Most investors make a lot of mistakes over their lifetime of investing. The following are some of the more common mistakes, as well as handy tips on how to avoid them.
Taking too much risk – period.
This is a very common mistake and goes against the basic logic of investing, which is that you should never take more risk than necessary to achieve your financial goals. Taking too much risk is sometimes the result of greed, but more often it is due to a lack of investment knowledge regarding risk. Any finance professional understands that higher volatility in an investment portfolio equates to larger potential losses – possibly even a complete loss. This is especially the case for highly leveraged investments, where you can lose more than you actually invested. As well as volatility, investors also need to be mindful of contingent risks, which can be harder to identify. The solution to taking too much risk is to firstly improve your knowledge regarding risk. Once an investor is aware of the total risk their portfolio is exposed to, they can then take the appropriate steps necessary to reduce the risk – if they believe their portfolio may suffer losses they are not comfortable with. An asset allocation review can provide detailed insight into the risks of an investment portfolio.
Taking too much risk to earn too little – i.e. poor risk adjusted returns.
This is something that is frequently overlooked, as investors repeatedly combine high risk, i.e. shares and property, with low return (cash), believing this will produce a good return with moderate risk. In reality, a portfolio such as this often simply results in a high-risk portfolio, with a cash buffer. Investors need to carefully consider their asset allocation, as, with some work, better returns can be generated for considerably less overall risk, by more broadly diversifying their portfolio.
Failing to diversify properly, with their financial future largely dependent on the success of Australia’s top 20 companies.
It is very common for investors, even retirees, to hold a significant proportion of their portfolio in shares. Australia’s share market is very top heavy, with 47% of the S&P/ASX 200 Index (Australia’s benchmark share market index) concentrated in only 10 large companies. Our local market is also dominated by financials and materials, which comprise over 53% of the total market. This concentration is unusual in a global context, and it means that Australians, with their equity-heavy portfolios, are betting their futures on the success of a handful of big businesses. For the sake of comparison, the S&P 500 (the US benchmark index) has only 18.9% concentrated in the 10 largest companies, and only 17.3% of the overall index represents financials and materials companies. Proper global diversification can go a long way to addressing these portfolio imbalances, as can seeking out investments that do not carry equity market risk.
Relying too much on rising asset prices (being “overweight good times”) with no downside protection.
Most investment portfolios in Australia are dominated by shares and property and have nothing in their portfolio that can perform well when asset prices are stagnant or falling. Regrettably, markets don’t go up all the time, and when the inevitable market corrections or collapses occur, investors very often flee to cash, miss the recovery, and then leap back into the market after it has bounced. The key to avoiding this is to hold a well-balanced portfolio that can do well irrespective of whether the market is rising or falling, whether economic growth is above or below expectations, and whether inflation is accelerating or decelerating.
Relying on correlations that won’t hold up when needed most – in bad times.
Investors think they are well diversified because they own a number of Australian shares, and possibly even international shares, as well as listed property investments. But in the GFC, all shares and listed property went down together, so the correlations didn’t hold up when they were needed most – in other words, investors didn’t get the cushioning effect that they hoped they would by diversifying their portfolios across different sectors and geographic regions. This emphasises the need to hold investments that are characteristically different (i.e. they don’t all rely on rising asset prices to generate a profit), so as the correlations will hold up – even under the most extreme conditions.
Not considering the danger of sequencing risk.
Sequencing risk, simply put, is the danger, that of all the possible returns from an investment, you will get the worst return at the worst possible time. A typical example of this risk was in 2007, when many people nearing retirement, who had large share investments when the Global Financial Crisis struck, had a great deal of their savings wiped out. Many of these investors had to delay retirement for several years or more, due to the horrendous losses sustained. This was extremely unfortunate, as investors nearing retirement, or retired, should not have a large exposure to volatile investments, such as long-only shares. As retirement approaches, investors should restructure their portfolios to minimise sequencing risk, by diversifying into more conservative investments.
Thinking short term about your investments, when investing is actually a long-term consideration.
It is a well-known fact that investors underperform the investments they invest in, largely due to short-term thinking. They tend to focus on how an investment has performed in the last 1-2 years, rather than how it has performed over the long term. They invest when a fund (or asset class) is experiencing a good run and pull out when it is having a bad run. This is totally contrary to the wisdom of sophisticated investors, such as Warren Buffet, who says, “Be greedy when others are fearful, and fearful when others are greedy.” Put another way, we could simply say that the key to investment success is, “buy low, sell high”. Whilst this might be obvious, and easy to say, very few people do this, as their emotions override their common sense, typically leading them to buy high, when all the news is positive, all their friends are jumping in, and recent history looks wonderful. It feels great to buy investments that just seem to be “on a roll”, so it is little wonder that people do this. Then, when everything turns horrible, they capitulate and sell – sell low, that is. Unfortunately, this is the opposite of the behaviour that is required to do well financially.
The truth is, that investors don’t need the nerve of a fighter pilot to be successful, but they do need to do everything they can to remove emotion from the investment equation. And the best way to do that is to think through what the “tough times” might look like, before they occur, and have a well formulated battle plan. If you have done this, and you have faith in your plan, knowing that you put it together when you were thinking logically, then you will be inclined to stick with it through good times and bad. That alone, will put you miles ahead of most investors.
The bottom line: Poor asset allocation is the most common mistake.
Investors need to pay careful attention to getting their asset allocation right, as the asset allocation is the most important aspect in determining the long-term risk and return of an investment portfolio. A strategic asset allocation is the central aspect of a well thought out plan and should be designed to navigate the broadest range of economic circumstances and be psychologically tolerable to ensure that it can be adhered to over a long-term investment horizon.