Nearly Everyone Invests in Mutual Funds and ETFs
publication date: Sep 20, 2010
When I worked as a personal financial counselor and taught adult education courses, I marveled at how the same investing mistakes came up again and again. Most individuals learn from their mistakes and get better over time but there's no reason you can't learn from others mistakes and get down the experience curve quicker.
From getting your finances in order to selecting funds to maintaining your portfolio over time, various potholes and dangers can get in your way. Here are the most common fund investing mistakes you're likely to make and how you can sidestep them.
Lacking an Overall Plan
Just as you shouldn't build a house without an overall plan, you shouldn't invest in mutual funds and ETFs until you have a sound and comprehensive financial plan. The plan doesn't have to be a fancy, professionally or computer-generated one, but it should include the basics:
Mutual Funds For Dummies, 6th edition
Publication Date: July 2010
Failing to Examine Sales Charges and Expenses
Would you ever buy a car without considering its sticker price? How about checking out the car's safety record and insurance costs? Mutual funds are like cars in one respect - you should check under the hood before you buy. But the good news is that fund fees are actually a lot easier to understand compared to the various car costs.
Before you consider buying any mutual fund, be sure you understand precisely any sales charges as well as the fund's ongoing operating expense ratio. Over the long term, a fund's fees are one of the biggest, and most predictable, determinants of the fund's likely future returns. This point is especially true with boring old money market and conservative bond and stock funds.
Chasing Past Performance
Before anyone hires a job applicant, he likes to know that person's track record. Ditto for professional sports teams seeking new players. Of course, when hiring a money manager, which is what you're doing when you invest in a mutual fund, you should examine that manager's prior experience. However, many investors simply throw money at funds currently posting high returns without thoroughly examining a fund manager's experience.
More often than not, current hot funds cool off (especially as small funds get larger and market conditions change) and many under perform in the future. The reason is quite simple: The market forces that lead to the relatively brief period of high performance inevitably change.
Ignoring Tax Issues
Do you know your current federal and state income tax brackets? When a particular type of stock or bond fund makes a dividend or capital gains distribution, do you know what rate of tax you'll pay on that? Long-term capital gains (from investments held more than on year) and stock dividends are taxed at federal income tax rates lower than applied to ordinary income.
Many fund investors aren't well informed when it comes to the tax consequences of their fund purchases and sales. Although you don't want the tax tail to wag the fund selection dog, you should know how taxes work on your funds and which funds fit best for your tax situation.
Falling Prey to the Collection Syndrome
Some people buy mutual funds and ETFs the way they build a clothing collection. Visits to different stores and articles recommending specific items lead to purchases. Before you know it, you may own numerous funds that don't really go together well. Do you know what portion of your investments is in stocks, bonds, foreign stocks, etc.?
This is why you should develop your overall plan first and then buy funds to execute that plan. For example, after you decide that you're going to invest, say, 20 percent of your retirement plan money into international stock funds, then you can set out to identify and then invest that amount of money into your chosen foreign funds.
Trying to Time the Market's Movements
Just as no one enjoys losing a game, who wants to invest in a fund only to see it fall in value? Sometimes, though, that may happen even though you've done your homework and selected a good fund.
Stock and bond funds fluctuate in value, and you must accept that inevitability when you invest. Some people like examining pricing charts online to guess when a fund is about to turn around and increase in value. Don't waste your time on such unproductive and time-consuming endeavors. Identify good funds, buy into them over time, and don't jump in and out.
Following Prognosticators' Predictions
Don't make the mistake of believing that some supposed expert bold enough to make financial market forecasts on television, on radio, or in print actually has any proven talent to do so. Such blustery babblings are merely for the publicity of a given firm or individual. Please see the many articles on various pundits in the Guru Watch section of this site.
Your long-term goals and desire or lack thereof to accept risk and volatility in your investments should drive your fund selection. Use information, not predictions, in building a winning fund portfolio.
Being Swayed by Major News Events
You're human and have emotions. September 11, 2001, was a horrible day for Americans (and many other people around the world) that caused some people to panic and sell investments when the financial markets reopened. Similar emotions and reactions happened during the 2008 financial crisis/panic. Wars, oil price spikes, large corporate layoffs, the latest retail sales and consumer confidence reports, and Federal Reserve meetings and interest rate changes are but a few of the news reports that can move the markets.
Don't make your investing decisions based on the news (noise) of the day. The only action you should consider taking if doom and gloom are in the air is to consider using some of your spare cash and buying when a sale is going on. If you're looking to scale back your stock investments, do so during a time of confidence and economic optimism when stock prices are elevated.
Comparing Your Funds Unfairly
While teaching adult education courses and working with clients as a counselor, I've witnessed many people who were disenchanted with otherwise good funds. Often this effect was the result of their knowledge that other funds, often seeming similar on the surface, were doing better. Perceptions changed when these folks discovered that the other funds weren't holding the same types of securities and that their funds were actually doing fine compared with a relevant market index.
Don't be quick to assume that your funds aren't doing well simply because they've gone down recently or are producing lower returns than some other funds. Compare them fairly over a long enough period (years, not months or weeks) and then decide.
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