Many new investors fall into a common trap created during bull markets, as a percentage of your paycheck is automatically invested into the mutual funds tied to your 401(k) plan. This automated process leads many investors to rely on the relatively easy, cheap and low-risk approach to capitalize on the long term benefits of stock ownership. But even with this easy process, it is still possible to make costly mistakes that can diminish returns and put your wider portfolio in danger. Coolchecks.net customers and anyone who wants to maximize their investments need to be aware of some common pitfalls that investors should avoid.
1 – Know the Stocks You Own
Most investors believe their 401(k) plan is well-diversified. Let’s say that we invest half of a retirement savings account in a Tech fund and the other half in a fund that is tied to the S&P 500. Without looking at the actual stocks being purchased, it can be easy to miss the fact that as much as 30% of an S&P 500 fund might include tech stocks. Then, if we look at the total exposure to tech stocks, the percentages could potentially exceed 60% for a single industry.
Needless to say, this is how how a diversified portfolio operates, and excessive exposure to a single sector leaves investors vulnerable to price swings for that industry. If this hypothetical example was seen prior to the 1999 dotcom bubble, this investor would have unnecessarily encountered substantial losses. These problems could have been avoided by simply knowing the stocks that are part of your chosen fund.
2 – Don’t Chase a Fund’s Past Performance
Another common mistake can be seen when investors get caught up in the hype of the next “hot mutual fund.” It can be very tempting to act on advice from a friend or a persuasive commercial but basing an investment decision on a fund’s past performance is usually unwise. This is because markets are cyclical in nature and so a fund investing in a profitable niche now could easily underperform later on.
There are also many examples where a fund does well under one manager and then performs poorly if that manager leaves the firm. For this reason, it is important to know if the fund strategy was the creation of a single manager or is part of a larger, institutionalized investment process that will be repeated in the future.
3 – Be Aware of Fees
Investors tend to focus on macroeconomic factors (such as the state of the labor market or the national economy as a whole), and instead ignore the fees associated with a particular mutual fund. This potentially costly mistake can have a major impact on the returns investors are able to capture over time. For example, let’s say we invest $5,000 each year in an S&P index fund over a 30-year period. During this time, the investment would total over $400,000. But if the fund’s fees came to 1.5% each year, that total investment would fall to less than $300,000. This amazing difference is the result of compounding investment.
Fees can have a particularly strong impact on bond funds, which tend to produce lower yields on an historical basis. Investors should look at the fund prospectus (to see the associated expense ratio), and read Morningstar.com to compare the funds expenses to others in a similar investment category.
4 – Don’t Forget the Effect of Taxes
In many cases, investors will buy into a fund during the later part of the year, as the fund makes net capital gains distributions to clients. But if you wait until those payouts have completed, you can avoid tax obligations before you have made any real returns on your investments.
A common mistake is seen when investors fail to track the cost basis for the fund when choosing to reinvest their dividend payouts into additional share purchases. This creates problems as investors likely make mistakes reporting larger taxable gains when selling the fund – essentially, paying taxes twice (taxes on the dividend income and on the gains made selling the fund). Other mistakes are seen in funds that aggressively manage the stock portfolio as a means for maximizing returns. Problems here occur when the fund is not held in an account that is not tax-deferred, such as a 401(k).
5 – Keep Your Investment Focus
Many investors hold onto their positions longer than they should. This is because many think that outcomes that occurred in the past will happen again in the future (see Tip 2). A smarter way to monitor fund performance is to establish a target for your holdings position that is appropriate for the expectations in that specific sector. When your target limit is reached for that fund holding, sell some (or all) of your holdings and take your profits. Targets like these can take some of the emotion out of the investment process. This is important for making rational decisions that can ultimately protect your savings.
Conclusion: Do Your Homework and Watch the Performance of Your Fund
Since mutual fund investments are widely regarded as a simple (or even automatic), it is important for investors to maintain focus, watch the changes seen in portfolio allocation and to ask questions when gains performance is not meeting your expectations. Has something changed with the fund’s strategy? Have previously successful managers left the company and are no longer guiding strategy? These are important events that could mean it is time to look for other options.
Here, we looked at 5 simple tips for new investors to follow when managing their savings investments. It is always important to read the materials that are provided by the fund, do your own research (on sites like Morningstar.com), and to consider selling your shares when unexpected changes are made within the fund. At least once each year, you should check to see that the same management team is in place and look at the changes that are being made in the underlying stock selections.