When it comes to managing your investments, there can be a lot of factors to consider. However, you don’t need a doctorate in economics to avoid making some of the most costly mistakes. By keeping a well-rounded approach to managing your finances, it’s likely you may find more success in meeting your goals.
After all, does it really matter whether you beat the Standard & Poor’s 500 index if you reach your personal financial objectives? In no particular order, here are the five most common risks facing investors today.
[See: 10 Skills the Best Investors Have.]
Keeping too much cash. Having an emergency fund of three to six months of your fixed non-discretionary expenses is a very good thing. Having 24-plus months of expenses on hand in cash reserves is typically not. For the majority of people, three to six months of fixed non-discretionary expenses will suffice as adequate emergency reserves.
The biggest risk in keeping too much cash on hand is the opportunity cost. Even in periods of high interest rates, the real return on cash after taxes and inflation is negative. Over the long run, only the equity markets have the potential to earn returns that outpace inflation.
According to J.P. Morgan, a $10,000 investment in the S&P 500 in 1996 would result in an annualized return of 8.18 percent by 2015, or $48,230. Investors who may have stayed in cash for a small amount of time and missed only the 10 best days for the stock market would have seen their annualized return sink to 4.49 percent over the same period, or $24,070. Missing the best 20 days yielded a 2.05 percent annualized return and missing the best 30 days produced a negative annualized return of minus 0.05 percent.
Although past performance does not indicate future results, historical data can show how a short-term approach to investing can have a big impact on the long-term outcome. Investors who stayed in cash during this period would not only see no benefit from market growth, but they would actually have a negative real return, due to inflation.
Investing too heavily in employer stock. There are a number of ways investors fail to diversify their assets, and holding too much employer stock is a very common example. There are a few ways investors wind up in a concentrated company-stock position: equity-based compensation (stock options, RSUs) are not liquidated and reinvested in other assets, employer stock is held in a retirement plan, and over-participation in an employee stock purchase plan. Across all the types of ownership, it is suggested that no more than 10 percent of your net worth is invested in company stock.
Holding single stocks is risky in general, but when that stock is your employer, the company you already rely on to pay your salary and benefits, the proposition becomes even riskier. Scandals, regulatory changes, and even merger-and-acquisition activity can have a profound impact on stock prices and erase much of your net worth if you’re not properly diversified.
[See: 7 Stocks That Could Save Your Portfolio.]
Locking up a large portion of net worth in real estate. In the same spirit as the previous risk, when individuals lock up a large part of their cash in illiquid real estate investments, it can cause a number of other financial risks. It may prevent you from having excess cash to diversify in other asset classes and perhaps more importantly, even though the real estate market is strong now, events like the collapse of 2008 can happen again. In fact, the new administration is already beginning to discuss rolling back certain lending regulations that were put in place following the events in 2008 in order to prevent such a crisis happening again.
The illiquidity of the real estate market can significantly reduce the flexibility you might need for your finances. Even in the best of markets, it takes potentially months to sell a property. And if you just need a small amount of available funds, it’s not like you can just sell off one bedroom to raise cash, unlike being able to sell a portion of your brokerage account. Having adequate liquid assets outside of real estate is an important component of your wealth strategy.
As interest rates slowly begin to rise, buyers are becoming increasingly nervous in the face of the sustained sellers’ market in many cities across the country. Buyers should try and remain patient — it seems unlikely that the growth some areas have experienced can persist in the years to come. Putting all available funds into a home purchase is risky and may leave you house poor and out of the stock market for a while.
Trying to time the market. The market will rise, the market will fall; trying to execute a trade at the absolute best time is nearly impossible. In the previously mentioned guide from J.P. Morgan, between 1996 and 2015 six of the best 10 days in the market occurred within 14 days of the 10 worst days.
In another words: things change quickly and markets can be volatile.
Investors are better off focusing on investing over the long-term. The concept of “buy low and sell high” is palatable to many investors, but when panic-stricken headlines appear and people see the impact to their own portfolio, it can be much more difficult to remain unemotional and search for value.
Letting taxes drive the strategy. Now is the perfect time to explain why it is not a good idea to let potential tax savings drive a financial plan or investment strategy. As Washington begins drafting plans to potentially overhaul the current tax code, it appears everything is on the table.
In addition to the proposed changes to tax rates, deductions may change across the board, including mortgage interest, personal exemptions, charitable contributions, and even a possible repeal of the federal estate tax. While some of these elements may include an adjustment period or even grandfathering, generally any tax strategy isn’t complete in a one-time event, but part of an ongoing plan to reduce or defer taxable income until the benefits are expected to be meaningful.
Tax implications are always an important consideration of any financial plan or investment strategy, but don’t let the tail wag the dog. Projections of tax implications are based on the assumption that current regulations will persist. Should those assumptions change significantly, those who executed a strategy that was solely focused on potential tax benefits may have taken quite a risk if there was an opportunity cost in doing so.
For example, using a Roth IRA can be an effective way for certain individuals to diversify assets and manage taxes in retirement; however, if the tax code were to change significantly, this may no longer be the case. The opportunity cost of investments held in a Roth IRA is the compounding on tax-deferred growth. This can be a significant amount in larger accounts. On the other hand, setting up and structuring trusts to manage estate taxes may not have such a large potential opportunity cost; but there are of course attorney fees and other expenses.
Keeping a well-rounded, diversified approach to managing your finances may not be the most exciting topic. You may never “win big” on that stock you picked way back. But there’s also a much better chance you won’t be as affected by a market correction or downturn if you don’t have too many eggs in one basket.
[See: 7 of the Best Cheap Stocks to Buy Under $10.]
Keep yourself focused on your goals and why you’re investing in the first place — maybe it’s an early retirement, a vacation home, or college for the kids; all require a prudent strategy over the long term.
Disclosure: Illustrative examples are not intended to reflect the future performance of any investment. Sources are the 2016 “J.P. Morgan Guide to Retirement” and J.P. Morgan Asset Management analysis using data from Morningstar Direct. Twenty-year annualized returns are based on the S&P 500 Total Return index, an unmanaged, capitalization-weighted index that measures the performance of 500 large-cap domestic stocks representing all major industries. Past performance is not indicative of future results. An individual cannot invest directly in an index. Data as of Dec. 31, 2015.
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5 of the Biggest Risks Facing Investors originally appeared on usnews.com
