Count me among the “sinners”! I actually committed one of these sins and it cost me $5,000.
I’ve been a financial planner for 16 years and saw thousands of people in my business and through my blog that have consistently made the same general investing mistakes. Worse, many people don’t even know they’re committing them.
So let’s take a look at the seven deadly sins of investing, including the one I committed that cost me five grand.
1. Being Clueless About Diversification
Many investors suffer from two common allocation sins: either being too conservative and/or poorly diversified. Being poorly diversified means putting most or all your money into a single investment or even investment class.
You shouldn’t do that even with broad investment categories, like stocks. Even though they may represent the majority of your portfolio, you still need to hold at least some money in bonds and cash.
One of the problems particular to stocks has to do with exchange traded funds (ETFs). Now they’re generally the best way to invest in stocks. But if you have multiple accounts, like a brokerage account, a 401(k) and an IRA, you probably have several ETFs across all your investment accounts. The problem is even though you’re invested in different funds, it’s almost certain each hold many of the same stocks. Because of this duplication, fund investing can make it very difficult to be adequately diversified.
But the fund problem can be even more extreme. A lot of people are holding their stock portfolios primarily in ETFs based on the S&P 500 index. If you’re holding the same fund across different accounts, your portfolios are identical from one account to another.
While the S&P 500 index has generally been considered the best single one to invest in over the past decade, it excludes entire sectors. For example, it doesn’t include any international stocks (the S&P 500 index is comprised entirely of US-based companies.)
Fortunately, there are ways you can do an analysis of your portfolio to see how diversified you really are – or aren’t. For example, you can go to various online sources, like Morningstar, that will show you the top 10 holdings in each of your funds. If you see a pattern of the same stocks dominating each of your funds, you’re not as diversified as you may believe.
If you want an even deeper and more personal drill down, you can sign up for one of my personal favorites, Personal Capital. It’s a free app that will enable you to sync all your investment accounts in one place. It’ll perform an analysis on your accounts, to let you know exactly what you’re holding in your portfolio. That will give you a chance to eliminate duplication, and seriously diversify your holdings.
2. Holding Way Too Much Cash
We all need to have a certain amount of cash. At a minimum, you need to have cash sitting in an emergency fund for unexpected expenses or short-term income disruptions. You also need to have some cash to take advantage of any investment opportunities that may arise. But at the same time, it’s completely counterproductive to have too much sitting in cash.
The big problem with cash, especially right now, is the interest returns are ridiculously low. The more money you have in cash, the more money you’re losing by not having it invested in other asset classes. This can be costing you thousands of dollars each year, and that’s why you need to minimize how much cash you have.
Once again, this is where funds can become a complication. It especially applies to mutual funds. Many hold a certain amount of cash in the fund. I’ve seen mutual funds that have 5%, 10%, and even as high as 15% in cash.
You need to be aware how much cash your mutual funds are holding. If it’s more than 1% or 2%, you may be holding more cash than you think. And of course, the whole purpose of mutual funds is for generating growth – not holding cash for safety.
Having too much cash in your investment portfolio even has a name: cash drag. It’s when too much money is sitting in non-investments, providing little or no return on your money.
This is another area where a portfolio analyzer, like Personal Capital, can help you find the funds that are holding too much cash.
3. Paying Excessive Fees
The problem with fees is they reduce your return on investment. If you’re paying 2% per year in investment fees, a 10% return on your portfolio will be reduced down to 8%.
This can cost you a fortune. If you invest $10,000 for 20 years at 10%, your portfolio will grow to $67,274. But if, due to fees, your return is only 8%, you’ll have just $46,609 after 20 years. The 2% difference will end up costing you well over $20,000 over 20 years.
That’s why investment fees matter.
One of the investment areas were fees are a big problem is when you’re working with a financial advisor. The typical fee you’re paying to the advisor is anywhere between 1% and 3% of your account value. But that’s just the fee you pay to your advisor. There may also be trading commissions as well as internal expenses associated with funds you don’t even see.
Hidden Investing Landmines: Fund Fees
For example, internal expenses on mutual funds averages 1.31%. If you’re paying 1% to your financial advisor, and your portfolio is invested entirely mutual funds at 1.31% in expenses, your real total investment expense will be 2.31%. The best way to avoid excessive mutual fund fees is to avoid mutual funds altogether (at least active mutual funds). ETFs are often cheaper, more tax efficient alternatives.
A few years back, I acquired a new client who had guessed he was paying about $200 per year for his all-in investment expenses. We did a portfolio analysis on his investments, and found they were really $5,500 per year. That’s why it’s so important to know what you’re paying in investment expenses from all sources.
If you’re working with a financial advisor a question you must ask is what is my all-in cost for working with you? If the advisor can’t or won’t answer your question, you need to find a new advisor.
