Investing is challenging and the task has become increasingly difficult as our access to information has evolved over the last decade. Technology and innovation have helped to educate the investing public, and, while these enhancements have created a more informed investor, the abundance of news and data creates a separate set of challenges.
Whether in an office, at the gym, or traveling abroad, we can instantly obtain stock quotes, economic data, and corporate news. Daily account performance is readily available by using apps on our phones. This immediacy of information makes it more difficult to tune out the noise that can lead intelligent, disciplined individuals off the path of their long-term plans.
The goal of this article is to bring four of the most common investment mistakes to your attention and to provide suggestions to help you avoid making them.
1 | Owning Too Few Investments or Highly Correlated Investments
Too few investors appreciate the risk of limiting their investments to just a couple of stocks. A highly concentrated portfolio is more akin to speculating than investing.
Holding too few investments tends to be more common during bull markets, making this topic timely in the first quarter of a new year.
The U.S. stock market was amid one of its more impressive 5-, 10-, and 15-year stretches through the end of 2024. Volatility remained low, as the market did not experience a 10% pullback last year.[1] In addition to low volatility, the S&P 500 has reached a historic level of concentration amid the bull market, where the top ten stocks make up 39% of the index.[2] Appetite for risk has been increasing, while vehicles used to mitigate risk like bonds and cash have underperformed relative to their historical returns. More worrisome is ta lack of risk management when U.S. stocks are at valuations in the 90th percentile of their historical range.[3] Investors have become increasingly comfortable with placing bets on a handful of companies.
How can you avoid owning a concentrated portfolio?
The answer is diversification. Long term goals are achieved by owning a variety of investments that are stress-tested under numerous economic scenarios. A diversified portfolio will own a mix of growth and value stocks, bonds, foreign equities, and private investments, and will include exposure across sectors and industries. By diversifying your investments, you are likely to experience more consistent returns without extreme variability in your portfolio.
2 | Chasing Past Performance
Technology and a 24-7 news cycle have made performance-chasing extremely tempting. The best-performing investments are the ones most frequently discussed.Artificial intelligence is shaping every element of our lives, and the largest publicly traded companies in the world have an enormous amount of capital to invest in this segment of the market. Not only are the largest companies leading in spending, but the influx of capital is also allowing them to acquire smaller innovative competitors. The result: you have a handful of stocks that have led the market higher over the last couple of years, while many others have lagged. Investing in these names sounds appealing because they have rapidly growing revenues and, on the surface, appear well-positioned to continue to thrive. What could go wrong?
While the group of stocks referenced (commonly known as the “magnificent seven”) have been successful recent performers, investors may forget that an equally weighted basket of those stocks lost more than 40% in 2022 when the S&P 500 was down only 18%. The magnificent seven stocks were among the most expensive (as measured by traditional valuation metrics), and when the market sold off, the high growth companies sold off 2.4 times more than the S&P 500.
The hard crash of expensive, high-growth companies is a dynamic we have repeatedly observed throughout history:
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- When the tech-heavy NASDAQ index crashed in March of 2000, it took 15 years for the index to return to its prior peak.
- The NASDAQ took six years to recover from the financial crisis of 2007.
We are not sharing this data to discourage you from investing in rapidly growing companies. You should absolutely invest in growth and innovation. The goal is to discourage you from over investing in these companies.
What can you do to avoid performance chasing?
Limit your exposure to high-growth or momentum-based securities to a portion of your portfolio. Remember that investing is not always exciting, and the best strategies involve a combination of slow, steady, and even boring, mixed with higher risk and volatility.
Complementing high-growth investment strategies with a value-based approach can offer a more predictable set of returns. Exchange-traded funds in the value investing category typically focus on fundamentals, reasonable pricing, cash flow, and other metrics which provide a complementary approach. Bonds and money markets offer predictable cash flow with less volatility and may also be suitable complements, depending on your investment objectives.
