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Money mistakes to avoid

9 lessons to take away from the market's ups and downs.

Consumer Reports Money Advisor: August 2010

The memory of 2008's breathtaking market collapse isn't likely to fade anytime soon. But even that painful memory may not prevent people from pouring money into the next investment bubble. So, lest we forget, here are some common investor mistakes, pre- and post-meltdown, and how to avoid them the next time around.

 

1. Following the herd

This emotional approach to investing often results in buying high and selling low, the opposite of what most of us want to do. For example, investors poured money into mutual funds at the height of the market before the technology bubble burst in 2000. Some of this activity is fueled by "portfolio envy," where everyone around you seems to be making money, so you climb in as well.

But whether the Standard & Poor's 500 is up a certain amount or your neighbor is making a killing shouldn't matter to you. Your strategy should be based on your individual goals, time horizon, and risk tolerance, not those of your neighbor. If you follow the herd into an investment you run a good shot at buying near the top. Similarly, the greatest volume of selling is generally near market bottoms, when the news headlines are the most dire and a turnaround seems most improbable.

Last year people poured money back into stocks as the market climbed. But then debt problems in Greece created worries of a double-dip recession. People sold their stocks and ran for cover, which added to the market's volatility last spring.

What to do instead

Put your investments on autopilot. Set up an appropriate asset allocation and make regular investments at set intervals, regardless of what the market is doing or pundits are prognosticating.

If you're still some years away from leaving the workplace, consider target-date funds, which shift their mix of investments automatically based on your anticipated date of retirement. They were criticized for their inability to protect investors from losses in 2008, but the funds performed well for people who stuck with them over the last two years.

In fact, target-date funds helped investors beat the S&P 500 by a full 6 percentage points in 2009, according to a study by the investment research firm Dalbar. This is because the funds "positively influence investor behavior," the study says. "Convinced that professionals are at work making prudent decisions instead of blindly pursuing a failed strategy, investors are less inclined to withdraw their money after a market downturn."

 

2. Running for safety

In the aftermath of the 2008 market meltdown, many investors realized that they had too much invested in stocks and too little in bonds and cash. Some reacted by liquidating what was left of their stocks and pouring money into Treasury bonds as a safe haven. Unfortunately, that, too, could turn out to be a mistake. Should interest rates rise or the U.S. fiscal situation deteriorate, being locked into Treasuries, particularly long-term ones, or just having too large a bond position could mean trailing inflation. If you bought your bonds through a mutual fund, you could actually lose money.

What to do instead

Playing it safe might make sense if you don't have a long time horizon and can't wait for the market to recover. But if you're younger you should continue to hold stocks. If you're a bond investor, stick to shorter-term issues until the interest-rate picture becomes clearer. Treasury Inflation Protected Securities, which are Treasuries that rise with inflation, would be a smarter play at this time than 30-year Treasury bonds.

 

3. Making unrealistic return projections

People often make assumptions about how much they'll have for retirement based on the 9 to 10 percent annual returns in the S&P 500. Yet those returns may have been based on an unusually good era for stocks, and it doesn't account for inflation or management costs. Long stretches when the market goes nowhere are common.

What to do instead

Keep investing in your retirement account, but adjust your expectations in light of recent events. Many experts predict the next decade will be one of muted growth given the debt problems here and in Europe. PIMCO, the largest bond manager in the world, estimates about a 4 to 6 percent annual return in the years ahead for a diversified portfolio of stocks and bonds. GMO, which manages $106 billion in assets and has been accurate in projecting market returns in the past, expects a portfolio of 60 percent stocks and 40 percent bonds to return under 4.5 percent annually over the next seven years.

