12 Common Investment Mistakes (and How to Avoid Them)
Confidently put your money to work by knowing what NOT to do with your investments. The best advice to help you set and power up your portfolio.
Congrats! If you're reading this, you have a wonderful problem to solve. You have money—from savings—to invest!
You worked hard to have—what is sadly becoming a luxury, extra cash, in your life. That takes dedication and effort.
You probably had to cut your budget to the bone to pay off debt—whether it was a mountain of student loans, the credit card balances that have been nagging at you for years, or a personal loan.
But you're smart. Super smart.
After eradicating your debt, instead of celebrating with a shopping spree or a lavish vacation, you responsibly get back to work.
Before long you have set aside three to six months' worth of expenses in a savings account. Emergency fund? Check.
Now, with every paycheck you set aside a bit of savings.
You do so because you have a daily dream of retiring as soon as possible, saving up for your kid's college degree, or buying a big-ticket item, like a home.
You have graduated from purely saving and having an adequate emergency fund in place to start making money with your money, or investing.
But it's scary investing your hard-earned money.
You don't want to make a mistake.
When you google, "how to invest as a beginner," you're overwhelmed by all the noise out there.
The number of articles and advertisements warning you how complicated it all is don't help.
You worry—understandably so—that if you don't proceed carefully you could lose everything in an instant.
But guess what? The biggest mistake is: Not investing at all.
That's right. Most people are so intimidated by investing that they don't - or they procrastinate too long.
Big mistake. The earlier you start investing, the more your money will start growing for you.
Since you're smart enough to save, we know you're smart enough to research how to invest your hard-earned money - without making the common investment mistakes that too many of us do.
We're going to walk through an overview of investing basics and then dive into the top 12 investment mistakes that people make.
Once we're done, we're going to look over some of the most helpful tips and strategies to build wealth through investing, so that you can continue being on top of your finances.
Let's get started, responsible person!
Investing 101: Why do it?
Why bother investing at all when your hard-earned dollars can earn a guaranteed rate in a savings account or Certificate of Deposit (COD)?
Easy answer: Your wealth truly won't grow with those low-risk investments.
"But I do invest," you may be telling yourself.
Savings accounts and CODs don't count as meaningful investments.
Yes, they're secure. While the majority of savings accounts offer FDIC protection—insuring your bank deposits up to $250,000—the interest rate you'll earn on these accounts is low.
Take a look yourself.
Most banks give less than an 0.6% return on any money you put into a traditional savings account.
In fact, given the relatively high interest rates you'll earn by investing in the markets, over the long run, it's actually riskier to squirrel away your money in a savings account than to invest it.
Because of something called "compounding interest" and "inflation."
Knowing what compounding interest and inflation mean instantly put you on solid ground as an investor.
Don't freak out from the terms.
It's easy to wrap your head around what these mean.
We'll explain compounding interest with dollars and cents.
How compounding interest works
Compounding interest is a term that describes how not only your initial investment grows more valuable over time, but also how the interest on that interest grows.
If you had $1 and the bank paid you 10% interest each year, you would have $1.1 after one year.
So, the next year you would be paid 10% interest on $1.1, not $1.
Each year the amount earning interest grows. Compounding interest is why it is so important to get started investing as early as possible. The earlier you invest, the faster it can grow - without you doing ANYTHING.
Let's explore two scenarios that imagine you invest $100 today.
If you put $100 in your savings account, earning .6% a year, it would only grow to $112.71 after 20 years.
In other words, it would take you two decades to earn a measly $12 in interest!
But the average return on investment if you invested your money in the US stock market over the last 100 years is 7%(even taking into consideration inflation, which will cover later).
Let that sink in a bit.
Put your money in a savings account and you'll get less than 1% return on your money.
Put the same amount of money into an investment account and you'll average a return of 7%!
This BIG difference is important because of the compounding interest effect.
Back to that $100.
This time, instead of a savings account, we are going to put it into an investment account and invest it in the US stock market.
