Becoming a successful investor isn't just about doing the right things. Often, it's about not doing the wrong things.
Based on my own experience and conversations with other investors, I've come to believe that there are only a few simple rules you need to follow to achieve financial freedom: Spend less than you earn; buy and hold good dividend-growing companies or exchange-traded funds (ETFs); stay diversified; keep your eye on the long term.
But there are countless ways to screw up.
Today we'll look at seven of the most common mistakes that newbie investors – and even some veterans – make. Full disclosure: I have committed some of these sins myself. See how many apply to you.
1. You have the patience of a two-year-old
There's a big difference between a trader and an investor. A trader buys a stock with the expectations of selling it for a profit a few days, weeks or months later. An investor behaves like an owner of the business, and is happy to hold a stock for years while being rewarded with rising profits and dividends.
If you find it hard to resist buying and selling stocks based on the latest headlines, one solution is to use a passive indexing approach. There's less emotion – and less work – involved in monitoring a portfolio of index funds than individual stocks.
2. You try to time the market
A friend of mine was convinced that he could sense when the market was nearing a peak or reaching a bottom, and would time his index fund trades accordingly. It worked like a charm – until it didn't. If you think you can time the market, you have to ask yourself what special powers you have that millions of other investors don't. Having a balanced portfolio of stocks and fixed-income to suit your age and risk tolerance, and forgetting about trying to outsmart the market, is a superior strategy in my books.
3. You're a sucker for stories
People are naturally greedy, which makes them vulnerable to stocks with a compelling "story." The narrative usually involves a new invention or technology that will revolutionize an industry, resulting in massive profits and a soaring stock price. Sure, it happens. But more often than not, the story takes an unexpected turn and investors get burned. That's why you should be wary of any stock with a get-rich-quick story line, lest you suffer an unhappy ending.
4. You ignore fees and expenses
Paying 2.5 per cent annually in mutual fund expenses may not seem like much, but over many years it adds up to some serious coin. Example: Assuming an annual stock market return of 8 per cent, or 5.5 per cent after deducting fees, $100,000 would grow to $291,775 after 20 years. By cutting fees to 0.5 per cent – easy to do with ETFs – that same $100,000 would grow to $424,785. Ignoring expenses can be costly indeed.
5. You put your head in the sand
I'm shocked at the number of people who blindly follow their broker's recommendations. News flash: Brokers often push investments that enrich them and their firms at your expense – new issues, principal-protected notes or stocks they need to clear out of their inventory, for example. Unscrupulous advisers also encourage clients to trade, even when doing nothing would be the preferable option. Not all advisers are bad, of course. Some have their clients' best interest at heart. But being an informed investor is your best defence against being manipulated.
6. You reach for yield
Repeat after me: The stock with the highest dividend yield isn't always the best investment. Yellow Media ought to have made that perfectly clear. Yield should be just one consideration when buying a stock, and if it's too high, it could be a red flag. A safer strategy is to choose a moderate yield – say in the 3- to 5-per-cent range – from a company with a long track record of rising revenue, profit and dividends.
7. You lack a strategy
Some people prefer indexing. Others focus on dividends. More advanced investors may look for undervalued securities. Following a strategy – or combination of strategies – helps to instill discipline. If you lack a coherent plan, you'll be more prone to making decisions based on emotion. You'll also be less able to ride out market downturns without getting rattled. Writing an investment policy statement that sets out your investing goals and style is one way to impose some discipline on your decisions.