- Taking Excessive Risk
Many investors gravitate toward investments offering the highest potential returns while ignoring the associated risks. If your investment loses 50% of its value during a bear market, it will take a gain of 100% just to return to break-even status. The goal of a well-diversified, balanced portfolio is to reduce market risk while earning steady, consistent returns over a long time horizon. Minimizing losses during downturns generally produces higher average compounded returns over a long time horizon.
- Using Stocks to Meet Short-Term Cash Needs
Funds that are needed to meet a specific financial goal in less than a three-year period, and perhaps longer, should not be heavily invested in stocks or stock funds. Examples of goals are a car replacement, the down payment on the purchase of a home, or even plans for a major vacation. The logic behind this is simple. Stocks are quite capable of losing 30% of their value or even much more in a rather short period of time. When these periods of volatility occur, the odds are that you will not escape the carnage. Based on historical data, it often takes 2-4 years and sometimes longer to recover from a major market setback. When your goal is short-term, it is more important to protect your resources than to reach for higher returns.
- Lack of Diversification
Diversification is the key to managing total portfolio risk and volatility. Reallocating funds moderately between asset classes that have a low correlation relative to the U.S. stock market can potentially reduce portfolio volatility without significantly sacrificing long-term portfolio returns.
- Concentration – Keeping Most of Your Eggs In One Basket
A concentrated investment strategy is the quickest way to accumulate wealth as long as you make the correct investment decision. It is also the quickest way to lose wealth if you make a poor investment choice. A general guideline is to limit any individual stock to 5% or less of the stock portion of your total portfolio. An allocation above 5%, while carrying significant risk, could be justified if you are knowledgeable about the specific investment and are confident that this particular investment can outperform the broad market or other alternatives.
- Stretching For High-Yield At The Expense Of Quality and Stability
Income-oriented investors are frequently attracted to the promise of high-yielding investments. It is important to mention that investment returns are comprised of two factors. One factor is the income or yield that is generated in the form of interest or dividends. The second factor is capital appreciation or depreciation (loss). Total return, the sum of these two factors, is the bottom-line and all that counts. If an investment advertises a yield that seems too good to be true, it probably is. Interest rate or yield is irrelevant if you lose your investment.
Christopher Parr is a River Hill resident and President of Parr Financial Solutions Inc.- an independent, fee-only financial advisory firm: www.ParrFinancialSolutions.com