If you're like most investors, you'd probably rather spend your free time with family, friends, watching football, shopping or taking the kids to the park. The financial markets are complex, and there is a lot of information that can be confusing to someone who's simply trying to save for retirement, sock money away for their kid's college education and build a nest egg. Here are eight rookie investing traps to avoid while you map out your investment plan.
Don't let emotions rule your portfolio.
A common mistake do-it-yourself investors make is switching investments to cash at the wrong time and letting fear or greed rule their decisions. "This is a marathon, and you invest over multiple market cycles, not letting market dips scare you into selling at the wrong time. Create a written plan with your goals and objectives as well as your portfolio allocation. Refer back to this document if you find yourself wanting to exit the markets," says Todd Douds, director of operations at Pittsburgh-based Fort Pitt Capital Group.
Don't chase performance.
Markets move in cycles, and investors who look back at last year's big winners and jump on board might be buying near or at a top. Don't follow a fad and buy into a hot stock without doing solid research on the fundamentals. "If an asset class or security has already had large gains, that was yesterday's good idea. Don't follow the crowd because you will just be chasing performance, which is a loser's game," Douds says.
Don't trade too much.
For many long-term investors, the best strategy may be to hone in on a proper asset allocation between stocks and bonds, pick funds and hunker down for the long term. Eager beavers who switch in and out of funds too often will find commissions eating away at their nest egg. "Trading has costs to it, and the more you trade, the most cost you incur in your portfolio. Buy assets at a reasonable price and hold onto them," Douds says.
Don't forget about the fees.
Exchange-traded funds have revolutionized the cost of investing in a variety of asset classes. Rookie investors may ignore expense ratios, but over time, high fees can eat into a portfolio's overall return. Many funds are available to investors today with a 0.20 percent expense ratio ($20 annually per $10,000 invested) or less. While costs are only one factor to consider when choosing a fund, they are an important consideration.
Don't try to time the market.
Individual investors and sometimes even professionals fall into the trap of trying to time the market, or in simple terms, selling high and buying low. "It has been shown time and again that trying to outsmart the collective wisdom of the millions of smart, well-informed people who trade in the market is very hard to do consistently, no matter who you are. Disciplined rebalancing keeps you away from that market-timing trap," says Derek C. Hamilton, certified financial planner at Elser Financial Planning in Indianapolis.
Don't put all your eggs in one basket.
Proper diversification is the foundation of successful long-term investing. Spreading investments across different asset classes and into those that move in the opposite direction of stocks helps reduce risk in a portfolio. "Many investors think of diversification as simply owning more stocks, but do not realize you must also consider asset allocation as well as how your investments move in relation to one another, which is known as correlation," says T. Michelle Jones, vice president at Bryn Mawr Trust in Bryn Mawr, Pennsylvania.
Demand full transparency from your advisor.
If you use a financial advisor, it is important to understand how he or she gets paid. Some are paid from the financial products they sell, while others are "fee-based," which means they collect these payments to some extent and charge clients a fee. Then there are "fee-only" advisors, who are paid only by their clients without any product-based payments. "How much you pay is important, but so is the source. Is your advisor paid to provide objective advice to prudently manage your wealth or to sell you financial products?" Hamilton says.
Be patient and learn.
If you're looking to build a nest egg for retirement or your kid's college account, plan to have time on your side. Don't monitor your portfolio every day. Review your statements quarterly at most, says Danielle L. Schultz, certified financial planner at Haven Financial Solutions in Evanston, Illinois. "Beginners are often surprised to see how much the market can vary day by day and jump in and out, usually at just the wrong times. I recommend people learn about how to really analyze companies," she says.
More investing tips:
10 ways to invest to become a millionaire
Avoid these 8 rookie investing mistakes
Include taxes in your tally.
Withdrawing money from retirement accounts is, of course, not a free ride, so $1 million gross is not $1 million net. “If the $1 million were in a traditional 401(k) or IRA, all withdrawals would be taxable,” says Christine Pavel, vice president of wealth management at GCG Financial in Deerfield, Illinois. “You also have to consider how much the investor will withdrawal from the portfolio, and for how long.” Assuming 3 percent inflation, looking forward 30 years and accounting for retirement account taxes, “An investor would be lucky to be able to withdraw $20,000 or less from the account for 30 years,” she says.
