Investing Mistakes New Investors Should Avoid
Investing mistakes are all too common, especially now that most of the world has gone to a do-it-yourself model with everyone from waitresses and doctors expected to become experts in capital allocation by selecting their own retirement assets and portfolio strategy.
Be it in a Roth IRA, a 401(k), or a brokerage account, the biggest risk most investors are likely to face are their own cognitive biases. They work against their own best interest by making foolish, emotion-driven mistakes.
It is this lack of rationality, combined with an inability to stick with a valuation-based or systematic-based approach to equity acquisition while eschewing marketing timing, that explains the research from studies put out by Morningstar and others that show investor returns are often far worse than the returns on the stocks those same investors own!
In one study, at a time when stocks returned 9%, the typical investor only earned 3%; a pathetic showing. Who wants to live like that? You take all of the risks of owning stocks and enjoy only a fraction of the reward because you were too busy trying to profit from a quick flip rather than finding wonderful cash-generating enterprises that can shower you with money for not just the coming years, but decades and, in some cases, even generations as you pass on your holdings to your children and children's children through the stepped-up basis loophole.
We want to address six of the most common investing mistakes we see among new or inexperienced investors. Though the list certainly isn't comprehensive, it should give you a good starting point in crafting a defense against decisions that could come back to haunt you in the future.
Paying Too Much for an Asset Relative to Its Cash Flows
Any investment you buy is ultimately worth no more, and no less, than the present value of the discounted cash flows it will produce. If you own a farm, a retail store, a restaurant, or shares of General Electric, what counts to you is the cash; specifically, a concept called look-through earnings.
You want cold, liquid cash that flows into your treasury to be spent, given to charity, or reinvested. That means, ultimately, the return you earn on an investment is dependent upon the price you pay relative to the cash it generates. If you pay a higher price, you earn a lower return. If you pay a lower price, you earn a higher return.
The solution: Learn basic valuation tools such as the P/E ratio, the PEG ratio, and the dividend-adjusted PEG ratio. Know how to compare the earnings yield of a stock to the long-term Treasury bond yield. Study the Gordon Dividend Discount Model. This is basic stuff that is covered in freshman finance. If you can't do it, you are one of the people who have no business owning individual stocks.
Instead, consider low-cost index fund investing. While index funds have been quietly tweaking their methodology in recent years, some in ways we consider harmful to long-term investors as we think the odds are extremely high they will lead to lower returns than the historical methodology would have had it been left in place — something that isn't possible given we've reached a point where $1 out of every $5 invested in the market is held in index funds. All else equal, we haven't, yet, crossed the Rubicon where the advantages are outweighed by the disadvantages, especially if you're talking about a smaller investor in a tax-sheltered account.
Incurring Fees and Expenses That Are Too High
Whether you are investing in stocks, investing in bonds, investing in mutual funds, or investing in real estate, costs matter. In fact, they matter a great deal. You have to know which costs are reasonable and which costs are not worth the expense. Consider two hypothetical investors, each of whom saves $10,000 per year and earns an 8.5% gross return on their money.
The first pays fees of 0.25% in the form of a mutual fund expense ratio. The second pays fees of 2.0% in the form of various account asset charges, commissions, and expenses. Over a 50 year investment lifetime, the first investor will end up with $6,260,560. The second investor will end up with $3,431,797. The extra $2,828,763 the first investor enjoys is due solely to managing costs. Every dollar you keep is a dollar compounding for you.
Where this gets tricky is that this axiomatic mathematical relationship is often misunderstood by those who don't have a firm grasp on numbers or experience with the complexities of wealth; a misunderstanding that may not matter if you are earning $50,000 a year and have a small portfolio but that can result in some really, really dumb behavior if you ever end up with a lot of money.
For example, the typical self-made millionaire who has his or her portfolio managed by a place like the private bank division of Wells Fargo pays a bit more than 1% per annum in fees. Why do so many people with tens of millions of dollars select asset management companies where their costs are between 0.25% and 1.50% depending upon the specifics of the investment mandate?
There is a myriad of reasons and the fact is, they know something you don't. The rich don't get that way by being foolish. In some cases, they pay these fees due to a desire to mitigate specific risks to which their personal balance sheet or income statement are exposed. In other cases, it has to do with the need to deal with some fairly complex tax strategies that, properly implemented, can result in their heirs ending up with much more wealth even if it means lagging the broader market.
