We asked experts to weigh in on some of the most common mistakes investors make, and while it's easy to see that chasing hot stocks (the most frequently cited mistake) would be an exercise in futility, they reported other less obvious pitfalls to watch out for.
There are never any guarantees when investing, but avoiding these 10 missteps will better your chances of success.
1. Mismatching investment with goal
Consider when you'll need access to your money. This will help you avoid unnecessary transaction fees, penalties and risk.
"If you pick the right investment vehicle for the right timeline, you've got it 90% in the bag," says Richard Salmen, a certified financial planner and the national president of the Financial Planning Association. "If your goal is only six months to two years off, you don't want to put your money in an investment vehicle that could fluctuate enough that you might miss it."
For some goals, such as paying for college, it may make sense to use a mix of investments, says Gail MarksJarvis, author of "Saving for Retirement (Without Living Like a Pauper or Winning the Lottery)."
"If you are saving for college and your child is within three years of going to college, you've still got seven years until that last year of college," she says.
So while the bulk of short-term college savings should probably be very safe in CDs or short-term bonds or a high-yielding savings account, maybe some of that money could be invested in stocks. "Just remember the rule of thumb," she says, "that money you'll need within five years shouldn't be in stocks."
2. Discounting fees
"It's hard to beat the stock market," says MarksJarvis. "There's one thing you can control and that's what you pay to be a part of the stock market, and that's where the expenses come in."
While all mutual funds have expense ratios, which cover investment advisory, administrative services and other operating costs, some are much higher than others.
"Let's take a $10,000 investment that earns an annual return of 8% before expenses for 20 years," says Greg McBride, a senior financial analyst for Bankrate.com. "If the money is invested in a fund with an expense ratio of 1.25% instead of an index fund at 0.25%, the investor would incur an additional $4,128 in costs over that 20-year period. But the ending account value of the higher expense fund would be $8,000 less than if invested in the lower expense fund because of the loss of compounding on the money paid out in expenses each year."
To complicate matters, some funds impose sales charges or loads. Load funds are available only through an investment adviser or broker who is compensated by sales commissions.
Picking no-load funds is one way to save money on fees. Instead of going through a broker, call a mutual fund company directly to purchase a fund.
"If you were paying your broker 5.75% for a load, you would say to yourself, 'Well, that's the cost to play, I might as well pay it,'" says MarksJarvis. "But if you were putting $10,000 into the fund, that would mean you were giving your broker $575 to pick that fund for you and that you were putting $9,425 to work."
While it might be worth paying a load if you don't have the time or inclination to make your own investment choices, just remember, it's hard, even for a skilled money manager, to make up for those extra fees.
"The fees will be higher for those funds," says John Pallaria, an adjunct professor in the CFP program at Boston University, "but in return, they're getting competent advice which will, in theory, give better results to offset the cost."
For no-load mutual funds, investors should aim to keep their annual expenses under the following thresholds, according to McBride:
- Active domestic equity: 1%.
- Active international equity: 1.25%.
- Active bond funds: 1%.
- Index equity/bond: 0.5%.
3. Letting investments languish
Saving money is a great start, but if you're not investing it wisely, you'll miss out on long-term gains, says MarksJarvis.
She illustrates this point with the example of a 35-year-old who, by holding $30,000 in a savings account until she retires, will have $46,000 after earning interest and paying taxes (assuming a 2% average annual return and a 25% federal tax bracket).
"On the other hand," MarksJarvis says, "if you put that same $30,000 into a 401k or an IRA, you wouldn't be paying taxes on the money as it builds up year after year. By investing in a simple stock market (index) fund, that very same $30,000 would likely, if it followed history, turn into about $540,000 (assuming retirement at age 65 and an average annual return of 10%)."
4. Paying taxes
In the above example, what if the investor bought the same mutual funds in a regular taxable account instead of investing in an IRA?
MarksJarvis explains: "If they earned the same return on their investments, instead of having $540,000 they would end up with about $260,000 because it would be taxed. This again assumes a 10% average annual return, retirement at 65, and a 25% federal tax bracket. Taxes take a huge amount out of the wealth that builds up year after year after year."
People sometimes forget to factor in the upfront tax benefits of 401k plans, says Salmen. "One of the typical mistakes that I see people making is paying extra on their mortgage but not funding their 401k or putting enough into it. Mortgage interest is usually your cheapest interest rate and there are tax deductions on top of that. Money that you put into a 401k, you're getting an upfront tax deduction on," he says.
Of course, you'll have to pay taxes eventually -- but not until it's time to take withdrawals from your tax-deferred retirement plan.
5. Failing to strategize
Wrong. Before you research the investment, there are a couple of things to think about. First, plan your investment strategy.
"For any investment program, sometimes people jump right to the investment they choose," Pallaria says. "But they need to determine what asset classes they want to cover before jumping to investments. Once you've got the asset classes, now go pick the investments that are best in these categories."
Next, make sure you're comparing apples to apples.
Some funds don't make as much money as others -- by design. A bond fund cannot compete with a stock fund because of the nature of their respective holdings. However, different types of funds serve different purposes. The bond fund can have a stabilizing effect on one's portfolio.