If you're in your 20s and start investing now, you’re in luck, says Joe Jennings, wealth director for PNC Wealth Management in Baltimore. “Due to the power of compounding, the first dollar saved is the most important, as it has the most growth potential over time,” he says. As an example, Jennings compares $10,000 saved at age 25 versus age 60. “The 25-year-old has 40 years of growth potential at the average retirement age of 65, whereas $10,000 saved at age 60 only has five years of growth potential,” he says.
Consider annuities as a building block.
Annuities, which people purchase to get an expected payout once they reach maturity – usually at or after retirement age – also have a rough reputation, particularly indexed annuities. But last year’s Qualified Longevity Annuity Contract regulation by the IRS set guidelines for investors to create their own pensions. “You can invest and put money in a retirement account, and with annuity guarantees that you will never outlive your money,” says Stan “The Annuity Man” Haithcock, an annuities expert and author of the book, "The Annuity Stanifesto," based in Ponte Vedra Beach, Florida.
It may seem sexier to get in on the latest initial public offering or that new stock your Uncle Mortimer promises will take off. But that’s no way to build a nest egg through the years, says Jim Merklinghaus, founder and president of JBM Financial in Rutherford, New Jersey. “My philosophy has been a conservative approach to retirement, investing consistently over a 30-year period of time. If your principal is 100 percent safe, you have already accounted for 12 years of a normal 30-year retirement. The plan that avoids the loss of principal far exceeds the joy of temporary returns,” he says.
Diversify between companies large and small.
Risk tolerance and portfolio mix are major factors in getting to $1 million, and they’ll differ depending on the investor. But if there’s one universal that applies, ”The portfolio should be diversified among large- and small-company stocks, domestically as well as in established foreign countries and emerging markets,” says Kenneth Moraif, senior advisor at Money Matters in Plano, Texas. “The appropriate allocation in each of these asset classes will be determined by the investor’s time horizon, their current assets, age and tax bracket.”
Use that 401(k) all the way.
Since retirement is the major savings goal with most nest eggs, make sure you maximize your retirement savings, says Andy Saeger, vice president and senior financial consultant at Charles Schwab in Naperville, Illinois. “Max out your 401(k) or other employer retirement plan, especially if you receive matching contributions. If you're age 50 or older, make catch-up contributions. If you can afford to save more, you may be eligible to open and contribute to an IRA, where your money can grow tax-deferred or tax-free until retirement,” Saeger says.
Thou shalt pay thyself first.
What used to be simple, sound advice is more of a commandment when $1 million or more is the goal. “If you make the financial plan first and then build your life around it, the outcomes are typically very positive,” says Mike Chadwick, CEO of Chadwick Financial Advisors in Unionville, Connecticut. “Most people do the opposite: They set up their life and then try to save after the fact, when it’s painful to do so. When something is paid off, save the extra money and you won’t feel the pain. And when you get raises, save the money until you’re on target.”
Avoid the temptation to spend first.
Most investors, especially in their younger years, think they can easily make up for copious spending and shopping. “This is certainly possible, but will require a potentially difficult, if not impossible, return on the investment or a significant increase in savings,” says Bellaria Jimenez, managing partner with MetLife Premier Client Group, based in Cranford, New Jersey. ”Investors must ignore temptations to spend and instead save.”
Patience, patience, patience.
Just as it takes years to get to retirement age, you’ll want to stick it out, as some investments hit expected bumps. “Over a typical working career, an investor can expect to experience at least eight to 12 poor market years,” says Jakob Loescher, a financial advisor with Savant Capital Management and based in Rockford, Illinois. “During these years, it’s important that the individual remain patient and not make any large market-timing mistakes.”
And finally, answer the $2.3 million question.
That’s how much money you’d need in 2045 to have the same purchasing power as $1 million today, assuming a 3 percent annual inflation figure. So how do you get to $2.3 million? “Assuming a starting account value of $50,000 and an 8 percent return on assets, an investor would need to deposit $13,500 at the beginning of each year over the next 30 years to achieve that result,” says Andrew Gluck, managing director of wealth management at GCG Financial.