Last Updated Oct 18, 2011 12:52 PM EDT
Halloween is right around the corner, but it's the stock market that's giving most Americans the real fright. Rising with authority one day -- as if all our economic woes were behind us -- and then crashing with a retirement-ruining scream the next. It's the equivalent of thinking that you've just made it through the Haunted House to safety, only to find that the zombies are real and they're chasing you into the parking lot.
But just as commercial haunted houses are usually pretty safe, the market isn't dangerous unless you get so frightened or confused that you do something stupid that will come back to haunt you, says Rimmy Malhotra, co-founder of GoalMine, an investment web site.
What are the 5 most terrifying investment mistakes you can make?
Follow the crowd: It's tempting to want to jump in with the winning team, whether they won in sports or investments. But the problem with buying "winning" investments is that they rarely repeat.
In fact, investing in winners in the wake of a win is almost sure to be a losing strategy. Why? The market is supposed to price shares based on expectations of future profits and at no time are expectations higher than in the throes of a good win.
In the late 1990s, for example, the stock market had gone through an entire decade of above-average returns. Technology stocks were particularly hot, with shares of companies like Microsoft and Cisco, delivering lottery-like winnings to investors. But just as investors started crowing about their gains loudly enough to lure people onto that bandwagon, tech stocks tumbled. Both Microsoft and Cisco are now selling for considerably less than they did in 2000, leaving investors to twist in the wind.
And that's just emblematic of what's common in the market. The moment investors spot and trend and start following it, the bulk of the returns have already been had. Morningstar investments has even studied the phenomenon and found that the typical investor loses about 1.5% of their return on average annually to following the crowd.
Just 1.5%, you say? Doesn't sound like much? Maybe not in a single year, but over time, it's a fortune. Specifically, if you had invested $100,000 and earned 10% on average, you'd end up with $2.28 million in 30 years. But if you earned 1.5% less -- or 8.5% -- you would have just $1.4 million in 30 years. Call that the $880,000 lemming penalty.
Trying to time the market:
It would be awesome if investors were psychic and could jump out of investments before they dropped and buy before they rose. Alas, the few who claimed that psychic powers helped them invest appear to be charlatans, like Hermosa Beach "prophet" Sean David Morton, whose investment predictions were unfailingly wrong and who was charged with securities fraud in 2010.
In reality, most investors "time" the market by panic-selling when the market drops so low that they can no longer stand the pain (which is usually right before it will bounce back) and buy feverishly when the market is mid-way through (or completely through) an upswing.
Here's the unfortunate reality: If you miss the trend by just a day, you could miss the bulk of the investment return that year. Indeed, one famous study shows that if you miss just the 10 most profitable days in any given year, you give up about half of the market's returns.
Over-tending Your Porfolio:
It's hard to see your stocks move around every day, without being tempted to trade. After all, wouldn't it be smart to "lock in" that profit? Or cut your losses when you see that one of your stocks is in a freefall? Turns out, not so much. A marvelous study called "Boys Will Be Boys" found that the more you trade, the less you make. Active traders, in fact, earn about 2 percentage points less on average than people who simply leave their investments alone. (The study's title has to do with the fact that men, when unfettered by their wives, are more likely to trade like maniacs and lose far more of their long-term returns as a result.)
Gambling the rent money
When stocks were hot, investors would put the rent money in investments, thinking that they could double it in a matter of months, allowing them to pay the rent and buy luxury car all at the same time. When the stock market crashed, there were a lot of gambers looking for new digs. But, many of them just moved their gambling ways to the next-hot thing -- real estate. They bought houses with no equity, and banked on the idea that they would earn enough in the future to pay the mortgage, or the house would appreciate wildly, allowing them to sell at a profit if they couldn't pay. The ongoing foreclosure crisis shows just how wrong they were.
If you have an important short-term goal, the money you need to fund that goal should be in safe investments, such as federally insured bank deposits. Not stocks. Not gold. Not bonds. Just safe, boring bank accounts and money market funds where the value of your account is stable and getting access to your money is as simple as writing a check.
Being scared stiff
What shouldn't be in federally insured bank deposits, though, is your long-term money. Unfortunately, that's hard for young investors to believe. Why? Ever since today's crop of 30-somethings graduated from college, all the stock market has done is tread water. Bonds and bank deposits did better. That's got young investors convinced that the stock market is a loser's game. In reality, stocks are cheap by historic standards. Even though the market can stay irrationally cheap (or irrationally expensive) for years, those who have decades before they need their retirement money have the time to wait. Historically, stocks are the only investment that has managed to maintain and increase investor's buying power over time.
Put your emergency fund in bank accounts, but (if you're young) the bulk of your retirement fund should be in stocks. If you want the full explanation of why this is a great time for that, check out Graduates: How to Become a Millionaire.
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