As emotional beings, humans tend to be their own worst enemy when it comes to making investment decisions. Holly Cook, managing editor for Morningstar's UK website, lists common ways in which investors slip up, and suggests how best to avoid these mistakes and maintain a good portfolio.
1. Letting anxiety rule your head
Back in 2007 you might have been feeling nervous about the stock market, with equities at all-time highs, and pondering whether it might be time to offload some holdings.
In 2008, you may have found yourself thinking that markets couldn't go much lower and it was time to plunge your money back into equities.
The chances, however, that you actually managed to accurately pick—and act on—these two turning points are very slim. Furthermore, miscalculating these points could have had a seriously detrimental impact on the value of your portfolio.
It's difficult to ignore your emotions completely but the statistics prove that stock performances over time tend to improve and come back. If you'd been fully invested in debt between 2000 and 2003, you might have been rubbing your hands with glee as you watched equities tumble amid the bursting of the tech bubble. But that same portfolio today would have substantially underperformed a mixed stocks and bond portfolio, even taking into account the stock market crash of 2008.
The key message here is threefold: taking a long-term view is important because it reduces the impact of volatility; trying to time the market leads to slip-ups; and diversification is very helpful for spreading risk.
2. Trying to time the market
As alluded to above, timing the market is a lot easier with hindsight. Accurately timing the market is pretty difficult, and many would argue it's impossible. Instead, focus on setting your investment goals, picking your investment strategy and spreading your investment risk, which will ultimately lead to steady returns -- returns that would have been substantially reduced if you'd tried to time the markets and missed, say, the best-performing month of each year. Trying to guess market movements is a risky and fraught investment style.
One particularly effective method of investing is a systematic investment plan, which is when you invest equal amounts of money on a regular basis into your portfolio. This allows you to bypass the risk of making poor investment decisions during tumultuous times. Rupee-cost averaging can help investors limit losses, while also instilling a sense of investment discipline and ensuring that they're buying equity at ever-lower prices in down markets.
3. Misunderstanding diversification
A common mistake to make is to think that because your portfolio contains 15 different funds, you're well diversified. But diversification isn't about the quantity of holdings.
Diversification means spreading your investments across assets, regions, sectors, and investment styles. But a savvy investor who had spread his money across a range of assets, sectors and regions would have achieved much smoother returns over the same time frame. But good funds combined in the wrong way can make a bad portfolio. One year's 'hot topic' can become the next year's dud. Anyone invested fully in one area takes the risk of watching their portfolio swing violently between notable gains and substantial losses.
An abundance of stocks and funds in one's portfolio makes it nearly impossible to get a good knowledgeable grasp on each holding. When you lose your focus, you lose your competitive advantage as an investor. Instead of having a competitive insight, you begin to run the risk of missing things.
4. 'Old age' means time to pull out of stocks
By all means, as your investment time frame shortens you may want to move from a more aggressive investment style to a more conservative one, perhaps shifting assets into bonds and cash and out of more volatile equities. But just because you're broaching retirement age doesn't necessarily mean it's time to focus your portfolio fully on fixed income.
There are three key points to take into consideration here:
Firstly, retirement income horizons are increasing -- if you can afford to retire early then congratulations.
Secondly, don't go by average life expectancy. In India, the average life expectancy was around 42 in 1960. It is now around 67 and 69 years for males and females, respectively.
But that is just the average. Chances are that most people reading this and who can afford decent healthcare will live for much longer. In fact, it is not unusual for individuals to live well into their 80s. So that's decades of living costs they need to have saved and invested for.
Thirdly, inflation erodes purchasing power. The value of a portfolio invested solely in fixed income will decrease over time, even at the current low rates of inflation, and increasingly so as inflation rises, as many expect it will do given the vast quantity of money injected into the system by way of the government's economic stimulus programmes.
Keeping a portion of your portfolio in other assets such as equities can help protect again inflation-erosion.
Photograph: Joseph Illingworth/Creative Commons