How to
Avoid Dumb Investment Mistakes in 2006
by Stephen Nelson
Smart people sometimes make dumb
mistakes when it comes to investing. Part of the reason for this, I
guess, is that most people don’t have the time to learn what they need
to know to make good decisions. Another reason is that oftentimes when
you make a dumb mistake, somebody else—an investment salesperson, for
example—makes money. Fortunately, you can save yourself lots of money
and a bunch of headaches by not making bad investment decisions.
Don’t Forget to Diversify
The average stock market return is 10
percent or so, but to earn 10 percent you need to own a broad range of
stocks. In other words, you need to diversify.
Everybody who thinks about this for
more than a few minutes realizes that it is true, but it’s amazing how
many people don’t diversify. For example, some people hold huge chunks
of their employer’s stock but little else. Or they own a handful of
stocks in the same industry.
To make money on the stock market, you
need around 15 to 20 stocks in a variety of industries. (I didn’t just
make up these figures; the 15 to 20 number comes from a statistical
calculation that many upper-division and graduate finance textbooks
explain.)
With fewer than 10 to 20 stocks, your
portfolio’s returns will very likely be something greater or less than
the stock market average. Of course, you don’t care if your portfolio’s
return is greater than the stock market average, but you do care if
your portfolio’s return is less than the stock market average.
By the way, to be fair I should tell
you that some very bright people disagree with me on this business of
holding 15 to 20 stocks. For example, Peter Lynch, the outrageously
successful former manager of the Fidelity Magellan mutual fund,
suggests that individual investors hold 4 to 6 stocks that they
understand well.
His feeling, which he shares in his
books, is that by following this strategy, an individual investor can
beat the stock market average. Mr. Lynch knows more about picking
stocks than I ever will, but I nonetheless respectfully disagree with
him for two reasons. First, I think that Peter Lynch is one of those
modest geniuses who underestimate their intellectual prowess. I wonder
if he underestimates the powerful analytical skills he brings to his
stock picking. Second, I think that most individual investors lack the
accounting knowledge to accurately make use of the quarterly and annual
financial statements that publicly held companies provide in the ways
that Mr. Lynch suggests.
Have Patience
The stock market and other securities
markets bounce around on a daily, weekly, and even yearly basis, but
the general trend over extended periods of time has always been up.
Since World War II, the worst one-year return has been –26.5 percent.
The worst ten-year return in recent history was 1.2 percent. Those
numbers are pretty scary, but things look much better if you look
longer term. The worst 25-year return was 7.9 percent annually.
It’s important for investors to have
patience. There will be many bad years. Many times, one bad year is
followed by another bad year. But over time, the good years outnumber
the bad. They compensate for the bad years too. Patient investors who
stay in the market in both the good and bad years almost always do
better than people who try to follow every fad or buy last year’s hot
stock.
Invest Regularly
You may already know about
dollar-average investing. Instead of purchasing a set number of shares
at regular intervals, you purchase a regular dollar amount, such as
$100. If the share price is $10, you purchase ten shares. If the share
price is $20, you purchase five shares. If the share price is $5, you
purchase twenty shares.
Dollar-average investing offers two
advantages. The biggest is that you regularly invest—in both good
markets and bad markets. If you buy $100 of stock at the beginning of
every month, for example, you don’t stop buying stock when the market
is way down and every financial journalist in the world is working to
fan the fires of fear.
The other advantage of dollar-average
investing is that you buy more shares when the price is low and fewer
shares when the price is high. As a result, you don’t get carried away
on a tide of optimism and end up buying most of the stock when the
market or the stock is up. In the same way, you also don’t get scared
away and stop buying a stock when the market or the stock is down.
One of the easiest ways to implement a
dollar-average investing program is by participating in something like
an employer-sponsored 401(k) plan or deferred compensation plan. With
these plans, you effectively invest each time money is withheld from
your paycheck.
To make dollar-average investing work
with individual stocks, you need to dollar-average each stock. In other
words, if you’re buying stock in IBM, you need to buy a set dollar
amount of IBM stock each month, each quarter, or whatever.
Don’t Ignore Investment Expenses
Investment expenses can add up
quickly. Small differences in expense ratios, costly investment
newsletter subscriptions, online financial services (including Quicken
Quotes!), and income taxes can easily subtract hundreds of thousands of
dollars from your net worth over a lifetime of investing.
To show you what I mean, here are a
couple of quick examples. Let’s say that you’re saving $7,000 per year
of 401(k) money in a couple of mutual funds that track the Standard
& Poor’s 500 index. One fund charges a 0.25 percent annual expense
ratio, and the other fund charges a 1 percent annual expense ratio. In
35 years, you’ll have about $900,000 in the fund with the 0.25 percent
expense ratio and about $750,000 in the fund with the 1 percent ratio.
Here’s another example: Let’s say that
you don’t spend $500 a year on a special investment newsletter, but you
instead stick the money in a tax-deductible investment such as an IRA.
Let’s say you also stick your tax savings in the tax-deductible
investment. After 35 years, you’ll accumulate roughly $200,000.
Investment expenses can add up to really big numbers when you realize
that you could have invested the money and earned interest and
dividends for years.
Don’t Get Greedy
I wish there was some risk-free way to
earn 15 or 20 percent annually. I really, really do. But, alas, there
isn’t. The stock market’s average return is somewhere between 9 and 10
percent, depending on how many decades you go back. The significantly
more risky small company stocks have done slightly better. On average,
they return annual profits of 12 to 13 percent. Fortunately, you can
get rich earning 9 percent returns. You just need to take your time.
But no risk-free investments consistently return annual profits
significantly above the stock market’s long-run averages.
I mention this for a simple reason:
People make all sorts of foolish investment decisions when they get
greedy and pursue returns that are out of line with the average annual
returns of the stock market. If someone tells you that he has a
sure-thing investment or investment strategy that pays, say, 15
percent, don’t believe it. And, for Pete’s sake, don’t buy investments
or investment advice from that person.
If someone really did have a
sure-thing method of producing annual returns of, say, 18 percent, that
person would soon be the richest person in the world. With solid
year-in, year-out returns like that, the person could run a $20 billion
investment fund and earn $500 million a year. The moral is: There is no
such thing as a sure thing in investing.
Don’t Get Fancy
For years now, I’ve made the better
part of my living by analyzing complex investments. Nevertheless, I
think that it makes most sense for investors to stick with simple
investments: mutual funds, individual stocks, government and corporate
bonds, and so on.
As a practical matter, it’s very
difficult for people who haven’t been trained in financial analysis to
analyze complex investments such as real estate partnership units,
derivatives, and cash-value life insurance. You need to understand how
to construct accurate cash-flow forecasts. You need to know how to
calculate things like internal rates of return and net present values
with the data from cash-flow forecasts. Financial analysis is nowhere
near as complex as rocket science. Still, it’s not something you can do
without a degree in accounting or finance, a computer, and a
spreadsheet program (like Microsoft Excel or Lotus 1-2-3).
Kirkland
WA certified public accountant & author Stephen L. Nelson CPA
has written more than 150 books. His bestselling book is Quicken for
Dummies, which sold more than 1,000,000 copies. His books have sold
more than 4,000,000 copies in English and have been translated into
more than a dozen other languages. His web site is
http://www.stephenlnelson.com
Bellevue-Redmond WA CPA Stephen L.
Nelson is the author of numerous bestselling books including Quicken
for Dummies and QuickBooks for Dummies.
Stephen Nelson may be contacted at http://www.stephenlnelson.com
or steve@stephenlnelson.com
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