Their returns may look lower on paper but the actual inter-generational wealth may end up being higher because the fees include certain planning services for advanced techniques that can include things like "tax burn" through purposely defective grantor trusts.
In many situations, it involves risk management and mitigation. If you have a personal portfolio of $500,000 and decide you want to use Vanguard's Trust division to protect those assets following your death by keeping your beneficiaries from raiding the piggy bank, the roughly effective fees of 1.57% it is going to charge you all-in are a steal.
Complaining they cause you to lag the market is entitled and ignorant. Vanguard's staff is going to have to spend time and effort complying with the terms of the trust, selecting the asset allocation from among their funds to match up with the cash income needs of the trust as well as the tax situation of the beneficiary, dealing with inter-family conflicts that arise over the inheritance, and more. Everyone thinks their family won't be another meaningless statistic in a long line of squandered inheritance only to prove doesn't change much.
People who complain about these types of fees because they are out of their depth and then act surprised when disaster befalls their fortune should be eligible for some sort of financial Darwin Award. In a lot of areas in life, you get what you deserve and this is no exception. Know which fees have value and which fees don't. It can be tricky but the consequences are too high to waive it away.
Ignoring Tax Consequences
How you hold your investments can influence your ultimate net worth. Using a technique called asset placement, it might be possible to radically reduce the payments you send to the Federal, State, and local governments, while keeping more of your capital earning passive income, throwing off dividends, interest, and rents for your family.
Consider, for a moment, if you oversaw a $500,000 portfolio for your family. Half of your money, or $250,000, is in tax-free retirement accounts, and the other half, also $250,000 is in plain vanilla brokerage accounts. It is going to create a lot of extra wealth if you pay attention to where you hold certain assets. You would want to hold your tax-free municipal bonds in the taxable brokerage account. You would want to hold your high dividend yield blue-chip stocks in the tax-free retirement accounts. Small differences over time, reinvested, end up being massive due to the power of compounding.
The same goes for those who want to cash out of their retirement plans before they are 59.5 years old. You don't get rich by giving the government taxes decades before you otherwise would have had to cover the bill and slapping on early withdrawal penalties.
I have told you more times than we can count that your focus should be on purchasing power. Imagine you buy $100,000 worth of 30-year bonds that yield 4% after taxes. You reinvest your interest income into more bonds, also achieving a 4% return. During that time, inflation runs 4%
At the end of the 30 years, it doesn't matter that you now have $311,865. It will still buy you exactly the same amount you could have bought three decades earlier with $100,000. Your investments were a failure. You went thirty years — nearly 11,000 days out of the roughly 27,375 days you are statistically likely to be given — without enjoying your money, and you received nothing in return.
Choosing a Cheap Bargain Over a Great Business
The academic record, and more than a century of history has proven, that you, as an investor, are likely to have a much better chance at amassing substantial wealth by becoming an owner of an excellent business that enjoys rich returns on capital and strong competitive positions, provided your stake was acquired at a reasonable price.
This is especially true when compared with the opposite approach — acquiring cheap, terrible businesses that struggle with low returns on equity and low returns on assets. All else equal, over a 30+ year period, you should make a lot more money owning a diversified collection of stocks like Johnson & Johnson and Nestle purchased at 15x earnings than you are buying depressed businesses at 7x earnings.
There was a period of four years recently when, peak-to-trough, the stock lost more than 50% of its quoted market value even though the original valuation wasn't unreasonable, the business itself was doing fine, and profits and dividends kept growing. Wise investors who use times like that to continue reinvesting dividends and dollar cost averaging, adding to their ownership, tend to get very, very rich over a lifetime. It's a behavioral pattern you see constantly in cases of secret millionaires like Anne Scheiber and Ronald Read.
Buying What You Don't Understand
Many losses could have been avoided if investors followed one, simple rule: If you can't explain how the asset you own makes money, in two or three sentences, and in a way easy enough for a kindergartener to understand the basic mechanics, walk away from the position. This concept is called Invest in What You Know. You should almost never — and some would say, absolutely never — deviate from it.