When it comes to investing, there is no fool-proof way to get it right always. But there are mistakes that cost the investor dearly.
Here we have highlighted three very common errors investors tend to commit. Avoiding these investing mistakes can save you significant amounts of money in the long run.
- Investing too conservatively for your time horizon
Investors often hear these words: “pay attention to your risk tolerance when allocating your assets”. This instantly puts them on the defensive and they tend to focus on short-term volatility. Consequently, they shirk away from stock and equity funds.
What they need to understand is that if they do have a long time horizon, they must put up with some of that short-term volatility. In the end, typically investments that are more volatile over the short-term will produce better returns over the long term. For wealth creation, and to beat inflation, equity is the best option.
For people who are in their 20s and 30s, it means that they want to have a portfolio that's predominantly invested in stocks or equity mutual funds. As they get closer to their retirement age, they could to tip more of the portfolio into safer securities.
Having said that, regardless of one’s age, if you need the capital in a year or two, then stay away from the stock market. The short-term gyrations can wipe out your savings if you are forced to liquidate.
Do read more on this in 3 essentials of equity investing.
- Rear-view mirror investing
Investors tend to drive with a rearview mirror perspective. They look at whatever has performed best in the recent past and then decide that's where they want to put all their money. Oftentimes that is the category that is the most highly valued. So if infrastructure stocks have run up, they gravitate towards those stocks or funds. Ditto with any other sector such as Media or Pharma or Financials.
Shopping for investments based on past returns is not a good idea. Considerable thought must be given to the fundamentals of the investment. Do you really want a sector fund in your portfolio? Is your portfolio already sufficiently diversified? Or, it could also be the case of a market captilisation zone. If mid- and small-cap stocks have run up, investors flock to such funds. And then when the inevitable slump happens they panic and sell.
This also happens in the case of individual funds. A particular fund may perform excellently and investors notice it. But it may not be a consistent long-term performer.
Investing based on a limited amount of information is detrimental to one’s portfolio. Simply reaching for a fund with the highest numbers is the worst strategy possible, as those high performers often revert to the mean. Rather than chasing the hottest performers, investors are better off focusing on fundamental information about funds' strategies, management, and expenses to help populate their asset-allocation mixes.
- Misunderstanding diversification
Diversification is not as simple as ‘don’t put you’re your eggs in one basket’. On a broad level, it means spreading your investments across assets, regions, sectors, and investment styles. It goes beyond that. Within each asset class, one should not go overboard. Good funds (and too many of them) combined in the wrong way can make a bad portfolio.
A common mistake to make is to think that because your portfolio contains 15 different funds, you’re well diversified. But diversification isn’t about the quantity of holdings. Use our Instant X-ray tool and you may be surprised at the overlap within your portfolio.
Morningstar’s director of personal finance, Christine Benz, refers to this as portfolio sprawl. When she reviews readers’ portfolios, she finds that investors have a glut of funds in their portfolios. For every single portfolio she receives that's whippet-thin--without an excess stock, fund, or ETF to spare—she comes across 10 more that have 50, 60, or even 100 individual holdings.
Concentration in a portfolio is certainly not advised: One year’s ‘hot topic’ can become the next year’s dud. Anyone invested fully in one area takes the risk of watching their portfolio swing violently between notable gains and substantial losses.
On the other hand, an abundance of stocks and funds in one’s portfolio makes it nearly impossible to get a good knowledgeable grasp on each holding. When you lose your focus, you lose your competitive advantage as an investor. Instead of having a competitive insight, you begin to run the risk of missing things.
While you can read more about how asset allocation differs from diversification, a prudent move would be to employ the services of a financial adviser to design a smart portfolio.