4. Tacky Tax Planning
This is about minimizing the tax burden from your investing activities. The best way to do this is by holding as much money as possible in tax-sheltered retirement plans. Employer-sponsored plans, like the 401(k), 403(b) Thrift Savings Plan (TSP), are an excellent way to do that. Not only can you contribute up to $19,000 per year in tax-deductible contributions (or up to $25,000 if you’re 50 or older), but the investment income in the account builds on a tax-deferred basis.
If you’re self-employed, you can take advantage of one of several retirement plans for small businesses. These include SIMPLE and SEP IRAs and solo 401(k)s. In some cases, you can make even larger contributions to these plans than employees can make to employer-sponsored plans.
Failing all else, you can make a tax-deductible contribution of up to $6,000 per year (or up $7,000 per year if you’re 50 or older) to a traditional IRA.
In each of these plans, your investment income accumulates on a tax-deferred basis. No tax will do until you reach retirement, and you begin making withdrawals.
Adding a Roth IRA for Even Greater Tax Protection
But you can even get around paying taxes in retirement entirely by using a Roth IRA. Contribution limits are identical to the traditional IRA, and investment earnings are tax-deferred. But once you reach 59 ½, and as long as you been in a plan for at least five years, you can begin taking withdrawals tax-free.
Even if you have one of the other plans, you should still participate in a Roth IRA if you’re eligible. It will add an important element of tax diversification to your retirement investing, by ensuring that at least some of your retirement income will be completely free from income tax.
Even better still, many employer plans include a Roth option. You should absolutely take advantage if it’s available.
5. Day Trader Syndrome
This is one of the biggest investment delusions around, and it’s surprisingly popular. After all, who wouldn’t be drawn by the idea of opening a brokerage account, sitting at your computer, and making hundreds or thousands of dollars each day by moving in and out of stocks?
The reality is day trading is the investment equivalent of buying lottery tickets. At least 90% to 95% of people who do it lose money. That probably explains why few of us know anyone who day trades for a living.
But I can’t be too critical here. This is the deadly investing sin I committed, the one where I lost $5,000. I don’t know if you would call it day trading in the strict sense. I had this idea I could invest in a penny stock and make thousands of dollars on it. No, I didn’t accept any outside advice. Instead, I wanted to do it my way – even though I had no idea what I was doing.
That $5,000 loss was for a single trade, which is why my foray into speculative investing came to an end so quickly. But if you look at the statistics on day-trading, it’s a similar situation. The vast majority of people who try it fail. Maybe it’s one of those concepts that works better on paper than it does in real life. But that’s why it’s best avoided.
A big part of the problem with day-trading is you can’t get reliable information from the people who are doing it. They may tell you of their gains, but they omit their losses. A day trader might tell you he’s up 10%, but you have no way of knowing if that’s 10% on one trade, 10% for the day, or 10% for the week.
Yes, there are people who make money day trading. But they’re professionals who only arrived to that place after years of practice.
6. Letting Headlines Derail You
Let’s start with the real purpose of the media: it’s to sell advertising. All those catchy – and sometimes shocking – headlines are designed to get your attention. The more people who click through, the higher the potential advertising revenue is. In most cases, the headline you’re reading has no effect on your life. But if it gets you to go to the article, it’s accomplished its mission.
Here’s a case in point: a few years back, I received a call from a client who was in full-on panic mode. He’d seen a story on TV that said the average 401(k) plan had lost $37,000. He thought that meant he was getting clobbered on his investments too.
The ironic thing is he didn’t even have a 401(k)! He had other investments, and had lost a little bit. But he was retired, and nothing in that story even applied to his life.
Media sensationalism can cause you to panic and overreact, even to “news” that doesn’t apply to you. Don’t let news stories get you to change your investment strategy. You need to think long term, and ignore the short-term disturbances.
7. Debt Denial
There’s no way to invest for your future if you’re drowning in debt. The problem for many people is they don’t know how bad their debt situation is. They may not even know how much they owe.
That shouldn’t be you. If you have debt, take some time and add it all up so you’ll know exactly how much you owe, and how much you’re paying in interest. It’s okay to invest money if you have some debt, like putting away $50 or $100 a month while you’re paying off your debt. But at the same time, you should have a plan in place for how you’re going to pay it off.
Until you get to that point, you have no business investing. It will do you little good to invest and earn 10% if you’re paying 20% or more on credit cards. The math is totally against you.
And whatever you do, don’t get caught up in the self-imposed trap of borrowing money to invest. For example, you might reason you can borrow using a home equity line of credit on your home with a 4% interest rate, and invest it in the S&P 500 at an average annual return of 8%. But it won’t work that way.
There are emotional factors attached to both investing and debt. We just discussed how the headlines can affect your emotional state. But being in debt can also create a negative state of mind. As well, it’s all too easy to borrow money to pay for other expenses, and go even deeper into debt. You’ll end up in a Catch-22 you can’t get out of.
If you have a serious debt problem, face it and fix it before you begin investing.
Seriously consider if you’re committing any of these seven deadly investing sins. And if you are, don’t panic. Each one can be remedied, insuring better investment results in the future.