Don’t make these financial mistakes in 2016
Market volatility has certainly returned. If Thursday’s close is any indication, most global markets are likely entering a bear market following market peaks in late-2015.
With all of this going on, I continue to see, read, or hear about the same mistakes being made by investors in an attempt to either avoid losses or seek gains. Here are five mistakes I’d suggest you avoid:
- Listening to prognosticators. No one knows with certainty anything about the future. The ones who occasionally make the correct call are usually one-trick ponies and you won’t likely know them in advance; the ones who don’t will cost you a lot of money. Focus on what you can know or do: save, invest prudently, control spending, and maintain optimal insurance. If you do these four things for life you’ll likely do really well. If you lead your life following talking heads and prognosticators, well, good luck.
- Thinking “the market” is the S&P 500 or what you see on CNBC. The U.S. market cap is approximately 50% to 60% of the world market cap. That number fluctuates yearly but overall the U.S. is roughly only half the world’s equity market cap. The S&P 500 is only one component of the U.S. market and is also primarily large cap stocks, while there are thousands of mid- and small-cap companies worldwide. The market place is also made up of bonds and real estate, both equal to if not larger in value than stocks. Anchoring your investment experience and benchmarking performance to what’s said on TV in the belief that it’s “the market,” will lead you to making very poor decisions with your money and likely leaving you under diversified, as well.
- Seeking out the perfect investment strategy. I commonly read or hear about how one money manager offers a superior strategy to another, or why one way of investing is the only way to invest. There are certainly superior strategies compared to chasing performance, paying high expenses and fees, market timing, or simply working with shysters, but in the world of prudent investing, there are multiple ways to invest one’s money, many of them very reasonable. Remember, no single strategy is always going to work all of the time. For example:
- Buy and hold is awesome in bull markets and historically offers the best very long-term return, but it doesn’t consider risk management and can be very painful when markets take a rapid turn (like we’re seeing now).
- “Strategic rebalancing” is wonderful when markets are volatile because it also helps manage risk, but when return is on a tear you’ll feel like a fool when you keep selling stocks to buy bonds.
- “Indexing” is absolutely the leader in keeping costs low and usually outperforms active managers, but if a bubble shows up indexing can get absolutely clobbered due to its very nature of market-weighted valuations.
- “Active management” (the reputable, lower-cost ones primarily) can often diversify funds, spread out risk exposures, and maybe even limit downside risks during severe bear markets in a way that indexing can’t. However, it requires a very advanced appreciation of their approach and a long holding period with hope it works, all while you might get annoyed by underperformance in a bull market, especially if costs are high.
- “Value-investing,” like Warren Buffett, or buying “cheap relative” companies has a very long-term positive record of performance, but that outperformance has been very absent for the last few years. In fact, Buffett had an absolutely horrible relative year in 2015. He was down more than 11% last year. Russell 1000 Value as an asset class was down 7.5%. Does this mean this will continue? Did the benefits of value disappear? Unlikely. Value has ample evidence supporting it over very long periods of time and Buffett has an amazing record. But I won’t be surprised to see folks give up on its long-term history given short-term results.
- “Income investing,” or basically buying investment for interest or dividends income, is easier for some investors to appreciate, especially in retirement. It works well if you truly can live on that income and appreciate the risks as yields shift or especially when many investors are all competing for the same yield and markets inflate like we saw last year. Due to the concentrated exposure of the portfolio, when they become overvalued or out of favor they come with the same risk exposures as anything else — perhaps even more.
All of these strategies and many others are reasonable, they just don’t work all of the time. They can’t. If they did, they would, by the very nature of the markets, get bid up in pricing so high that the value of the strategy disappeared.
The key here is to make sure the strategy matches your goals, risk tolerance, and, most importantly, your commitment. Bailing on it at the wrong time can throw years, if not decades, of planning out the window. If you don’t know what to do with a strategy, here’s a simple approach: diversify not just your portfolio but your investment strategies, as well. I personally like this idea. Most importantly, be sure you’re comfortable with it and can commit to it before you execute it.
- Chasing returns or yield after the fact. Stop doing this. All of the above strategies are reasonable, but chasing them based on their recent performance is mega-stupid. Research on investor behavior and performance conclude the same — that return chasing by the average investor can cost them at least 3% a year in return.
An example of this has been seen throughout the last two decades. Through the 1990s people chased the U.S. markets. The markets peaked in 2000 before crashing dramatically, wiping out much of the previous years’ gains. It took more than a decade to get back to square. It took even longer than that on an inflation-adjusted basis. During this same time, international markets were on a tear, which fully supported globally diversified portfolios. Yet it appears many investors missed out on this because of the chasing they did in the 1990s. Now, since 2009 the script has flipped again. The U.S. was/has been on the tear, whereas international markets haven’t kept up. Diversification, though, in all periods worked really well relative to chasing returns. Keep it simple, don’t chase.
- Believing that taking on risk automatically entitles you to a return. Taking risk exposes you to a return, but it also exposes you to — wait for it — RISK! Risk means potential for loss. That’s the whole point.
I’m dismayed by comments like “if I take the risk, I’ll get the return.” Not necessarily. For example, investors who chased yield in 2014 through 2015 did not fare as well as a simple diversified portfolio. When the 10-year treasury (the risk free bond) pays only 2.3% and you want 6% in yield, you are taking a serious amount of additional risk in your yield portfolio. If you chased 6% yield, you probably owned very high dividend-paying stocks, possibly leveraged energy, high yield bonds, and other high risk assets. Many of these investments got hammered in the past two years. That 6% got eaten up badly in principal depreciation. When you target a 150% yield premium as a goal, you are radically increasing your risk spectrum.
Another comment I hear is “the market always comes back.” It doesn’t have to. Ask any Japanese investor who invested during the 1980s. Ask any S&P investor who invested into 2000 and then waited a decade to see it return, or worse, a NASDAQ investor who invested in the late 1990s.
You only get a return if the serious risk doesn’t happen. Risk and return are related, but one doesn’t entitle you to the other. This is another reason why diversification is reasonable and prudent. Make sure you truly appreciate this.
There are other mistakes folks make, as well, such as not getting proper insurance, not having a current estate plan, or spending too much and not saving.
These are all primarily behavioral mistakes that can also be prevented. Start by knowing who you are as it relates to your financial planning, risk tolerance, and goals. Be honest and humble. Then build a good financial plan. Hire a reputable fee-only fiduciary financial planner if you need the help (most folks do). Then be sure you completely understand the plan and are committed to it.
Avoiding these mistakes should at least help you be “less wrong” than others.
Happy New Year!
MICHAEL DUBIS is a fee-only CERTIFIED FINANCIAL PLANNER™ and president of Michael A. Dubis Financial Planning, LLC. He also previously served as part-time lecturer at the University of Wisconsin Business School James A. Graaskamp Center for Real Estate. Mike can be reached at firstname.lastname@example.org.
Disclaimers: This article contains the opinions of the author. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services described in this website or that of the author’s.
Mike Dubis does not guarantee the relevancy, appropriateness, or accuracy of any outside information or links. Mike Dubis does not render or offer to render personalized investment advice or financial planning advice through this medium. All references that might be made to an investment or portfolio's performance are based on historical data and one should not assume that this performance will continue in the future.
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