(10/11/11) How To Avoid the 4 Biggest Mistakes

We decided the best way to find out what mistakes individual investors make the most was simply to ask them and present the results, writes Christine Benz of Morningstar.

Have you ever cringed when friends or family members have confided in you about speculative stock bets that have gone awry? Or watched in dismay as they followed the advice of brokers who didn’t have their best interests at heart?

It might be a small consolation, but this is a common occurrence among many investors. I recently asked participants in the Investment Basics forum of Morningstar’s Discuss boards to share the most common mistakes they’ve seen friends and family members making, and the comments rolled in at a rapid clip. Several users also shared their own investing miscues, and what they learned from them.

Safe Can Be Sorry
Several posters noted that they’ve frequently observed their loved ones (or themselves) falling into the pitfall of being too conservative or panicking during market weakness, only to be left with the nagging question of when to get back in.

Masongca noted that a frequently observed investment mistake is "Believing that such investments as certificates of deposit, Treasury bonds, and other similar fractionally dividend-paying instruments contribute to portfolio growth. Fact: Since WW-II, US inflation has averaged in excess of 3%. Go figure.

"We’ve been raised with lifetime recollections of our parents (and theirs) advising of painfully severe times during the Great Depression. The intended lessons were to never rely on any except the safest ’guaranteed returns’ available.

"If acted upon, however, an investor loses principal every day, every month, every year. Panic reduces rationality to a score of zero."

Msn56308 sounded a similar theme, writing, "I’m often amazed at how many people, and particularly the older generations (like my grandfather, 78), completely panic that the world is ending when the markets crash. They have seen and even lived through the economy as it went through times like this, and the country turns out fine.

"I’ve tried to no avail to convince them that they don’t usually lose their money until they pull it out. So if they’d just ’ride it out’ they’d be fine."

In a related vein, Chief K shared this observation: "A friend cashed out his stock investments in 2009 because ’[he was] more comfortable being out of stocks during this decline.’ But when asked, he had no idea how he would know when to buy back into the market.

"Deciding to get out during a down market is rational and is easy; but deciding when to buy back into the market is not easy. It rarely goes straight down and never seems to go straight back up for long enough to be certain about that new direction."

Taking a Flyer
At the opposite extreme, several posters noted that they’d seen loved ones and acquaintances taking a bet on sectors and individual securities without regard for valuations, diversification, or an overall asset-allocation plan.

Darwinian wrote, "For several years, my brother-in-law has been heavily invested in gold. I have warned him repeatedly that he should sell down because it is risky for a retiree to be so heavily committed to one asset, but he just won’t listen. Recently he started compounding his mistake by moving into silver."

Meanwhile, Dragonpat shared a tale of colleagues who drank the dot-com Kool-Aid. "Two guys worked in my lab during the dot-com debacle. They were ten years older than me and less than or equal to five years from retirement, and had 100% of their portfolios in our 401(k)’s growth/tech fund.

"Our 401(k) had seven other choices in it (stable value, long-term bond, S&P 500 index, value index, two international funds, and a small-cap index fund) beside the high-growth fund stuffed with dot-com issues. They lost 50% of their portfolios more than three years (2000-2002). Then they boomeranged out of that and 100% into the lowest-yielding, but safe, stable fund."

In addition to ill-considered sector bets, posters also lamented that friends and acquaintances have sunk too much into individual stocks without thinking through the ramifications.

Dgiffin opined about the importance of separating the hype from a security’s actual investment merit. "[Investors often don’t know] the difference between a good idea and a good investment. Good ideas may relate to sectors and occasionally an exchange traded fund.

"The safest play is to know your stock, which means knowing the company, its metrics, and its management. I am amazed by how long it takes a good idea to be developed into a good investment."

NEXT: Talking Heads Are Trouble

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Talking Heads Are Trouble
Speaking of hype, many users noted that they’ve watched in frustration as friends, family members, and acquaintances have followed hot tips from experts without adequate regard for a security’s fundamentals or their overall asset-allocation plans.

