Achieving financial success is as much avoiding bad investment ideas as embracing good ones.
Do your best to side step these financial pitfalls.
1. Driving while looking in the rear view mirror.
What’s one of the top methods of choosing your 401k investments? It’s simple. You look at the different funds and you select the ones that have increased the most in the last year. That small cap fund looked great when it was up 27 percent in 2010. The problem is that once you piled your retirement savings into it, it was down 8 percent in 2011 when the broader market was flat.
In fact, your tendency should be to purchase asset classes that have gone down and sell those that have increased in value. Rebalancing every year can give you superior returns.
2. Ignoring investment costs.
Most investors don’t have a clue about investment costs, yet it’s the best predictor for future investment performance. Think of expenses as a moving walkway in the airport, except in this case you’re the little kid running down the walkway going against you. The higher your investment fees, the faster that walkway races against you in your journey to financial independence.
Investment costs for mutual funds can be easily found on morningstar.com or from the fund company itself. More insidious are the expenses and tax impact of the fund buying and selling a big portion of its portfolio each year. Look at the fund turnover ratio to keep these costs down.
3. Letting investing inertia take over.
Inertia can keep you overly static or kinetic in your investment approach. Sure signs of an ossified portfolio are having three 401k plans in place from current and former employers. Letting your investments ride for two years or more without a thought means that you are giving up one of the most valuable investment strategies: regular rebalancing.
On the other hand, hyper focus on your portfolio performance can transform you into a twitchy smartphone trader. Twitchy rarely wins the investment race.
4. Letting the tax tail wag the investment dog.
Income taxes are on the mind of most of us in April, but there are times when too much focus on taxes can drive poor investment decisions. Startups have been flourishing in Boulder County, and with them stock options.
From a tax perspective, it makes a lot of sense to exercise options and hold stock long enough to qualify for long-term capital gains. Paying 15 percent tax on your profit instead of 25 percent or worse sounds like a no brainer.
But if your startup becomes a wind-down, you could end up owing taxes on profits you never even receive. The primary issue to consider should be the wisdom of a concentrated investment in one company, rather than the tax impacts.
Many investors purchase variable annuities and cash value life insurance policies for their purported tax benefits. Unfortunately these investments often have annual expenses that exceed two percent. That can wipe out any tax benefits, which could have been oversold in the first place.
5. Equating complexity to a desirable investment.
As we build up our net worth, there’s a natural movement toward more “sophisticated” investments. This could take the form of a hedge fund, private Real Estate Investment Trusts, limited partnerships, and private equity funds. As a whole, these investments have a better track record of making money for the managers than the investors.
Many of these funds have fees of 2 percent annually plus 20 percent of investor profit. You need to hire an outstanding fund manager to overcome those fees.