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5 Ways Most Investors Are Just Plain Wrong

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A fool thinks himself to be wise, but a wise man knows himself to be a fool.” From “As You Like It,” by William Shakespeare

Perhaps MarketWatch readers are exceptions, but I’ve come to believe that most investors are just flat wrong. Their errors, which could be easily avoided or corrected, seriously hurt them and their families.

Here are five examples:

1. Blindly following pundits

Investors pay attention to financial news and commentary (OK so far) and then make decisions and take action based on what they read, hear and see. Wrong!

Even when things are rosy, disaster always seems to be lurking in the shadows and ready to pounce. (If you want to build an audience, you’ll have a hard time finding a much better formula than that.)

Every week people send me thoughtful analysis from various experts, gurus, analysts and other commentators who appear to be very smart and invariably suggest important portfolio changes. Often the suggestions are portrayed as urgent.

The analysis and advice always seem to make sense, at least on the surface. But investors who act on that advice are much more likely to hurt themselves than to help themselves.

When I hear doomsday gurus and (sometimes on the same day) read lists written by other gurus of reasons that the stock market is inevitably headed to 30,000, my attitude is something like “I don’t know about that, and I really don’t care.”

Fear and greed may be good for the pundits and brokers, but they have a devastating cumulative effect on individuals’ investment decisions. A recent DALBAR study found that in the 20 calendar years ending in December 2012, the Standard & Poor’s 500 Index SPX -1.13%  had a 7.8% compound rate of return. In that same period, the average investor in U.S. equity mutual funds earned just 3.5%.

Most of that lost performance resulted from ill-advised buy and sell decisions.

My best advice: Once you have a good long-term strategy, turn off the television, throw away the marketing mailers and focus on living your life.

2 . Focusing on recent performance

Investors think a few months or a few years of performance is very meaningful and is a good basis for decisions. Wrong!

I am always surprised when advisers and experts teach that performance over one year, three years or five years is enough to be statistically meaningful. Even a 10-year track record doesn’t prove anything.

Nevertheless, recent performance beguiles investors and sells securities – generating trades (and big profits) for Wall Street.

Investors often brag to me about specific funds they own that have done better than the market. When I ask how long they have owned these funds, often it turns out they are relatively recent acquisitions.

Here’s a true story. An investor once asked me to put a certain sector fund into his portfolio, as it had doubled in value in the past 12 months. I told him half a dozen reasons that this was a bad idea, but he didn’t seem to care.

I asked him point-blank: “Why do you want to own this fund?” His answer: “So I can tell my friends I own a fund that doubled in the last year.”

My best advice: Learn the difference between what is possible (almost anything) and what is probable or likely. You can’t know what’s really likely until you have 30 to 80 years of performance data.

3. Thinking mutual funds are risk free

Investors think that if they own mutual funds, they’re protected against the biggest risks they face. Wrong!

It’s true that any fund manager can protect you against the risk that one or two stocks will destroy your portfolio. But that’s not the real danger. The real danger — and you aren’t immune even if you own 1,000 stocks in a fund — is that the whole market could take a nose dive. This is known as market risk.

Naive investors often believe a fund manager is an all-knowing, benevolent person who will get shareholders out of the market when that’s a good idea.

If those investors took the trouble to read the fund’s prospectus, they would know the fund’s job is to keep its shareholders invested in some specified type of stocks regardless of the ups and downs of the market.

My best advice: Rely on the appropriate amount of fixed-income investments, not stock fund managers, to keep you within your risk tolerance.

4. Believing fund sellers will protect you

Some investors think mutual fund salespeople and managers will try to stop them from making stupid mistakes. Wrong!

When you write a check to a mutual fund company to invest in one of its funds, the fund company has no interest in doing anything except following your instructions.

Even if they somehow knew that you were putting all your money into a risky fund in the hope that you could impress your naive friends, they have no responsibility to learn your personal story and warn you that your action might be inappropriate. In fact, any mutual fund employee who did that might find himself or herself out of a job.

The fund is responsible only for taking your money and following the dictates of the fund’s prospectus.

My best advice: To keep from making dumb mistakes, follow my advice in the next item.

5. Thinking advisers are a waste of money

Investors think they know enough and that it’s smart to avoid paying anything for professional help. Wrong!

For more than 30 years I have been trying to help investors make better decisions and create better outcomes for themselves and their families. I have spoken with and had email exchanges with thousands of them. Almost always, they are sure they are on top of things and making the best decisions.

But we are humans, and we sometimes fail to notice that there can be a big difference between what we WISH were true and what actually is true.

Every one of the mistakes I have listed is typical of investors who think they manage their portfolios on their own. I believe that nearly every investor I talk to is making at least one important mistake that has the potential to negatively change somebody’s financial future.

My best advice: No matter how certain you are that you’re right, get a second opinion.

I don’t think everybody needs to hire an adviser who charges ongoing management fees. But I do believe every investor can benefit from paying a few hundred dollars to ask a handful of questions of an objective professional who doesn’t sell any products. Others may find it worthwhile to get a more thorough analysis for a flat fee of $2,000 or so.

To find an adviser who will do that, a good place to start is the Garrett Planning Network of fee-only hourly advisers, most of whom recommend (as I do) no-load funds and ETFs by Vanguard.

This will cost you a little money, but that money could turn out to be one of your best investments ever.

Richard Buck contributed to this article.