In the first year you invest, you'd have $100 plus 7% return, or $107.
Just by leaving your money invested , and assuming you didn't put any additional money in the next year, you'd have $107 plus 7%, totaling $114.49.
(In two years, you already made more money in an investment account earning 7% interest than a savings account earning .6%!)
Year three? $122.50.
Year four? $131.08.
Skip ahead 20 years. You'd have $386.97.
Now think about that $100 if you added a few zeros to it. Each year. Woo wee!
The growth of the $100 to $386.95—or a 387% increase—is due to compounding interest. The money is making more money just sitting there.
To make matters worse, that $112 would probably leave you with LESS "worth" than you had when you started due to inflation.
If compounding interest grows your worth, then inflation sucks out its life force
We won't get into too many details here, but simply put, inflation is a financial phenomenon that describes how money can become less valuable (or less worthy) over time.
Read all about it over at Investopedia, if you're curious to learn more.
You need to care about inflation because if it grows too high and/or your money grows too slow, then you'll be left with less worth than when you started.
A little confused? Don't worry.
Here's what we mean.
Let's say you're earning a near-impossible 2% with your bank savings account.
Inflation, however, is growing at 3%.
In this case, the amount of money in your bank account will grow just a bit—but you won't be able to buy nearly as much with those dollars.
The cost of things is growing faster i.e. inflation, than the return you're getting with a savings account.
The average inflation rate in the US over the last 20 years is 3.22%, according to InflationData.
So, sticking your money in a savings account that is earning an never-heard-of 2% interest rate will still result in you "losing" money since inflation is over 3%.
Long story short: Savings accounts are fine for emergency funds and other medium-term needs, but if you really want to make big bucks with your money, you have to invest it.
Sadly, because people are so intimidated by investing and fear making mistakes, fewer people are investing. This is the first and biggest mistake.
Young people, especially, according to a study by Franklin Templeton, make this mistake. They still remember the Dot Com market crash in the early '00s. And what went down in 2008, or "The Great Recession" cuts super close.
Given all the tumult over the last few decades, along with the searing images of the Great Depression, it's no wonder that people—young and old—are cautious when it comes to investing in the stock market. No one likes the thought of losing their money by investing.
That's a shame, because while everyone should be smart and sensible about investing, they shouldn't avoid it altogether, as that $100 we invested proved.
Basic investing terms and concepts you need to know
The difference between saving and investing is that the latter involves a greater level of risk with the hopes of larger returns on your investments.
Unlike with a savings account, when you invest, there is no guarantee that you will get your money back.
That's intimidating. But there are PROVEN ways to minimize this risk and more importantly, to maximize the rewards.
The simple way to do this is understand that there are different investment options to choose from, which include things like stocks, bonds, mutual funds, ETFs, and real estate.
Just like you wouldn't put all your eggs one basket—financial managers are fond of saying—you wouldn't put all your money into one type of investment.
The different types of investments explained:
When you buy a share of a company's stock, you are essentially purchasing a piece of that company. So if you buy Apple stock, you'll get a small fraction of Apple's earnings when the company is doing well. But if Apple were to lose market share or have a defective product, and its stock price went down, you would also share in the company's losses.
Bonds are essentially IOUs—the company borrows money from you, the bondholder, and agrees to pay that money back with interest. Bonds are generally considered safer than stocks, but the value of a bond can also decrease.
Mutual funds enable investors to buy a wide range of assets with a modest amount of money. So instead of spending hundreds of dollars for one share of each of the largest companies sold on the stock market, you can buy mutual funds, which will give you a fraction of ownership in many different companies.
Exchange-Traded Funds (ETFs)
ETFs (exchange-traded funds) are similar to mutual funds, but they trade on the stock exchanges. Real estate involves investing in properties. The key to investing success is to determine a healthy balance that will enable you to grow your money without incurring more risk than you can handle.
Real estate can include residential homes you rent out, commercial property, or ownership shares in a hotel or other large property.
