Six ways to avoid expensive investment mistakes

(MoneyWatch) As noted in my new book "Think, Act, and Invest Like Warren Buffett," Warren Buffett discussed the following seeming anomaly in his 2004 letter to Berkshire Hathaway's shareholders: "Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous."

My own experiences over the past 18 years confirm Buffett's views. I have seen many family fortunes lost because of the failure to follow some simple, basic rules of prudent investing. And I've also seen far too many retirement plans fail and hard-earned savings lost because of the same type of mistakes. In his letter to shareholders, Buffett went on to list three primary causes for the unfortunate outcomes: high costs, portfolio decisions made on tips and fads, and efforts to time the market.

What's particularly sad is that a large majority of investment mistakes could be avoided if investors followed a few very basic principles. If you're not adhering to them, you too may be your own worst enemy.

  • Have a written plan that's tailored to your unique ability, willingness and need to take risk. Having a written plan will help to minimize the risks created by behavioral mistakes.
  • While you can't control returns, you can control costs and tax efficiency. Thus, invest only in low-cost and tax-efficient vehicles. The odds of achieving your financial goals will be increased if you avoid expensive products like hedge funds and private equity, high-cost actively managed vehicles of all kinds, and variable annuities with high costs and surrender fees.
  • Avoid concentrating risks. Broad global diversification across multiple asset classes is the only truly free lunch in investing -- so you might as well eat a lot of it. That means not only avoiding concentrating risk in single companies (especially the stock of your employer), but also concentrating in sectors and countries.
  • Understand that risk and expected return are related. If a Wall Street firm or an advisor is trying to sell you a product with a high yield or promises a high return, know with certainty that the security entails a high degree of risk, even if you can't see it.
  • Make sure that any investment advice you receive is truly independent, given solely with your best interests at heart. Avoid working with any advisor who won't provide you with what's called a fiduciary standard of care -- the highest standard of care under the law. I don't know why anyone would even consider working with an advisor who isn't required to give advice that is in their best interests, yet tens of millions of investor do just that.
  • Insist on total transparency, audited financial statements and the separating of advisers and money managers from custodians and accountants who verify transactions and holdings. Following these basic principles would have protected those who made the mistake of investing in Ponzi schemes such as the one perpetrated by Bernie Madoff.

While following these six rules won't protect you from the types of losses experienced in the financial crisis of 2008, they'll help you avoid many of the most grievous mistakes investors make, including some that are impossible to recover from.

Here's an analogy I like to use: If you drop an egg and a tennis ball off the table, the egg will shatter, while the tennis ball will bounce back. Investors who made the mistake of investing in complex, opaque investments with Madoff, or who put all their eggs in one basket such as once roaring companies such as Enron, Bear Stearns or Lehman Brothers, have seen their portfolios shattered like the dropped egg. Once shattered there's no recovering.

On the other hand, those investors who suffer losses in their low-cost, passively managed, well-diversified mutual funds and ETFs at least have the opportunity to see their asset values bounce back, like that tennis ball. And history suggests that if they have the discipline to stay the course the odds greatly favor their being rewarded for their patience.

Image courtesy of Flickr user 401(K) 2013

  • Larry Swedroe On Twitter»

    Larry Swedroe is a principal and director of research for the BAM Alliance. He has authored or co-authored 12 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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