By Simon Moore
At FutureAdvisor we analyze over $30 billion in investor portfolios to recommend improvements, and as a result we are able to see common mistakes that a lot of Americans are making. Below are some of the key mistakes that people make and some tips for how to correct them. Here I have picked the mistakes that I believe have the greatest impact on overall wealth creation.
At FutureAdvisor we analyze over $30 billion in investor portfolios to recommend improvements, and as a result we are able to see common mistakes that a lot of Americans are making. Below are some of the key mistakes that people make and some tips for how to correct them. Here I have picked the mistakes that I believe have the greatest impact on overall wealth creation.
#1 – Holding too much cash
Waiting to invest, or even pulling money out of the market at the wrong time is an extremely common mistake
we see many investors making. Of course, having up to 6 months of
salary on hand as an emergency or rainy fund makes sense to deal with
short term financial risk such as unemployment or unanticipated large
expenses. Yet, beyond that, cash has historically been a drag on long
term performance and holding it yields no obvious benefit.
The first problem with cash
is inflation. Because of inflation, any investment needs to rise in
value just to maintain its value. Inflation is about 2% a year in the
US, this means that every year the cost of what you buy rises 2% a year
on average. So every year your money goes 2% less far. This adds up over
time, it means in about 30 years the value of your savings, if parked
in cash, can be sliced in half. And remember, inflation right now, is a
lot lower than it has been in the past.
The second problem with cash
is that many investors like to believe that they can time the market to
some degree. The evidence for this is scant at best, research has shown
you need to be right eight times out ten
for market timing to improve your performance. However, it perhaps
wouldn’t be too much of an issue if investors then moved their money
back into the market. Unfortunately this isn’t what often happens, the
market can move up for long periods, an investor may move to cash
because of fear or valuations. The problem is that that investor then
does not move back into the market, either the buy signal that they are
hoping for doesn’t arrive or they never get over the fear that caused
them to sell in the first place. Either way the average annual return
which the markets have historically offered of 6-7% is missed by being
in cash. That’s a costly mistake.#2 – Overpaying in fees
#2 – Overpaying for investment fees
Fees determine performance to a greater degree than many realize.
This is especially evident in today’s environment of relatively low
inflation, because low inflation means returns on all assets are likely
to be lower than they have been historically, and so fees will eat a
greater proportion of your return. Often advisors can charge over
1% in fees, and that cost can really eat into your savings over time.
Over 20 years you’d have almost 20% less in savings because of these
fees.
The other important misconception about fees is that they don’t necessarily lead to better performance.
Investment fees are certain to eat into your savings, but the idea that
paying more gets you a better service as it may for other products has
not been shown to be true for financial services by many studies. So by
paying more you end up simply getting less. Vanguard offers a number of
low fee Exchange Traded Funds (ETFs) and an efficient low fee portfolio
can be constructed simply from a S&P 500 tracker (VOO), a
diversified bond fund (BND) and some diversified developed and emerging
market funds (VEA) and (VWO), respectively. That combination is fairly
simple to implement and will cost you under 0.10% in average fees per
fund.
#3 – Wasting your time on investing decisions
If you have a professional
career then the value of your income over time matters, and is obviously
something you can influence through the work you put in and, as a
result, the bonus or any pay raise you receive. You want to
maximize your effort at work so that your pay and career prospects rise
as fast as possible. That’s why you don’t train as a realtor when you
want to sell your house, or burn the midnight
oil reading legal textbooks when you want to make will. However,
investing seems easy enough so many people are tempted to try their hand
at it. Unfortunately the investment results are often sub-par, but in
addition the time spent on it can have a significant cost when that time
could have improved their career trajectory or meant more time with
friends and family.
#4 – Insufficient saving
The fact is that financial wizardry and optimal portfolios can only get you so far. America’s savings rate is too low,
and many people are in debt rather than saving. Expecting to reach your
financial goals when saving less than 5% of your income is unlikely to
cut it for most people, yet that’s what many Americans are doing. The
problem is more acute when Social Security, by its own admission,
is likely to have a long term funding gap so may not provide the
retirement contribution in a few decades that it does currently.
As a rule of thumb, saving
10-15% of your income is more likely to get you on course of financial
security if you’re under 40. This has the double benefit of not just
increasing your income, but reducing the amount of money you need to
live off.
Saving for retirement is the
classic problem of something that is very important but not urgent and
so it is often ignored. There are many things you can do to increase
your savings rate such as taking advantage of any 401(k) matching that
your employer offers or saving any pay raise or bonus, so that you don’t
have to cut back on existing expenditures.
#5 – Ignoring tax consequences
Many investors are able to
quote what percentage return a particular index did last year. The
challenge is as a tax-payer you are highly unlikely to achieve that
return due to the impact of taxes. If this were clearer to people then
the take-up of 401(k)s and IRAs as savings vehicles would be higher, as
would usage of strategies such as tax efficient asset placement and tax
loss harvesting. All of these can boost your after-tax returns
significantly, but don’t change the return you see in your brokerage
account, which is typically presented before the impact of any tax
payments.
The first step here is to
take full advantage of your 401(k) and IRA as ways to save to
retirement. Generally start off with your 401(k) up to your employer’s
matching level then use an IRA which likely has a broader selection of
low cost investment options. Then make sure that investments that have
greater cash returns are held in these tax sheltered accounts such as
REITs and bonds. Finally, consider a strategy of tax loss harvesting so
that if an investment loses money then you sell it and switch into
something similar but not identical this can help lower your tax bill
come next April.
If you’re able to avoid these
five major mistakes, then that alone should set you on a good
trajectory in managing your money, since any single one of these has the
potential to derail your performance.
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