Investing errors to avoid this year
- When yields are nonexistent, it makes little sense to try to live off them.
- Changing tax laws don't call for radical changes in portfolio strategy.
- Tune out news when making investing decisions, or pay attention at your peril.
Investing errors come in all shapes and sizes. Some mistakes are timeless, such as not investing at all, while others are specific to events and circumstances.
For instance, economic and investing conditions over the past few years represent something of an extraordinary time, beginning with the stock market plunge in 2008.
"While the wounds are still very fresh as far as 2008 goes, let us not forget that was really almost a once-in-a-generation type event. And because it is still so fresh in people's minds, people think it is going to happen again in the very near future," says Michael Gayed, CFA, co-portfolio manager of the ATAC Inflation Rotation Fund.
Scarred by the downturn, many investors scaled back on the amount of risk they're willing to take while others spiked up the risk level in their portfolios as a result of low interest rates.
Investing error No. 1: Trying to live off interest
To kick-start the economy, the Federal Reserve has kept interest rates at record lows. Though Federal Reserve Chairman Ben Bernanke is pushing everyone into riskier assets, retirees and near retirees don't have to oblige him.
"You have people trying to live off of interest income and dividends -- which, to me, is a very poor strategy," says Larry Swedroe, principal at Buckingham Asset Management and author of the book, "Think, Act and Invest like Warren Buffett."
"Just think how foolish it would be if you have some 99-year-old woman who's got a million dollars, and in today's environment, she's getting 1 percent or 2 percent on her money, so she has $10,000 to $20,000 to spend, and she won't touch her principal," he says.
It's no different for a 65-year-old, according to Swedroe. With planning and the right investing strategy, retirees should be able to withdraw 3 percent or 4 percent from their portfolios per year.
Investing error No. 2: Chasing yield
Chasing yield is the other side of the coin. Investors interested in safe, fixed-income products have cast wide nets to find higher yields than those available with Treasury securities or bank CDs.
People "start buying risky assets like junk bonds or things that aren't really safe investments. They're equities, but they throw off more cash, like real estate, master limited partnerships or dividend-paying stocks. But these are not substitutions for safe, fixed income," Swedroe says.
"If you get a repeat of 2008, well guess what: While my bond portfolio is going up because it owns only the safest bonds, your quasi-bond portfolio is dropping 25 (percent), 30 (percent), 40 (percent), 50 percent," he says.
To avoid the yield-chasing trap, income investors should work with a financial planner to develop a safe withdrawal strategy. Traditionally, the bond portion of a portfolio should be a safe haven from risk. Many products being sold these days introduce unnecessary elements of risk that some investors may not be aware of. For instance, investments that promise "upside potential with downside protection" may deserve a hard look. That category includes structured CDs, structured notes and equity-linked annuities.
"Wall Street is wonderful in creating products to respond to perceived wants and needs out there in the marketplace. If they can rip you off for 5 percent of your objective every year by providing downside protection, they're only too happy to sell you that. And you probably won't understand it," says CFP professional Frank Armstrong, founder and principal of Investor Solutions Inc. in Miami.
Investing error No. 3: Basing strategy on new tax laws
The "fiscal cliff" negotiations at the end of 2012 threw some not-unexpected tax law changes at high-income households.
"Changing your entire investment strategy to account for a reasonably small change in the tax law doesn't make sense," says Armstrong. "Generally, it's a mistake to let the tax tail wag the dog. We don't want to go back to the bad old days when we invested in tax-sheltered stuff just to avoid taxes or defer them down the road."
Instead of scrambling and reacting to events largely out of their control, investors should focus on events within their control and work to minimize short-term gains and emphasize asset allocation strategies, according to Armstrong.
Investors shouldn't be penny-wise but pound-foolish when it comes to their money. Instead, they may reap more rewards by looking closer to home.
"In general terms, people aren't saving enough, and I think that's a huge mistake," Armstrong says. "Notwithstanding the ineptness of our government, the one thing that you can control is how much you save and how you invest it. And you ought to concentrate on those issues and stop worrying about the clowns in Washington (D.C.) to the extent that you can."
Investing error No. 4: Avoiding slow economies
Recent research has shown that stock market returns are negatively correlated with a fast-growing economy. For investors, that means that focusing all their energies on quick-growing BRIC countries -- that's Brazil, Russia, India and China -- and avoiding recession-struck Europe can backfire.
It did backfire last year if you eschewed European companies. Vanguard's European Stock Index fund gained nearly 21 percent last year despite flat gross domestic product growth forecast for the year.
"That's another example of chasing recency. The year before, in 2011, Europe got killed, and people sold and it turned around," says Swedroe.
By contrast, the Chinese economy grew 7.8 percent in 2012. The Shanghai Stock Exchange Composite Index, the largest stock exchange in mainland China, finished the year up about 3.2 percent.
Investing error No. 5: Reacting to news
Investors who sold European stocks or mutual funds may have been tuned in a little too closely to the news.
"If you take yourself back to January last year, the fear was obviously that you would have an implosion in Europe," says Gayed. "Did not happen. End of last year, the fear was the fiscal cliff would cause a collapse. Did not happen. And all throughout that, (Standard & Poor's 500 index) had its best year since 2009 despite all of the doom and gloom that is out there."
"The biggest mistake that people make is they are not respectful of price movement within the market and instead get too nervous listening to overconfident pundits," he says.
Instead of watching the news, pay attention to the market and what the market expects. It may not have the same expectations as Nouriel Roubini or other high-profile forecasters.
"Ignore all forecasts. You're going to be subject to confirmation bias and put a lot of weight on the ones you agree with and ignore the ones you don't agree with," says Swedroe. "It makes you overconfident."
Tuning out the noise gets difficult as volatility roils markets and the global economy drags. These are interesting times to be an investor, and it can get confusing with the cacophony of news and forecasts and ever-shifting opinions from all sides. The best advice is timeless: Have a written investing plan and a preconceived strategy. It won't cure all your problems, but it may help you avoid a few basic investing errors.