3 | Emotional Investing
There is no substitute for understanding your loss threshold, which is easier said than implemented. Your tolerance for losses is likely to decrease as you age and as your assets grow. A 10% loss may not bother when you have $100,000 invested. You may feel differently about the same selloff when you have $2 million invested and experience a $200,000 decline. For these reasons, it is important to assess your risk tolerance every few years.
Investing comes with risk, which is why a diversified mix of stocks offers greater upside compared to a savings account or a CD. History tells us we will be rewarded for taking that risk if we demonstrate patience in our approach.
If you find yourself becoming uneasy at the thought of losing money, this is a perfectly normal reaction. Numerous books have been written on neuroeconomics, and we encourage you to read further on the subject. As human beings, experiencing loss of money generates a stronger emotional reaction than the satisfaction of making money. Our brains are wired to work against us when it comes to making sound investment decisions. The financial media does not help because they have a conflict of interest when it comes to providing sound financial advice. Their job is to maximize ratings, rather than serve as an ally during periods of turbulence in the financial markets.
How to avoid investing emotionally?
Understand your risk tolerance prior to investing and avoid deviating from it. Implementing a rules-based approach to investing, which includes rebalancing and maintaining a limited amount of stock exposure, can help you stay the course when times are challenging. Resisting the urge to check your accounts weekly can help you remove yourself from the highs and lows associated with investing. When conditions are particularly negative, you may want to limit exposure to the financial news. Remember the markets are looking forward a year or longer. The news you hear is typically immediately priced into financial markets. If you change your investment approach based on what you read, the odds are you are reacting too late.
4 | Ignoring Taxes
Taxes are a part of investing, but investors often overlook their impact. Anyone with a non-retirement brokerage account should be thinking about taxes when they invest.
Investment income may be subject to both federal and state tax. Married couples filing jointly with MAGI [i] above $250,000 ($200,000 for single filers) are also subject to the 3.8% net Investment Income Tax.
If you live in a high tax state, you could easily pay 50% tax on certain investment income. Capital gains, qualified dividends, and interest income can all be taxed at different rates, adding further complexity to tax management.
You may not be able to eliminate investment tax, however with an understanding of tax laws, you can drastically reduce what you pay.
How can you minimize investment tax?
While we have written a full chapter in our books on this topic, we have included four key points here:
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- Own municipal bonds in non-retirement accounts. Municipal bond interest is exempt from federal tax and may also be exempt from state and local tax if the issuer is from your state of residence.
- Purchase tax-efficient funds. Mutual funds are required to distribute realized capital gains to investors, meaning you could have a tax bill without selling the fund. ETFs have a different structure which is more tax advantageous for investors owning brokerage accounts.
- Understand the difference between long-term and short-term capital gains. Long-term capital gains rates are lower than short-term rates (taxed as ordinary income). Holding your investment for at least 12 months will reduce your tax liability when selling securities.
- Leverage account registration to implement asset location strategies. If you have retirement accounts, you can own vehicles taxed as interest (such as corporate bonds or high-yield bonds) in IRAs, and 401(k)s. Dividend-paying stocks could also be owned in retirement accounts, preventing you from paying tax on the income as it accrues. Holding growth stocks in your brokerage account may help to defer tax until selling the position.
Conclusion
Investing is a tremendous tool for growing wealth. Avoiding common mistakes that can negatively impact your net returns will only enhance your odds of financial success. Diversification, focusing on long-term goals, managing emotions, and being mindful of taxes are all key strategies for building a resilient investment portfolio. Adopting a disciplined, thoughtful approach will allow you to improve your chances of achieving your financial goals and securing a prosperous future.
[1] https://www.schwab.com/learn/story/it-was-very-good-year
[2] Ned Davis Research as of 12/31/2024
[3] State Street Global Advisors as of 12/31/2024 as measured by PE, NTM PE, Price to book, and Price/Sales
[i] Modified Adjusted Gross Income