Like other human endeavours, investing is a skill that needs to be learned. Part of being good at the skill is avoiding certain behaviours that can wreak havoc with your portfolio. With this in mind, let’s take a look at five common mistakes investors make.
Not having a diversified portfolio
You’ve probably heard countless times that you should have a diversified portfolio. It’s pretty much an investing cliché. But like most clichés, the wisdom of diversification is correct. Why should your investments be spread out among different asset classes and stocks? There are two primary reasons. First, it allows you to sleep at night because even if one of your investments goes sour, you won’t lose a huge chunk of your net worth in the process. Take anyone who had most of their portfolio in Nortel at the top of the tech bubble in 2000 before Nortel shares collapsed. Those people probably wish they didn’t have so many eggs in one basket. A second reason to diversify is simply that when one part of your portfolio is falling, another might be able to offset it. For example, bonds tend to do well when the stock market is plummeting.
Paying unnecessarily high fees
We talked about this issue in a previous post, and it’s worth reiterating: there really isn’t a good reason to buy mutual funds when you can buy index funds instead. With most mutual funds in Canada, you’ll pay a management fee of 2% or more on your investment every year. Index funds, on the other hand, charge more like 0.3% to 0.5% and often deliver better returns. In essence, when you buy a mutual fund you’re hoping for the portfolio manager to outperform the market. Unfortunately, very few managers are able to achieve this feat. What mutual funds, in general, tend to do is transfer a decent part of your wealth to Bay Street. That’s not a wise financial decision.
Impulsive decision making
Your money is something you’ll probably need for retirement, so there’s no reason to make rash financial decisions. With every investment choice you are faced with, give yourself the time to think it over. Whether you’re deciding which stock to buy or which GIC has best rate, you’ll be glad you did your homework and gave careful deliberation to the issue at hand. Taking your time means you’ll be able to make the most informed decision possible. And it also means that you won’t be making a decision based on emotion. So just because you read in the paper that one stock is popular among investors, don’t think you need to rush out and buy it the next day. If you catch yourself making important decisions based on fear or greed, that’s a sign you’re being impulsive about your investments.
Having too many deposits at one financial institution
It’s unlikely a major bank in Canada will fail, but for savers it’s best to be safe than sorry. In a practical context, this means spreading out your deposits so that as most of your savings are covered by CDIC insurance as possible. For instance, let’s say you have $120,000 in cash at one bank. The CDIC covers up to $100,000 per eligible account, so one option would be to put $100,000 in a GIC and then the other $20,000 in your TFSA (assuming you have the contribution room). If the bank fails, all $120,000 will be CDIC-insured. Another possibility would be to take $20,000 and place it in a savings account with another bank. Once again, all of your $120,000 would be protected by government deposit insurance.
Allocating too much to bonds and cash
Bonds and cash (GICs and high-interest savings accounts) have a role to play in a balanced portfolio, providing both interest income and capital preservation. Nonetheless, we recognize that like all investments, bonds and cash aren’t totally risk-free because there can be a problem with investing too cautiously. The risk is that inflation picks up significantly, thereby eating into your returns. Always keep in mind that when the inflation rate is higher than the interest rate you’re receiving, the purchasing power of your money is going down. In other words, you might be getting 1.5% on a GIC but if inflation is at 2.5%, you’re effectively losing money. The lesson? It’s okay to have some money in bonds and cash, but don’t go overboard.