 

4. Overpaying for past performance

If you buy a fund because its manager delivered big returns in the past, you could end up paying management fees for old returns that he or she might not be able to duplicate. For example, CGM Focus was one of the best performing funds of the past decade, with an almost 18 percent average annual return through July 31, 2009. But Morningstar's "Investor Return," which measures the performance that people actually achieve in a fund based on the timing of their purchases, shows that investors lost nearly 17 percent annually during that period. That's because many bought into the fund at the end of 2007, right after a run-up and just before the market implosion. The volatility, 1.23 percent expense ratio, and 464 percent turnover rate of CGM Focus illustrate why many investors are often better off in index funds, which have lower costs and lower turnover than managed funds.

What to do instead

Christine Benz, director of personal finance at Morningstar, recommends holding a mix of index funds and low-cost managed funds. Index funds are the cheapest way for individual investors to build a diversified portfolio and get what's basically a market rate of return. Managed funds can fill in niche areas of the market, such as real estate or high-yield bonds, where a conservative manager can avoid some of the scarier investments that might be included in an index fund devoted to that sector. Companies like T. Rowe Price and Vanguard offer cheap, conservatively managed funds.

 

5. Not focusing on when you'll need your money

The average holding period for mutual funds is still less than five years, according to Dalbar's 2010 survey, indicating that people move in and out too quickly.

What to do instead

Don't put money you'll need within the next five years in the stock market. Think about what might pop up during that time—car purchases, home renovations, college tuition—and keep money to cover those expenses in a high-yield online bank savings account.

 

6. Putting too much faith in your broker

If you have a stockbroker, it may be nice to feel that you can trust him or her to look out for your interests. But your broker's interests are not necessarily aligned with yours, since the more trading you do, the more money he or she makes. Some have been known to push their clients to invest in higher-priced products from which they collect a higher commission.

What to do instead

If you have the time and the inclination, it's often best to do your own research into whatever investments you buy. If that's not possible, look for a fee-only financial planner. Go to napfa.org, the website of the National Association of Personal Financial Advisors, for names of members near you.

 

7. Counting on your home as an investment

It may be your biggest asset, but you shouldn't expect to make much money from your home. Historically, real estate has returned only about half a percent a year after taking inflation into account. Even during the housing boom of 1977 to 2004, prices for residential real estate increased by only about 7 percent annually after inflation.

What to do instead

Don't base any assumptions of your ability to retire on how much your home might appreciate. As home prices climbed over the past decade, many buyers overreached to take on more house than they could afford, assuming that they'd make more profit when the property was sold. The plunge in housing values has left many with unaffordable mortgages and homes that can't be sold.

 

8. Not harvesting losses (or taking gains)

"Stay the course" is the mantra of many investment advisers, and we generally agree. But there are times when it makes sense to sell. For example, selling losing stocks can help you cut your taxes during that year and reduce any fear that you could lose everything in a downturn.

What to do instead

Evaluate whether you'd benefit from taking losses. You can offset any gains and up to $3,000 in ordinary income with losses; any additional losses can be carried forward into the next year. On the flip side, selling at least some stocks when you're ahead can lock in your gains and limit future losses.

There are no tax consequences in taking gains or losses in your 401(k) or IRA. Review those holdings periodically and consider rebalancing if your asset allocation is out of whack. That involves selling the asset classes that are overweighted and buying those that are underrepresented. (Or you can shift your contributions to rebalance over time.) Check your allocation once a year or after major moves in the market. Hewitt Associates, a human resources consulting firm, reports that after the market tanked in 2008, many people were overweighted in bonds in their 401(k)s. Those who didn't bring their stock positions back to the desired level missed out on some of the upside when stocks rallied.

 

9. Being overconfident

Some investors tend to ascribe their gains to their own abilities rather than the whims of the market. And they tend to think that they're smarter than the average investor on the other side of that trade. That may be the case, but you're not competing with the average investor—you're up against investment pros.

What to do instead

Don't let your confidence lead you to trading more often than you should. Again, dollar cost averaging into mutual funds within an IRA or 401(k) gives you psychological distance from the market's gyrations.

This article appeared in Consumer Reports Money Adviser.

   

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