If you think investment education is expensive, just try ignorance.
The reality is the simplest investment mistakes can still cost you thousands of dollars over your lifetime. They cost you directly in terms of immediate losses, and those losses then add insult to injury because you also miss out on all the future compound returns.
There's no reason for you to learn about investment mistakes the hard way. Instead, learn from others so you can avoid the obvious potholes. Here are my top five investment mistakes that can destroy your portfolio's long-term performance:
1. Diworsefying Your Portfolio
Diversity in your portfolio is a good thing. However, the wrong kind of diversity makes things worse. You can actually "diworsefy" your portfolio by adding new assets with risk profiles similar to the assets you already own.
For example, if you have a well-diversified portfolio spread among a variety of U.S. stocks, adding an ETF or mutual fund based on large-cap U.S. stocks doesn't really help.
Instead, your goal when diversifying should be to include assets that might occasionally produce opposing sources of return. For example, real estate or bonds can make a valuable portfolio diversifier for stocks because it is more likely to zig while the rest of your portfolio zags.
In other words, your goal is to add non-related assets that are inversely correlated -- or not even correlated at all. Never diworsefy by adding more of the same.
2. Basing Future Expectations on Historical Returns
"Past performance doesn't guarantee future results."
You've seen this disclosure so many times that it's easy to ignore the truth behind it. Just because there is a certain historical return doesn't mean that your individual portfolio will see that return going forward.
Yet, investors make this mistake all the time by picking a mutual fund or stock investment based on its recent past performance. Numerous research studies have proven there is no reliable relationship between historical track records and future returns.
Similarly, another common investment fallacy is to rely on long-term averages as an expectation for the future. For example, Nassim Taleb is the well-known author of the book, Fooled by Randomness. He points out that the average return for the Dow Jones Industrial Average between 1900 and 2002 was 7.2 percent. However, only five of those 103 years produced returns between 5 and 10 percent.
The lesson is simple. You can't assume past returns indicate future returns, and you can't expect long term "average" returns in any given year either.
3. Too Much or Too Little Risk
Risk is a double-edged sword. Too much and you could end up with unacceptable losses. Too little and your assets won't grow fast enough to outpace inflation.
It's important to evaluate your risk profile and take calculated risks based on expectancy. Surprisingly, that means focusing on asset allocation using low-cost, index funds and ETF's while avoiding the seduction of individual stock picking.
Research proves it is very difficult to add value in excess of transaction costs through stock picking as evidenced by the data showing low-cost index funds tend to outperform their actively managed competitors.
Similarly, when you define risk as loss of purchasing power it brings valuable perspective to the fallacy of avoiding risk by investing in cash equivalents. The reality is you will end up with such a low rate of return that your investments could lose purchasing power net of inflation by being too conservative.
The key is to develop a balanced risk profile resulting in an investment strategy that achieves your investment objectives without excessive volatility along the way.
4. Too Much Focus on Taxes or Fees
Don't make the mistake of putting tax and expense considerations in front of investment expectancy.
Sure, you want to pay attention to the tax efficiency of your investment strategy. And no, you don't want to throw away money needlessly on expenses.
But these considerations are always secondary to investment expectancy -- how much you will gain or lose on the investment.
Investing is complex, and it is very easy to lose focus on what is most important. Focus on profit or loss first, and accept the tax consequences and expenses as a necessary evil of making a profit. You should never save 50 cents by losing a dollar.
5. Low Liquidity
Illiquidity is a subtle, yet deceptive, investment evil.
An illiquid investment is an asset you can't readily sell and convert to cash. It can back you into a corner at the worst possible time.
One of the best risk management tools you have at your disposal is the ability to limit your losses by exiting when you need to. It is the only competitive advantage the small investor has compared to the big boys.
However, an asset with low liquidity doesn't offer that luxury. Instead, you are stuck with your investment -- and the losses can keep piling up until you finally find a way to unload it.
While the inclusion of low liquidity assets in your portfolio can be justified by a very high potential reward, limit the portion of your portfolio exposed to these types of investments.
With proper planning you can save your investment portfolio from disaster. This means learning from the mistakes of others so you can avoid the obvious potholes that cause large losses.
Focus on risk management first by avoiding obvious mistakes so you can enjoy a smoother ride to your investment goals while sleeping better at night.
