Inexperienced investors make all sorts of mistakes. Some of these are too complex to address in a short article Ė after all, market pros spend years learning the ins and outs of the financial markets. But a few of the more expensive mistakes, it turns out, are pretty easy to tweak with a little effort and attention to detail. These three fixes will pay high dividends and help make your portfolio, well, much less terrible.
Youíve no doubt heard about the wonders of diversification, perhaps accompanied by the saying ďdonít put all your eggs in one basket.Ē That doesnít mean you really paid it any heed, though Ė chances are that your stock portfolio is weighted towards just a couple thing. I know, I know Ė life comes in and these types of things get away from us.
Most folks have their assets tied up in two things Ė American stocks and real estate Ė a fact which makes the devastation of the 2008 recession way less surprising. If you have a home, youíre probably locked in to being overinvested in real estate. But you can fix the stock stuff.
Letís start at the most basic: donít put all your money in one, two or three stocks. As a general rule of thumb, you should put no more than 10% of your portfolio in a single company; 5% is an even better number.
Next up, donít invest all your money in a single corporate sector Ė i.e. finance, biotech or technology. Think back to 2000, where everyone had their portfolios locked up in high-flying tech stocks. Disaster Ė and the same thing happened in 2008, except with the banks.
And finally, donít invest in the company that you work in. This may come as a surprise, or evena contradiction to things youíve read elsewhere; after all, who else knows your company better than you?
Well, you probably donít know all that much Ė unless you happen to be an executive Ė and, more to the point, investing in your place of work is doubling down. Youíre already investing your human capital by trekking over there every day. No need to invest your savings as well. What happens if your company starts struggling? Their stock price will take a big hit right when you get laid off.
A LITTLE MORE ADVANCED
The best kind of diversification is that which steps beyond traditional US stocks and takes a look at all the other assets available for you to invest in. No, this doesnít mean you have to buy some of the weird stuff created by Wall Streetís financial alchemists. But, if you can manage it, you should mix in some bonds, foreign stocks and commodities in your portfolio Ė hell, maybe even some foreign currencies.
This might be easier than splitting your portfolio amongst 10 Ė 20 different stocks. Instead, you can use 4 to 5 ETFs to invest in these asset classes and achieve diversification. For example, the SPY ETF tracks the S&P 500 index, which means youíre really invested in a basket of 500 stocks, without all the trouble of purchasing them all yourself. Throw in a couple more ETFs from other asset classes Ė like the EFA for foreign stocks and the IYR for real estate Ė and youíre invested in hundreds of different things. Instant diversification, minus the part where you have to micromanage your portfolio. With ETFs, you can achieve phenomenal diversification with a 10 Ė 25% split.
LACK OF EXIT STRATEGY
Everyone is too concerned about entering a stock at the best price. As it turns out, the entry isnít as important as a solid exit strategy. One professional investor found that he could randomize his entries and still make a profit if he had an airtight exit methodology.
This seems counterintuitive, and itís probably a product of our consumer culture. We like to buy things, but most purchases donít require us to think about the endgame. Stocks do, however Ėyou should always know where you want to exit a position before you make your entrance. Set a stop loss order the instant you enter a position. This is to save you from your own bad decision making.
If you buy a stock at $50, you might say that youíll cut out at $47 Ė but when that time comes, everyone make a host of excuses to stay in. Our desire to be right trumps our desires to make money. Iím sure that youíve said Iíll sell once it comes back to even or something quite similar.
The rub: this almost never happens. Instead, you lose more and more money. Folks invested in Enron didnít lose all their money because the company was a dog Ė history is lined with the corpses of terrible, fraudulent firms. No, they lost everything because they held all the way down, even when it was clear that the enterprise was burning straight to the ground.
Always set an exit price before you buy. Itíll save you from yourself.
LACK OF SPECIFIC GOALS
People seem to invest without paying heed to their destination. The market can transport you a wide variety of places, but itís necessary to input your coordinates before you embark on your investing journeys.
This end point will be a product of your own desires and dreams. One-size fits all prescriptions are the norm here, but I cannot offer such panaceas and checklists. Only you know yourself and what you wish to achieve.
If you want a solid nest egg, you donít want to be chasing returns. You should be focused on steady growth with low drawdowns and volatility. Donít get all fussy about manias and sky-is-falling media reports Ė these do not apply to you. Alas, most people see huge returns and start to chase after them, get greedy. And this is how retirement accounts get destroyed; folks follow the whims of others, rather than their own needs.
If youíre a speculator, you need to be checking the marketís pulse pretty often. You need to stomach larger losses and volatility. You may be buying all sorts of crazy stuff. Donít freak out when your account bleeds red; this is the price of big returns. They require larger risks.
These are but two paths you can carve through the markets. There are millions more Ė map out where you wish to go, then invest in a fashion consistent with your goals.
But set the goals first and figure out how to do it after.
The best investors all have the same attitude. It isnít a rah-rah, happy-go-lucky one, or a fervent, unflappable passion for the markets. No, itís the steadfast belief that they are the arbiter of their own destinies. The losses, the gains and everything in between are theirs Ė and theirs alone.
Itís popular these days to blame Wall Street for Americaís problems and excesses. The onus of the crash has been placed at the feet of greedy bankers. Rather convenient, given that the market is made of millions of participants, very few of whom are pros.
Everyone got greedy. This is what humans do and will continue to do. We will do this because itís easier to slough off our shameful deeds on scapegoats in expensive suits. And history is destined to repeat itself, because no one learns.
That doesnít mean you canít change, though. Your portfolio is your domain. You call the shots, you make the decisions and you bear the responsibility for the outcome Ė good or bad.
Tough to accept? Sure. But the road to ruin is paved with indecision, complaints and excuses. And that is one experience I never wish to encounter again.
It falls upon you to decide if you feel the same way.