Eight essential steps to avoiding investment pitfalls
I have found that some of the commonly accepted investment “advice” can be misleading, creating potential pitfalls for investors. Some of this misleading “expert advice” comes from such respected journals as Money Magazine or the Wall Street Journal.
Let’s look at some ways to avoid the more common investment pitfalls.
1. Always differentiate between investing and trading – Based on Benjamin Graham’s definition, buying a stock or fund to hold for a long period is typically considered an investment. Other equity transactions are considered trading, with different rules and approaches because of their more speculative nature. Before buying a stock or fund, always determine whether the transaction is an investment or a trade.
2. Only use Stop/Loss orders when trading – Stop/Loss orders should only be used when trading. If you use a Stop/Loss order with an investment, your investment could be sold at the worst possible time. On May 6, when the DOW fell almost 1,000 points before recovering, outstanding Stop/Loss orders were likely executed. An investment portfolio, with Stop/Loss orders to sell at 15 percent below the opening price, would have lost 15 percent on May 6 instead of the 3 percent loss that the market suffered.
3. Avoid redundant mutual funds – I recently reviewed a $500,000 investment portfolio that is being “professionally managed” by a well known discount brokerage and mutual fund company. This portfolio contained 50 different mutual funds, with 13 US large Cap funds and nine Foreign Large Cap Funds. A diversified fund portfolio requires no more than one fund for each Morning Star “style box” category.
4. Avoid all sales fees with mutual funds – While most investors know to avoid front or rear end “load” mutual funds, many funds have a “hidden load” called a 12-b1 fee. This annual fee of .25 percent or more can greatly reduce long term investment returns.
5. When allocating assets, include ALL investible assets – Investors typically have several different accounts including retirement accounts, taxable investment accounts, real estate and savings accounts. Once a proper asset allocation is determined, all assets should be included in the asset allocation.
6. Always consider investment tax consequences – When taxable, tax deferred and tax free (Roth) accounts exist, put tax efficient investments in taxable accounts and tax inefficient investments in tax deferred and tax free accounts. Closely follow the tax law changes that will occur, starting in 2011. Some investments, such as stocks with high dividend yields, could change from being tax efficient to tax inefficient in 2011.
7. Avoid making purchases based on a stock’s P/E – While the market’s overall Price/Earnings ratio can be a useful indicator of whether the market is under or overvalued, the P/E of an individual stock can be very misleading. A low P/E for a company that is not growing may not portend a good investment, while a higher P/E on a rapidly growing company may show good value. Price earnings growth comparisons or owner’s earnings vs price comparisons are much better indicators of a stock’s value.
8. Avoid “Target Date” funds – A recent “panacea” from the mutual fund industry is “target date” funds. The concept is for the investor to pick the year in which they will begin withdrawing funds for retirement or other purposes. The fund management will then take care of the rest. However, different mutual fund companies have different asset allocations for funds with the same “target date.” A better approach may be to assemble your own “fund,” consisting of low cost, indexed ETFs or mutual funds. Annually, modify the asset allocation toward more conservative investments as the “target date” approaches.
Whether managing your own investments or using an outside investment advisor, be sure that your portfolio avoids these common pitfalls.
When using an investment advisor, always ask if they have a fiduciary responsibility for both the advice that they give and the products they offer. A fiduciary advisor is legally required to always place their client’s interests ahead of their own interests. Many brokers and agents are held to a lower “suitability” standard, where the products and advice offered may legally allow them to place their own interests before their client’s interest.
Wayne Farlow is the founder of Financial Abundance, LLC, providing fee-only financial planning, asset management and retirement planning services. He is the author of “Financial Abundance Guide,” available at www.finabguide.com . He can be reached by email at email@example.com or at 303-554-0309.