Smart investors take the investment types described above and build a diversified portfolio.
For instance, informed investors in their early thirties seeking to create a retirement fund may put 70% of their money into stocks, mutual funds, and ETFs.
The remaining 30% would be spread across bonds and real estate, whose values tend to not change very much i.e. they're less risky.
They don't put 100% of their money in Apple, for example.
How you build a diversified portfolio really comes down to what are your goals and your tolerance for risk.
There's no time like the present to start thinking about financial goals and tolerance for risk to achieve them.
How old you are and how much money you have don't matter
Another big mistake people make is thinking they need to have a certain amount of money to start investing. Or they think they have to be a certain age.
You're never too young—or too old—to start investing, provided your financial house is in order.
Once you've paid off consumer debt, and have an emergency fund, and have a $100 on hand (more than enough to start an investment account), you're ready to dive into the investment world.
However, before you push the "buy" button on your brokerage firm's website, it's important to sit and write down your financial goals (and then, what risk level you're prepared to reach them).
That's because "knowing yourself is just as important as knowing all those stocks and acronyms," says Patrick Gillespie, a reporter at CNNMoney.
The process of writing down what you want your investments to accomplish will provide guidance when choosing investments.
So, first things first: Ask yourself, "What are my goals?"
"It's like creating a road map," Gillespie says. "You wouldn't drive cross-country without at least peaking at Google Maps."
Examples of financial goals you might have include:
- buying a car
- saving for a down payment on a house
- saving for your child's college tuition
- saving up for retirement
Your goals—and your time horizon for accomplishing them—will determine how much risk you can afford to take when investing your money.
Figure out how well you want to sleep at night. If a lot, then you'll want to avoid risky investments
Speaking of risk, it's a good idea to determine your level of risk tolerance before you begin investing.
Generally speaking, the younger you are, the more risk you can handle since you have time to weather stock market downturns, like that guy in his thirties.
But each person and their goals are unique.
So, you'll also want to think about your personality.
For instance, once you've started investing, are you the type who will obsessively check the value of your investments on a daily basis?
Or, are you calm and laid-back, unfazed by stock market downturns (because you're in it for the long haul)?
Experts recommend that you think back to the most recent stock market downturn.
- Did you get very anxious and have trouble sleeping, even if you didn't have money invested yet in the market?
- Did you rush to sell the stocks in your portfolio and retreat to safer investments?
- Or were you able to tune out the noise, convinced that stocks would rebound eventually?
Not sure? Take this quiz at LearnVest to determine your personal risk tolerance profile.
12 Common Investment Mistakes & How To Avoid Them
Now that you're inspired to get started investing and your basically informed about how investing works, you're ready to dig in and take careful note of the top 12 common mistakes investors make.
These mistakes didn't come out of thin air.
These are the worst you can find. Avoid them at all costs.
#1: Investing (i.e. gambling) based on water-cooler tips.
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.
Be wary about these blowhards masked as investment tips. They are nothing more than a speculative gamble.
As Jay Yoder writes in Investopedia:
Think about it—if anyone really had profitable stock tips, trading advice, or a secret formula to make big bucks, would they blab it on TV or sell it to you for $49 per month?No—they'd keep their mouth shut, make their millions and not have to sell a newsletter to make a living.
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 buying a house, we all go and visit the house, check out the neighborhood, the local schools, commission a surveyor to ensure the build and structural integrity and hire lawyers," writes Quora user Elvis Pellumbi.
But when buying or selling shares, people often simply take someone else's word—be it a relative, friend, colleague or TV pundit.
For instance, look at the performance of many of the hot stocks from the dot.com bubble. Pets.com, for example, went public in February 2000 at $11 a share. The much-hyped stock rose to $14, but then quickly fell below $1 until the company went out of business in 2000.
Good places to start researching stocks
There you can view the fees associated with the investment, its historic returns, and the latest financial news associated with that company or fund.
Investing solely based on rumors, conjectures, or hot tips is gambling, not investing.
