The real danger to our wealth is not inflation or risky stock markets or federal budget deficits. Instead, the simple mistakes most investors make hurt them far more than any outside market or economic forces. An investor with a diversified portfolio who is patient and waits out temporary slumps in the markets has a high chance of making his wealth grow. Then why do statistics show that the average mutual fund investor, for example, earns nowhere near the long-term returns offered by the stock market? The answer lies in the four common mistakes that haunt many investors:
- They are too fearful and don’t take appropriate risk.
- They are too greedy and take too much risk at inappropriate times.
- They are too anxious.
- They are not diversified.
The complementary traits of fear and greed have long ruled investors. Fear of short-term fluctuation causes some investors to take too little risk. They put their money into vehicles they perceive to be “low risk” because they fluctuate very little in the short term. The problem is that the market does not reward investors for avoiding risk. Such low risk investments—bank deposits, money market funds, short-term U.S. Treasuries and the like—will not grow faster than inflation. And inflation, the silent disease that eats away at an individual’s wealth, is the real long-term risk to an investor. Investors who take appropriate risks have a better chance of getting higher returns that beat inflation.
Greed, on the other hand, makes investors take inappropriate risks that jeopardize their nest eggs. Investors who are greedy chase today’s hot investments, concentrate their money in the wrong places, and trade too much. The bear market of 2000-02 taught a hard lesson to many investors who got too greedy in the late 1990s. To make things worse, investors don’t stick with one outlook. If they remained fearful or greedy they would at least prosper some of the time. Instead, they alternate, hitting the fear and greed cycles at exactly the wrong times.
One error shared by all too many investors is impatience. They regard the day-by-day, month-by-month moves of their investments and the markets as significant. Unfortunately, short-term price changes are just a lot of confusing noise that tell you very little about the future. The long-term direction for the stock market is expected to be up, so why worry about short-term fluctuations? Such a focus forces investors to become too active, buying and selling in an effort to make their portfolios “work” for them today. Such activity is almost always counterproductive.
Finally, many investors still do not have adequate diversification. They hold a few stocks, or a few growth mutual funds, or a slew of municipal bonds. They expose themselves to the particular risks of those investments and don’t benefit from the unique properties of a diversified portfolio. A well-diversified portfolio holds many assets of different types whose movements are not well correlated. Many studies have shown that such portfolios have more consistent returns over time, with less short-term price fluctuations than occur in non-diversified portfolios.
Successful investors avoid these behaviors. They use the world’s investment markets to build portfolios that they sit on for many years. These investors obtain the market’s long-term returns and have a good chance of beating inflation while taking on an acceptable measure of risk. As you review your quarterly performance reports, I hope you see that owning a diversified portfolio has helped you to earn a very good return (during the last several years) with far less risk (or volatility) than the vast majority of investors.
Now, in order to comply with the provisions of the Gramm-Leach-Bliley Act, I am enclosing a copy of KFP’s Privacy Statement for your review. The Privacy Act requires that I deliver this to every client on an annual basis. In addition, as a Registered Investment Advisor, Keystone Financial Planning is required by state regulators to offer you a copy of Part II of Form ADV. The Form ADV is KFP’s registration with the Pennsylvania Securities Commission. If you would like a copy of Form ADV Part II, you may download it by going to the “Regulatory Compliance” page on KFP’s website (www.KeystoneFP.com). Please feel free to call me if you would like a copy mailed to you.
Thank you for your trust and confidence. Please let me know what I can do to improve the quality and value of my services to you.
About Christopher Jones
Christopher Jones is the Founder and President of Sparrow Wealth Management, a fee-only financial planning and investment management firm. Before entering the investment field, Chris was a management consultant for Deloitte Monitor. He graduated summa cum laude from Brigham Young University with a B.S. in Economics and a minor in Business Management.