"For example," MarksJarvis says, "someone might have a bond fund that perhaps an adviser put them in because that's supposed to be the safe part of their money. And they'll look at it and they'll say, 'Well, I'm only making 4% in that fund and I have this stock fund that's up 12%. Why not go with the 12%?'
"Well, there's a perfectly good reason," she says. "That 12% money is not going to be as safe."
6. Misreading the label
You don't want to find out that you're overexposed to a particular market sector after it hits a rough patch. Luckily, staying out of this trap is a matter of learning to read the label.
"One of the typical mistakes that people make is they get a list of mutual funds from their employer and they can't tell the difference between them. They don't know the vocabulary," says MarksJarvis.
Expand your vocabulary by a dozen words and increase your assets: Check out Bankrate's investing glossary.
Understanding the different types of asset classes will help you strategize (see Tip No. 5). Different asset classes do better at different times. Bonds may do well while the stock market is suffering and large-cap firms may weather tough times better than spunkier small caps. Boring bonds will never match stocks in a hot market and small caps may be better poised to take off like a shot than their larger, lumbering counterparts.
7. Neglecting research
No, we're not going to tell you about the next Google. We're going to tell you to do your homework.
What to look for:
- Type of fund (large-cap growth, small-cap value, etc.).
- How long the manager has been there.
- How much the fund costs (expense ratio).
- Minimum investment required.
- Portfolio holdings (list of securities).
- Performance information -- remember, past performance does not guarantee future return.
Where to look:
- Morningstar, an independent investment research and ranking site, offers a wealth of free information about mutual funds. Look beyond the star rating, though.
- Ask for the prospectus from the fund company or brokerage firm. This information is often available online.
- Get a copy of the most recent semiannual report (again, you'll likely find it online). These reports frequently feature a letter from the portfolio manager. His or her discussion of the past six months will give you an indication of how he or she runs the fund. A good manager discusses both victories and mistakes.
"When making investments, look to invest in the company and not the stock," says Shashin Shah, CFA, CFP with SGS Wealth Management in Dallas. "Research the company. Look at the Internet, anywhere from MSN to Yahoo Finance; purchase research reports. If you're investing $1,000, you might want to spend $5 to read a research report. Get information from the broker and how they made the picks. Order the company report."
Similar advice applies when you research mutual funds. Sometimes the fund name can be misleading, so you can't judge by that.
8. Putting it off
In the world of saving, procrastination is your worst enemy. If you're smart, you'll get started early.
According to MarksJarvis, in order to accumulate $1 million at retirement, you'll need to invest just $20 a week in a simple stock market mutual fund when you're 19, about $100 a week if you wait until you're 35, and roughly $300 a week if you delay until age 45, assuming a retirement age of 65 and an average annual return of 10%. (Of course, while 10% is in the ballpark of how the market performed historically over many decades, there's no guarantee that it will continue to do so.)
"Of course, you can catch up," MarksJarvis says, "but then you have to dig in deeper and it's actually a little more painful than if you were just saving small amounts to begin with."
But don't ever give up. A person who, at age 45, has accumulated $30,000 can still end up with a nest egg of about $460,000, if they put away $5,000 per year for 20 years, points out MarksJarvis. This assumes an annualized return of 9.6%.
Many people delay investing because of debt, says Salmen, but there's no excuse not to take the easy pickings.
"Some people want to invest money but say, 'I'm not going to do it until I get my debts paid off, and it makes sense.' For most people, they're never going to get there," he warns.
"At the very least, you should be taking advantage of the company matches in your retirement fund, which deliver a guaranteed 50% return on investment in the first year. That's free money. I don't know anywhere else you're going to get those kinds of returns."
9. Ignoring your portfolio
"I've had new clients walk in with statements in a box and they haven't even opened their statements," laments Shah.
Without reviewing your holdings, you won't know if your portfolio remains balanced, and you won't shift your holdings to achieve new goals or help you cope with changing life events.
The experts differ on how often you need to do a portfolio review. Shah recommends doing so on a quarterly or semiannual basis. Salmen meets three times a year with his clients. But all agree that it's important to review your holdings at least once a year, whether they're within a company-sponsored retirement plan or outside of one.
"Perhaps you're invested 80% right now in equities, and realize, 'I need to think in five years now instead of 10 because I want a vacation home' or 'I got laid off.' If you're looking at your investments regularly, you can shift to fit your circumstances," says Pallaria.
Find out how to use investments to reach your goals.
10. Getting emotional
"Emotion, both greed and fear, drive more of the decisions than anything else," says Salmen.
He describes the all-too-common trap emotionally driven investors fall into: "Most people don't earn what the market earns. They invest too heavily in too-risky investments that are doing well, then drop out when they go back down. They take all their money out of tech stocks, for example, put the money into bonds, then put money back in stocks after prices have gone back up."
His prescription is to invest a little bit of money from every paycheck, diversify, then leave it alone.
Pallaria recommends taking yourself out of the equation as much as possible. "The best thing that people can do to make it easy on themselves is to automate investing as much as possible. Have the money automatically taken out each month or each quarter. That's absolutely the best way," he says.
Called "dollar-cost averaging," this autopilot strategy enables you to buy more shares when the market is down -- and that's the whole idea behind buying low.