You'll also want to review the company's latest financial reports to get a better sense of its profits and expenses. InvestingAnswers offers a helpful guide to analyzing a company's financial statements.
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 them and tune out the noise," advocates Russel Kinnel, director of manager research for Morningstar.
Indeed, posts B. Hok on Quora,
"Investing requires patience, as so does life. Patience is not as easy as everyone may seem to think it is. True patience is the endurance through the stress, turmoil, and whatever nasty thing life will toss at you."
#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.
Who wouldn't want an extra $330,000 for about an hour of work a year?
Robert Brokamp at the Get Rich Slowly blogs demonstrates how simply rebalancing a portfolio over the course of nearly four decades can net you an extra $334,124— an amount that is more than three times the original investment.
As he says, "Who wouldn't want an extra $330,000 for about an hour of work a year?"
#4: Not diversifying your investments
You've probably heard the adage that you "shouldn't put all of your eggs in the same 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.
Diversify, don't 'diworsefy'.
When diversifying a U.S. stock portfolio, "you may want to consider non-related markets like gold, gold stocks, real estate, bonds, commodities and other asset classes that exhibit low or inverse correlation," suggests Todd Tresidder, founder of Financial Mentor, which educates business owners and investors about wealth building principles.
Diversify, don't "diworsefy," he cautions—don't simply add more assets with similar risk profiles.
For example, if you already have a portfolio of several stock funds, adding an additional U.S. equity mutual fund will only increase complexity and fees, and not decrease the risk inherent in your portfolio.
Too much can be a bad thing—in fact, experts suggest investors don't have more than 20 mutual funds in their portfolio, according to the Telegraph.
As Burton Malkiel, author of "A Random Walk Down Wall Street" and Wealthfront CIO, posted to Quora—your best friend for reducing risk is to diversify broadly.
"Reducing your portfolio risk is important because it will help you stay invested when the markets go through periods of turmoil."
#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, courtesy of Investopedia: 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.
But getting even "is just another way to ensure you lose any profit you might have made," according to Investopedia.
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.
"If the individual were to sell it as a loss they would be forced to admit that they made a bad decision. And admitting this is very difficult for some," writes Mike Patton on Forbes.com. Often though, cutting your losses and moving on is best, he says.
In general, trying to time the market is a fool's errand, say financial experts.
As investment legend Peter Lynch once said, "Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves." Instead, invest for the long-term.
#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").
"Fear is one of the greatest enemies of successful investing," says Kinnel, an analyst at Morningstar.
Fear is one of the greatest enemies of successful investing
When you sell off after the market falls, "you risk missing out on the next rally, and you might not even keep pace with inflation."
To prevent fear from managing your portfolio, "it's best to have rules in place that dictate when you will buy and when you will sell," says Patton.
For example, you might decide to sell winning stocks when they rise or drop more than 15 percent in value.
"To the extent that you can remove emotion from the equation, your chances of investment success will rise," Patton says.
#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.
Ask yourself if you would buy stocks with your credit card.
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.
"Ask yourself if you would buy stocks with your credit card," recommends Investopedia. "Of course you wouldn't. Using margin excessively is the same thing."
#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 turn your tax situation into a mess, with a mix of short- and long-term capital gains and losses that could result in a painful tax bill," he says.
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, according to the Securities and Exchange Commission's Office of Investor Education and Advocacy.
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.
While plan fees can be as high as four percent, aim to pay less than 1.5 percent in fees, all-in, suggests Craig Morningstar, chief operating offer at Dynamic Wealth Advisors in Scottsdale, Arizona.
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 fee-only advisor who is a fiduciary—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
Whether you are going at it alone, or working together with a financial advisor, or robo-advisor, avoiding the investment pitfalls detailed above will help you invest your hard-earned cash wisely and maximize your returns.
The cheatsheet to successful investing:
- 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.
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.
What's the best (or worst) investment tip you've heard? Let us know in the comments below.