It seems there’s quicksand no matter where an inexperienced investor looks. Yet, real learning only occurs when real money is involved. Luckily, quick progress can be made by avoiding mistakes that destroy your account before you really get going. Here are a few of the biggies to avoid.
Fail to Fund Your 401(k)/403(b)
If you are offered a tax deferred investment plan at work and don’t use it, you’re cheating yourself and paying the government more than you should. The contribution you make comes off of your current taxable income, and grows tax-deferred until you withdraw the money.
For a more detailed explanation of how to maximize your 401(k)/403(b)’s tax deferral and earnings (and specific examples of how to structure your holdings), see the Tax Mistakes Novice Investors Make article.
Fail to Properly use an IRA for Income Producing Assets
If you have investments that generate income, you pay taxes on that income each year unless it’s in an IRA.
IRAs can turbocharge your tax-deferred investments’ growth, if you use them the right way. But you shouldn’t just put any old investment into an IRA just to avoid paying taxes on the earnings.
For specific examples of how to properly use an IRA, see the Tax Mistakes Novice Investors Make article.
Fail to Invest in Master Limited Partnerships (MLPs)
An MLP is an equity that makes you a partner in the business, not just a shareholder. And, instead of dividends, you receive distributions which are extremely tax-friendly since the majority of the distributions are considered a return of capital. That means you do not pay taxes on the portion of the distribution that is a return of capital though it lowers your cost basis by the amount of the return of capital.
For more MLP information,, see the Tax Mistakes Novice Investors Make article.
There are lots of other ways to pay more than your fair share of taxes on your investments. But these are the top ways to ensure that Uncle Sam is getting more than the legal minimum.
Fees are the lifeblood of the financial services industry. Ever wonder how young guys (and some women but not many) go from college to making hundreds of thousands of dollars working “on Wall Street” in their first job? They sell the fee based services of the financial firms who hire and train them.
Even if you don’t pay the fees directly, they’re likely being syphoned out of your accounts and into the banker’s coffers.
Overpaying for Mutual Funds with their Hidden Fees
If you must invest in Mutual Funds (only if your employer sponsored plan limits you to MFs), you must look at all the fees they deduct from the fund and heavily factor them into your choices. Look for your funds fees in the prospectus.
Identify the No/Low load funds. But, pay particular attention to the 12b-1 fees. Funds with up to 0.25% are legally allowed to call themselves no-loads. Others look like low loads upfront but have large 12b-1 fees.
Seek to avoid (or at least be aware of) excessive trading fees or back end loads that will cost you when you exit the fund.
Find and use index funds to minimize fees and closely track the overall financial markets without attempting to time the ups and downs or rotations within the fund universe.
Once you’ve obtained the maximum company match, Consider opening your own IRA with a custodian who has a broader array of options for you to invest in. You may be eligible for a tax deferred (traditional) IRA or you may find a ROTH IRA is a better long-term option. When you change jobs, roll-over the 401k to your IRA and have more control with lower fees (generally).
Once you identify the excessive fees in your 401k choices, work to have them expanded, get a new trustee that isn’t directly affiliated with a Mutual Fund company or get the fees reduced. Share your findings with other plan participants and ask for their support. Show them and your HR representative how the excessive fees impact your long-term growth and retirement options.
The Mutual Fund industry extracts millions of dollars in fees, often for very little benefit, from our self-directed retirement accounts.
Overpaying for any Particular Equity
What you pay directly impacts your return. Never ask: is company XYZ a good investment, instead, ask: is company XYZ a good investment at this price (or what price)?
Benjamin Graham warned that successful investing requires us not to overpay for good companies or buy into mediocre stocks based on their current year earnings that are up simply as a result of a booming economy or a cyclical upswing.
Overpaying for Investment Services and Advice
Unless there is a real reason you must have a full-service broker, you should use a discount broker like Charles Schwab, E-Trade, Ameritrade or Brown & Co. The commissions on trades at discount brokers are less than one-fourth the amount you pay at a full-service firm. This alone can save you hundreds of thousands of dollars over the course of your investing life.
Failing to Reinvest Dividends
When your stocks pay you a dividend, you can either take the money in cash (credited to your account) or reinvest it in the company’s stock. Over the long-haul, compounded growth of dividend income creates most of the total return from on most equities. Reinvesting dividends will turbo-charge your portfolio – generating larger future earnings from past earnings and maximizing what Albert Einstein called “the greatest mathematical discovery of all time”.
Attempting to Time the Market
Market tops and bottoms can only be known in hindsight. Investors, especially amateurs, have no reliable way to tell the short-term future of the equity markets. We can, however, rely on the long-term trend which, along with the economy, continues to move higher.
So, instead of trying to time the top or bottom of the market, decide how much you want to invest each month or quarter. You’re automatically investing and you avoid the poor (emotionally driven) decisions most people make when trying to time the market. You may hear this referred to as dollar-cost-averaging or drip investing.
Being Excessively Diversified
Everyone knows that you shouldn’t keep all your eggs in one basket – but many people confuse themselves (and pay excessive fees) by taking diversification too far. If you split up $1,000 into 100 different stocks, the fees (even using a discount broker) and other transaction costs may exceed any profits.
By investing in an index ETF you get all the diversification you need with minimal fees with market average returns.
Making Fear Based Decisions
Many investors do their research, purchase equity in a great company at a reasonable price, and when the market tumbles (with little or nothing to do with the company’s business) they dump their stock for fear of losing more money. The company is the same company as it was before the market as a whole fell, only now it is selling for a cheaper price. Common sense would dictate that you would purchase more at these lower levels or, as Baron Rothschild, an 18th century British nobleman and member of the Rothschild banking family, is credited with saying, “The time to buy is when there’s blood in the streets.”
The buy-low/sell-high mantra has been around forever – most people can recite it but only a handful of investors actually do it because it violates human instinct. Most see the crowd rushing for the fire escapes, and instead of staying and buying at ridiculously low prices, panic and sell out too.
One of the keys to building wealth is avoiding large mistakes. Hope this review of the biggies helps you avoid some or all of them.
Live Long and Prosper – Leah the MoneyDiva.com