Tuesday, May 27, 2014

Investment Mistakes 101

If you want to have a future you must invest in your future. That is true in relationships. It is also true if you ever want to achieve financial freedom. Financial freedom is the point at which you no longer have to work in order to get a paycheck. You are free to pursue your own dreams without worrying about paying the monthly bills.

For most of us, there are two convenient methods of investing. The first is the market, stocks and bonds. The second is real estate that generates an income, rental property. I have decided, at least for now, real estate is not my thing. Paying cash for rental properties is a rich man’s game. Holding a mortgage on a property that someone else may or may not choose to rent makes me nervous. I don’t understand how to evaluate the cost and convenience risk of broken toilets in the night. I rather not deal with tenants, so that leaves me with the great American game, the stock market.

Wait until you have a few thousand in an emergency fund. Then if your employer offers matching money in a 401(k), go for it. Generally, matching money runs about 3%. Even if you are strangling on credit card debt, go ahead and get the 3%. If you need to deposit 3% of your pretax income to get 3%, just go for it. Even if you end up in bankruptcy court, generally your 401(k) will be safe. If you don’t have an employer retirement plan, wait a bit longer, perhaps until you have 2 or 3 months take home pay in an insured savings account. As always, I don’t give one size fits all advice. Use some common sense. If your job is insecure build up that emergency fund until you reach 6 months or more. If you think you have a pretty secure future, you don’t need to be as conservative.

Then start an investment program. If you don’t have a 401(k), start with a Roth IRA. Then move out into more sophisticated tax favored plans appropriate for your particular condition in life. Finally, start a taxable brokerage account.

If you don’t start an investment program, you have just made the first and most serious investment mistake. Don’t worry. You will make mistakes. You will lose money on something. Even Warren Buffet has made mistakes. Start with low cost index funds. That is what is offered by most 401(k) programs. If you don’t want to decide on an age appropriate balance between stocks and bonds, just buy shares in one of the low cost life cycle funds offered by firms like Vanguard. Often life cycle funds are also an option in 401(k) programs.

The second mistake is quitting. No matter your age or the condition of the economy, stay in the game. You might set up a range. I have decided that I will keep between 40% and 55% of my liquid net worth in stocks and stock funds. I will not try to time the market because I can not tell the future. As I grow older it will be harder for me to recover from a serious stock market disaster that wipes out 50% of my holdings, but even my parents, now in their nineties, still have a small percentage of their total holdings in old stock mutual funds and one significant position in a single company. There is something else to think about. Studies indicate that the ability to make investment decisions tends to peak in our mid fifties. Then as we grow older, our capacity to make complex decisions begins to decline. Bonds, bond funds, Certificates of Deposit, and insured money market funds make more sense than shares in individual stocks for the elderly.

The third and fourth mistakes are investing too much at one time or in one company.

The stock market goes up and down, sometimes for no good reason. Don’t try to time the market. Month after month, year after year, keep putting small amounts of money into your accounts. When the market is down your dollars will be buying more shares. When it is sky high you will be buying fewer shares. This is a safe way to build up your resources. It has a name, dollar cost averaging. Look it up.

Your holdings must be diversified. Never have more than 5% of your liquid net worth in a single company, even if that company is your employer. I would also add never have more than 15% of your net worth in any market sector, no matter how safe or glamorous. Internet stocks were all the rage in the late nineties, everybody was getting rich buying pure stupidity. Then the bubble burst. If you lost 70% of the value of your Internet stocks in 2000, a 15% position in that sector would have cost you 10.5% of your liquid net worth, painful but not the end of the world.

British Petroleum (BP) was one of the best managed companies on the planet. Their dividend was as safe as anything in this unhappy world. Then a fire started on one their oil platforms in the Gulf of Mexico. In a matter of weeks BP lost about 50% of its total net worth. If you were holding 5% of your liquid net worth in BP, you would have hardly even noticed anything had happened. If you had half your money in BP, you would have been in a world of hurt.

Be fearful when others are greedy and greedy when others are fearful.
Warren Buffett

Fear and greed drive the market. Avoid mistakes number five and number six by heeding the wisdom of Warren Buffet. Instead of trying to time the market let the market time your behavior. When you are below or above your range for stocks, rebalance. If the market is too high move a bit of your holdings in your tax favored account from stock funds to bond funds to bring things back into balance. This action has no tax consequences. If you chose to sell shares in a taxable account you have to consider taxes. When the market is in the tank and the Drudge Report puts up the dreaded flashing red light over their lead end of the world headline on the stock market, it is time to move out of bond funds into stocks funds. If you have some spare cash, now is the time to dump it into the stock market. In the first quarter of 2009 it was hard to make a mistake buying shares in a quality company.

There are other mistakes to consider that are made by more sophisticated investors. I will discuss them at some future time, but this list of six is plenty for now. The next time you look in the mirror, realize you are looking at your biggest problem. It isn’t the politicians. It isn’t the bankers. It isn’t the deranged mathematical geniuses running flash trading scams. It isn’t the con artists selling penny stocks out of boiler rooms found in New Jersey strip malls. Your biggest investment problem is you. Before pulling the trigger on any investment remember these words, “I can not predict the future.” If you act consistently and carefully over the course of a lifetime with an understanding of your own limitations everything will probably turn out OK.

1 comment:

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