Investment mistakes cost you money – that’s why they must be avoided.
There are only two paths to gaining the experience necessary to know how to minimize investment mistakes:
- Smart Path: by learning from other people’s investment mistakes.
- Expensive Path: by making your own investment mistakes and learning from the school of hard knocks Frankly, I’m no masochist. I prefer the more efficient method of learning from other people’s investment mistakes wherever possible. Learning vicariously helps you avoid losses, which leaves more profits in your pocket and accelerates your journey to financial freedom.
1: Diversify, But Don’t Diworsefy
Diversification is a valuable risk management tool, but only when used properly. Diversification only adds value when the new asset added has a different risk profile.
For example, 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.
Diversifying is adding more assets with a similar risk profile until your investment performance replicates the averages. For example, adding U.S. equity mutual funds to a diversified portfolio of U.S. stocks is a di-worse-ification.
Your goal when diversifying should be to add independent and sometimes opposing sources of return. This can lower portfolio risk and possibly increase overall return when coupled with other investment techniques explained below.
2: Don’t Pick Stocks – Asset Allocation Is More Important
Multiple research studies agree that at least 90% of the variance in a diversified portfolio’s returns is attributable to asset allocation. What’s surprising, however, is that most people mistakenly focus 90% of their efforts on the remaining 10% of return by trying to pick individual securities. It makes no sense. Don’t make the mistake of spending all your time on the decisions that will make little difference in your overall performance.
Don’t try to pick the next hot stock or top-performing fund when the experts who live and breathe this stuff are consistent failures at the task. Instead, spend your limited time and resources determining your correct allocation to asset classes and strategies, and you’ll be putting Pareto’s Law (the 80-20 rule where 80% of your results come from 20% of your efforts) to work for you.
3: Don’t Confuse Historical Returns With Future Expectations
Just because your investment advisor told you the average historical returns from the U.S. stock market are approximately 10% annually (or 7% or 8% depending on the time period and whether adjusted for dividends and inflation) doesn’t mean you should expect similarly. The future will likely be very different from historical averages, and your average holding period may not be long enough to replicate average returns.
For example, most long-term historical stock return studies use average holding periods of 30 years or more. Even if your investment career is 30 or 40 years, your average holding period will likely be less than half that length. The bulk of your savings are usually accumulated late in your career and spent throughout retirement. Almost nobody begins investing at age 30 with a large lump sum and retires at age 60 on that investment to create a 30 year holding period. Life doesn’t work that way.
The result is you should expect far greater variability in expected returns than long-term averages would indicate.
Additionally, average returns are a statistical fiction that seldom exists in reality. According to Nassim Taleb, author of “Fooled by Randomness,” the average return on the Dow Jones Industrial Average from 1900 to 2002 was 7.2%. Only 5 of the 103 years had returns between 5% and 10%. Obviously, the “average” is far from typical.
Finally, long-term averages may have little relevance to your current investment situation because the current investment environment may be anything but average. For example, few investors are taught that their holding period returns for stocks are inversely correlated to valuations at the beginning of the holding period. In other words, if stock valuations are higher than average when you begin investing, you should expect 7-15 year returns lower than average. If stock valuations are lower than average when you start investing, then you can reasonably expect 7-15 year returns higher than average.
In short, the investment advice you receive about long-term probabilities and average returns may have little or no relevance to the actual results you get. Don’t make the mistake of basing your investment plan on historical average returns – even if your investment time horizon is long-term. If investing was that simple and obvious, then more people would be successful at it – but they aren’t.
4: Don’t Invest Without a Plan
Don’t make the mistake of spending more time planning your vacation than planning your financial future. Numerous studies show that people who are methodical enough to create a written investment plan can expect to outperform their peers, not by just a few percentage points, but by multiples.
You must create a disciplined plan based on mathematical expectancy because anything less is gambling and not investing.
There are many different investment strategies that honor Expectancy Investing principles, but all of them require disciplined implementation over many years to assure that you come out a winner in the end. That means you should never “invest” in rumors, hot tips, stories, conjecture, future predictions, or an expectation the market will go up. You must have a plan based on provable positive expectancy, and none of these approaches qualifies as a plan despite their widespread use and popular appeal.
Your financial security deserves better.
5: Don’t Forget to Invest in Your Financial Education
You must learn before you can earn. Every investment you make in yourself will pay you dividends for a lifetime. I often tell coaching clients that investing isn’t brain surgery. It’s far more complicated than that.
Investing done right is both an art and a science. For that reason, you must be wary of half-truths and oversimplification that don’t respect the inherent complication of the process. Investing is an art because we’re emotional human beings masquerading as rational decisions makers. Our decisions are affected by our values, moods, crowd psychology, previous experience, greed, and fear. Yet, we persist in the illusion that we invest logically.
Investing is also a science because it requires a proper strategy based on provable scientific principles like diversification, asset allocation, valuation, correlation, probability, and much more. You must balance both art and science to become a consistently profitable investor. You must work on yourself to improve your decision-making process while also developing your knowledge of investment strategy. There’s nothing more financially dangerous than an investor making a million dollars worth of decisions with a thousand dollars worth of financial intelligence.
When it comes to investing, a little knowledge can be a dangerous thing, and a lot of knowledge can be a profitable thing.
So invest in your financial education. It will pay you dividends for a lifetime.