While Warren Buffett has achieved ‘legend’ status among investors globally, his frequently expressed advice on how to succeed as a long-term investor boils down to keeping your cool, staying clear on your goal and avoiding silly mistakes.
As a professional advice firm, we have seen people from all walks of life fall victim to these sorts of pitfalls – not just once but repeatedly. Indeed, a big part of the value that we add to people’s lives is showing them how to get out of their own way.
Of course, it’s one thing for clients to agree in calmer times about what not to do as long-term investors; it’s another – when volatility arises, or when temptation strikes – to resist the urge to throw out the rule book,
With that in mind, we have put together this guide to 10 of the most common pitfalls we see every day among investors and how you can avoid them:
1. Not Being Clear About Your Goal
It’s a truism, but if you don’t know where you’re heading and what you want to achieve, fretting about how you will get there will be a waste of time and energy. Depending on whether the goal is debt reduction or home ownership or education funding or retirement saving or charitable giving, financial plans will differ. This means the first questions to address in your plan should relate to the ‘what’ and the ‘why’. Only after that should you worry about the ‘how’.
2. Misaligning Your Time Horizon
If your goal lies 20-30 years ahead, what is happening on financial markets this week is just noise. How you allocate your portfolio between growth and defensive assets is a function partly of your investment horizon. For instance, a 100% equity allocation is not going to be appropriate for someone saving to buy a property in 18 months. A 35-year-old saving to retire in 30 years is going to be able to dial up the risk. So, first, know your goal and, second, know your horizon.
3. Failing to Sufficiently Diversify
For good reason, diversification is known as the only ‘free lunch’ in investing. Spreading your risk both across and within asset classes not only reduces the volatility of your investments, but also increases the reliability of outcomes. The best portfolio for you is the one that both maximises your chances of getting you to your goals and the one that you can live with. Diversification is the key ingredient there. It positions you to harvest the best returns wherever and whenever they appear.
4. Focusing on Bottom-Up
DIY investors tend to look at stocks individually and build portfolios from the bottom up, usually based on what they read in the newspaper or hear from friends. They give little thought to how those stocks work together (their ‘correlation’) or the diversity benefits they offer. Consequently, these people tend to end up with portfolios full of similar-looking securities. A better approach is top-down, one that takes account of the broad risk-return characteristics of the securities within and being mindful of the overall volatility and expected return of the whole portfolio.
5. Falling in Love with ‘Stories’
People understand the world through stories, but that’s a bad basis for investment. Why? Because all publicly available information is already reflected in prices. A good story does not necessarily mean a good investment. And there are plenty of people – in financial markets or at the pub – who want you to believe they know something no-one else does. In the end, buying stocks based on a good story is speculation, not investment. It requires luck, not skill. As such, it’s a coin toss.
6. Timing the Market
Alongside lack of diversification, this is probably the biggest pitfall. Timing the market – getting out at the top and back in at the bottom – is a nice idea, but there is no proven way of doing it. Market timing also requires getting two decisions right – when to get out and when to get back in. And even if your assessment is “right”, what if the market doesn’t come around to your view? Missing even a handful of the best days can dramatically hurt your outcomes. Instead of rolling the dice on timing, the answer is to embrace a systematic and disciplined rebalancing process.
7. Hunting for Yield
If you make income your primary goal, you can end up taking on far more risk than you bargained for, depending on a portfolio full of a few high-dividend payers in equities and a bunch of low-grade corporate credits in fixed income. The truth is that total returns come from both income and growth. If you forget the latter, chances are inflation will blow a hole in the returns that end up in your pocket. And if you chain yourself to yield, you can end up with a portfolio badly designed to manage volatility.
8. Following the Crowd
People are social creatures. This means they tend to believe that what’s right for their neighbours or someone they met at the club to also be right for them. There are a few problems with this approach. Firstly, it takes no account of each person’s goals, circumstances, tax situation, time horizon, risk appetite or overall portfolio. Secondly, it inevitably means buying high, selling low and adding unnecessary cost and tax consequences to your portfolio. The right benchmark is not the crowd but what’s right for you.
9. Not Understanding Compounding
It’s often incorrectly attributed to Einstein, but the quote about compounding being the eighth wonder of the world is not far off the mark. Compounding is the process in which an asset’s earnings – from capital gains, dividends or interest – are reinvested to generate additional earnings over time. Think of it as the snowball effect. Money makes money. We have found people tend to underestimate the effect of gradual saving and patience in building wealth, just as they tend to over-rate gimmicks promoted in the media.
10. Not Seeking Good Advice
Avoiding any of the pitfalls described above starts with both understanding what good advice can bring and how to identify it. Good advice does not mean shoehorning people into expensive and inappropriate investments for a high fee. It means first knowing the total person, clarifying their goals, horizons and risk appetites and then systematically building a diversified portfolio that helps them get to where they want to go. It also means helping them deal with all the challenges and opportunities that life throws at them along the way and guiding them to make good, sound decisions about their finances.
Those are just some of the major pitfalls we see again and again at Minchin Moore. The bad news is they are exceedingly common. The good news is that, with the right advice, they are all completely avoidable.
With that in mind, why not schedule a discussion with one of our advisers? We can put you on a track that avoids those obstacles and that maximises your chances of reaching your goals, whatever and whenever they might be.
