can lead to loss losses.
For example, you want to buy 100 shares of Microsoft stock, which is trading at $50 a share.
It will cost you $5,000, but you only have $2,500 cash on hand.
So you buy the 100 shares of Microsoft on margin, essentially borrowing $2,500 from the brokerage firm to do so.
Then the stock price falls to $40 a share.
Now, you only have $4,000 worth of stock, but owe $2,500 to the bank.
Even worse, you may have to deal with a margin call—when the broker insists that you add more money to your account to ensure that the borrowed amount is less than half of the total value of your portfolio.
Don't have the cash?
You may be forced to sell your securities to pay back the margin loan—locking in your losses, even if you strongly believe the stock will go up in value in the long-term.
New investors should shy away from using margin entirely.
#9: Trading too often
As you begin to get comfortable investing, don't rush to quit your job to become a day trader working off of your sofa.
Many brokerage firms charge you a transaction fee every time you buy and sell investments—these fees eat up and ruin any returns you may make.
Plus, come tax time, you may have a mess to muddle through resulting in higher accounting costs.
Frequent trading can quickly come back to bite you.
Instead, you'll be better off by creating a diversified investment plan and stick with it for the long-term.
#10: Not reading the fine print on fees
Fees are one of the few aspects of investing that you can control—and it adds up.
The average mutual fund charges as much as three percent of annual returns, meaning that you need to earn more than that to simply break even.
Paying an additional one percent in fees every year over the span of your career can result in the loss of tens of thousands of dollars at retirement.
So if you have a $100,000 investment portfolio that grows four percent annually (a conservative estimate), a one percent ongoing fee would add up to almost $28,000 in fees over two decades.
There's also the opportunity cost: If you had invested that $28,000, instead of pay it out in fees, you could have earned an additional $12,000 over 20 years.
Plus, amazingly, higher-cost funds are more likely to underperform than lower-cost funds, according to a Morningstar analysis.
This includes not only the expense ratio, but other transaction fees.
#11: Placing too much focus on past returns
As the saying goes, "past returns are not a guarantee of future earnings."
Just because an investment had a great return this year doesn't mean it will come out ahead next year, too.
"If you make your decision based solely on past returns, you stand a good chance of being disappointed," says Patton.
That's because "funds that were at the top of their peer group one year, often do not remain there the following year."
If you make your decision based solely on past returns, you stand a good chance of being disappointed.
So while it is a good idea to look at historic returns of an investment as part of your research process, you should place a greater emphasis on the business fundamentals—its revenues, expenses, and overall economic trends within the industry.
#12: Not taking advantage of tax-favorable accounts
If you have the option at your workplace of investing in a 401(k) or 403(b) plan or IRA for retirement, take advantage of these tax-favorable investment vehicles.
Many of these plans provide you with an immediate tax break—lowering your Adjusted Gross Income by the amount of your contribution.
Plus, when you contribute to a tax-deferred account, your earnings can compound tax-free.
If your employer matches a portion of your contribution, it's even more critical that you invest a minimum to get the full match.
Otherwise, you're giving up the chance to earn free money.
To help you identify your personal financial goals and create a healthy asset allocation to yield the risk/return balance needed to meet those goals, you might want to consider meeting with a financial advisor.
A fiduciary fee-only advisor, meaning he or she is required to act in your best interest, can also review your investment portfolio on an annual basis to ensure that you are sticking to your financial plan and not letting your emotions govern your investment decisions.
Other options include so-called robo-advisors, a generally lower-cost option in which a computer algorithm analyzes your investment portfolio and makes suggestions based on the information you provide.
Popular robo-advisors include:
- Charles Schwab Intelligent Portfolios
Stay invested in your new investment know-how
If you follow this advice, you'll be well on your way to having your money work for you.
Before long, you'll be able to retire early, pay for your kids' college tuitions, or finally take that dream cruise. Bada. Bing.
- Do your research and diversify your investment portfolio.
- Invest for the long-term, and don't let your emotions drive your decision-making.
- Rebalance annually, and pay attention to fees.
What's the best (or worst) investment tip you've heard?
Let us know in the comments below.