Carman shared a similar tale that highlights the perils of minding the headlines and getting caught up in periods of market euphoria. "Working in the information systems area, I saw a lot of friends and coworkers hop on the Internet startups bandwagon and lose a lot of money. None of them bothered to read the business plans or other filings of these startups and just followed the hype of their brokers or media experts.

"My dad always said you should take the advice of someone who is paid to sell or buy something for you with a grain of salt the size of a small cow-lick."

CentralValley noted that paying too much attention to the media can be just as unhealthy during periods of market panic, sharing this personal tale. "During the 2008 bear market, almost all of the commentators were scaring us on an almost daily basis by saying the worse is still to come. I ended up selling at the bottom.

"After being psychologically scared to death, I found it very difficult to get back into the market, thus missing the huge bull runup. [It was] my fault; I should have had an investment plan. I do now and will not listen anymore because if any of the commentators could precisely and correctly predict the direction of the market (up or down), they’d be at the top of the Forbes List."

Let Someone Else Deal with It
Several posters noted that seeking out individualized guidance isn’t always a panacea, either. They’ve regretted to see their friends and family members turning their portfolios over to advisors and brokers who might not have had the wherewithal to do a good job, or even have their best interests at heart.

Curmudgeon shared his own story, writing, "I wasted time and money with so-called ’professional investment managers’ (flat fee as a percentage of principal under management).

"Instead of a truly responsible, modern-portfolio-theory-based portfolio management, regular, quantifiable accountability, and transparency, all I got was lots of ongoing glib, glossy, sales-brochure happy talk, jargon riddled rhetoric, lots of glad-handing, needlessly high turnover—and associated tax impacts for my taxable portfolio, that relentless 1% or more in fees regardless of portfolio performance, not to mention pesky little trade fees ’just to cover our costs’ (all adding up long term to the ’tyranny of compounding costs’), questionable approaches to sticking with the asset-allocation discipline, a complete refusal to acknowledge these headwinds as significant factors in my pocketable returns, and generally mediocre, and in some cases downright lousy, total returns even before netting out costs."

Annuities aren’t inherently bad, but among those wary of brokers, the vehicles received repeat mentions from users who felt their friends, acquaintances, and family members had been burned by them.

Danahan shared this tale. "[I learned] from my 85-year-old mother that a broker she thought was a friend smooth-talked her into converting her safely allocated, six-figure IRA into a deferred variable annuity. I would urge all Morningstar followers to caution their elderly parents to avoid annuities for their IRAs."

Tar42 opined about the importance of conducting due diligence before hiring financial help, noting that a common mistake is "Not interviewing your prospective financial planner, not the other way around. Don’t let or him/her think they are doing you a favor for time spent in interviews."

Think for Yourself
A recurrent theme among many posters was that many of their loved ones had failed to take personal responsibility for their financial lives.

Raghubilhana put it simply, "Nobody cares about your money more than yourself."

Digging into a good investment reading list is a good starting point for taking control of your investments, according to numerous posters advised, "Read up on good books (books by Ben Graham, Bogle, Warren Buffett, and so on) instead of spending time watching CNBC."

Jpm_NC shared the following step-by-step guidance for those wishing to go it alone. "Take time to understand the market by reading some of the classic books about it. Subscribe to Morningstar. If someone is managing your money now, track his performance by putting your assets into a Morningstar portfolio.

"Look at the expense ratios of your mutual funds for glaring problems; anything more than 1.25% is a red flag as well as front- and rear-loaded expenses. Analyze the risk/reward of your portfolio.

Danahan advised a similar program. "Take the initiative to be your own investor; do the research, start slowly, and learn from your mistakes (which we all make), especially regarding fees."

Billyp espoused a radically simple but very sensible approach in his post. "The best advice is simply to read a couple of good books on asset allocation and then allocate into a diversified assortment of pure index funds. Subscribe to Morningstar Premium service for fund and ETF advice.

"Establish brokerage accounts with a broker like Vanguard that will allow you buy and sell at no charge. Buy only very low-cost no-load funds and ETFs with total management fees of 0.35% or less. Keep an eye on your portfolio, but stay cool, with the finger off the sell button. Rebalance periodically. Really, any dope can do this."