Maybe 2014 will be the year your favorite team will win the World Series. Maybe it’s the time you go back to school for a higher degree. Or you walk down the aisle. Or buy a new house or send your kid off to college.
A new year brings new opportunities full of endless possibilities, and it’s key to note that it’s a new year in investment markets as well.
The S&P 500 finished 2013 with a gain of more than 32%, the best performance in recent history. And if you become inspired by last year’s success and are looking to finally kick your long-term investment plan into full gear—avoid these five common investing mistakes.
Mistake No. 1: Don’t Predict the Future Based on the Past
When it comes to the stock market, the immediate past is an unreliable indicator of predicting future market performance.
Think of it this way: The S&P 500’s return for 2013 was its best annual gain since 1997. Ask yourself: if it took 15 years for the index to surpass that 1997 result, what is the likelihood that it will surpass it yet again, the very next year?
It’s possible, of course. But the probability is not particularly high.
Markets often experience short-term momentum as new money comes in chasing the latest “hot new thing.” But that momentum will tend to reverse before too long. When the “hot new thing” cools off, the money slows down. If you come in closer to the top, you are more likely to suffer a loss when the reversal comes.
Avoid the temptation to time the markets. Invest according to a strategy that makes sense for your long-term goals, not according to what you think the market might do tomorrow or next month.
Mistake No. 2: Don’t Put All Your Eggs in one Basket
You may think Apple is the greatest company that ever existed, or that Facebook will one day rule the world. That’s fine, but don’t let your emotional attachments dictate your investment choices.
Creating a portfolio that’s diversified across multiple asset classes, and that’s aligned with your goals and risk tolerance, will help you reach your long-term goals.
For that matter, unless you have vast knowledge and experience in investing in individual stocks, avoid the temptation to pick your own stocks. It will be more cost-efficient and less risky to choose liquid, pooled vehicles like mutual funds or exchange traded funds.
Most market pros fail to beat broad index measures consistently. In other words: even the highest-ranked professionals can’t beat the market. You should assume that the same will apply to you.
Mistake No. 3: Don’t Ignore Costs
If you have ever tried to read an investment prospectus or the small print on a company’s website disclosures, you know how hard it can be to understand the costs of your investments.
But cost matters. Every dollar that goes to pay for a fund management team or a distribution agent is a dollar that’s not working for your financial future.
Do your due diligence and make sure you are not overpaying for your investing advice. Ask your friends and family what they pay and research online to review your options.
Cost should also be a factor when you decide whether to invest in passive, index-linked funds or actively-managed funds. Passive funds are generally less expensive than active funds. When you compare long-term performance on a net-of-fees basis, you will tend to find that the index-linked funds perform better than the average active fund.
This doesn’t mean you should never consider an active fund, just make sure you build a compelling case for why you would expect better-than-average performance from that fund.
Mistake No. 4: Don’t Panic When Things Go South
Corrections are a fact of life in any asset market. And if you stay in the game long enough, you’re likely to experience at least one whopping crash at some point.
The last one, of course, happened in 2008, only six years after the plunge that began with the bursting of the dot-com bubble and ended with the 2001-02 recession.
Before that, though, equities enjoyed an 18-year bull market punctuated only by the brief (but intense) collapse on Black Monday in October 1987.
The 2008-09 market crash is proof that prices can fall very sharply, very quickly. Chances are that if you sold in a panic, the worst of the damage was already done.
The more important point to note is that by March of 2013 the S&P 500 had not only gained back everything it lost in the crash, it then went on to set a string of new all-time highs. If you had the discipline to stay in the market without panicking, you were made whole just five years later. By contrast, if you sold out at or near the market’s bottom, you turned paper losses into actual losses.
Mistake No. 5: Don’t Forget About Risk
If panic selling is the wrong way to manage risk, then the right way to manage risk is by diversifying your portfolio based on the risk properties of your assets.
Risk tolerance is really two things. First, it reflects your capacity for taking on more volatile asset exposures. Capacity is largely a function of your financial situation, and how badly that situation could be impacted by an unexpected fall in your portfolio’s value. In other words, can your portfolio handle the volatility?
The second part of the risk tolerance equation centers around your emotional and psychological comfort with risk. Some of us can sleep soundly during the market’s roller-coaster ride, while others feel that market volatility is traumatic. Risk isn’t a one-size-fits-all proposition, so make sure that your portfolio has a mix of higher- and lower-volatility assets that are right for you.
Avoiding these five common mistakes can make you a better investor for the new year and for many years to come.
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