Three rules to follow, three errors to avoid
The mega-tech stocks are on the move, and have been leading a rally in the big stock indexes. A growing number of novice investors are asking whether now is the time to finally jump into online trading, for fear of missing out on the next bull market. But this seat-of-your-pants approach can lead to heavy losses before you even really get started. So here’s a summary of my three key investment principles for novices and three errors to avoid.
Three errors to avoid
1. Investing by headline. Buying and selling based on your Twitter, Instagram, or Facebook feed can yield poor financial results. Novice investors fret way too much about the “news.” Tuning out the daily business news “noise” goes a long way to restoring peace of mind. Remember, all those “crisis” headlines change by the minute – and there’s never a time of no crisis. Check the news if you must, but take it with a huge grain of salt. Never trade based on the emotion of the moment.
The best way to keep that urge to emotional trading in check is to have an investment plan in place. Decide what your goals are, what your risk-tolerance level is, and allocate your assets according to a realistic assessment of your investment temperament – before you jump into the market.
2. Unrealistic risk tolerance. In my experience of nearly 20 years as an advisor, this is near the top of the list of investment errors novices make. Investors must have a true fix on what they’re comfortable losing in their portfolio’s value if there’s a sudden drop in the market – and remember this: there will always be sudden drops in the market. So how do you deal with the issue of false risk tolerance? The key is to ensure that your investment portfolio aligns with your true tolerance for risk. For example, if you swear up and down you have a high tolerance for risk, and are able to withstand a 30% decline in portfolio value, think about this: that 30% amounts to a $150,000 loss in a $500,000 portfolio. Think about it long and hard.
3. The crystal ball trap. Many investors have an unfounded confidence in their ability to buy and sell an investment at precisely the right time to maximize profit and portfolio performance. It’s called “market timing.” They believe they have some acute insight into the future that others do not posess. In practice, this is almost impossible to achieve consistently.
Then there’s wishful thinking – also a form of crystal-ball gazing. Novice investors will often buy an investment because it has recently gone up in price, in the expectation that it will go up some more. Investing solely on the basis of recent short-term past performance doesn’t work. In fact, it can actually magnify subsequent losses if the investment has already been gaining steadily for 12 months or more. Such investments very often wind up in the media spotlight, attracting a lot attention. By then, however, the smart money has already left, and the investment (a high-flying company, or a hot commodity, or the fad of the day) is ripe for a steep slide.
Three rules to follow
1. Preserve your capital. Whatever the size of your investment portfolio, your biggest challenge is how to keep it from being nibbled to death by ducks. Capital has many enemies, but three of the biggest systemic ones are inflation, taxes, and macroeconomic forces.
To preserve your wealth and keep it working and producing for you, you have to make those key decisions about your tolerance for risk and from there how to allocate those assets in the most tax-efficient way possible. Remember that “risk-free” really isn’t. Low-yielding investments like GICs, savings accounts, and government bonds will be eroded by taxes and inflation to the extent that you’ll actually be losing money every year.
2. Diversify your investments. It’s important to diversify assets over a number of classes (including fixed-income, equity, and alternative investments) using a variety of strategies, including hedge funds, venture capital, private offerings, tax shelters, and other vehicles for “accredited investors,” to ensure both capital preservation and tax-efficient growth to keep that income stream coming.
This process is called “asset allocation.” Are you currently diversifying your portfolio with enough non-correlated asset classes to your risk-tolerance level? Are you using hedging or income-generating strategies with options? These are not particularly easy questions for a do-it-yourself investor to answer. But if you’re having trouble sorting out how your various investment activities are affecting your overall returns, you might consider getting some help from an independent financial planner.
3. Tax efficiency. This is one of the biggest factors in wealth creation. Research has shown that creating tax efficiency in your portfolio accounts on average for about 28% of overall long-term investment returns. Surprisingly, the factors with the next largest influence on your portfolio returns are the time you spend on management, which accounts for 26% of portfolio returns. Managing your emotions (all that fear and greed) adds up to about 20% ranking.
This tells us that novice investors often get into trouble by placing too much importance on the aspects of portfolio management that contribute the least to long-term portfolio growth.
Your best bet for avoiding those capital-killing investing errors, always, is to follow the three rules: Have a well-thought-out financial plan that guides your portfolio asset allocation to match your true risk tolerance and financial objectives.