I know, I know…never is a strong word. But I want to take a moment to make the case that there are, in fact, at least five ways that people make investments that often turn out badly.
That’s not to say nobody does well in these types of investments. After all, exceptions prove the rule, right?
Nevertheless, for most of us, there are specific investment approaches that don’t add up in terms of the risk-reward balance.
“Risk” is the key concept here. We are raised to believe that risk-taking is a virtue and that risk avoidance is a form of cowardice or narrow-mindedness.
The battle is won by the bold, a message driven home in Hollywood movies. It always comes down to one guy — usually an ordinary cop or the bespectacled bookworm — to save the world.
Inexplicably, we transfer this illogical message to our investing lives, taking out-sized bets on flaky stocks, following crackpot self-help promoters or simply staying far too long in assets that clearly have run their course.
The cost is underperformance or, worse, losing years of appreciation in weeks or days, never to be recovered.
Yes, “return” is the goal. Otherwise, why invest at all? But that return should be risk-adjusted, that is, a return in line with the risk one assumes in seeking it.
To use a sports metaphor, an NBA player tossing a ball in the final seconds of a period has nothing to lose. If he makes it, the crowd goes wild and the team picks up three points. If he misses, well, it was a long shot anyway.
That same player would never throw away the ball during regular time. Losing possession matters in the thick of a game. A throwaway shot is likely to be rebounded by the other team and run back for a basket.
So, our player sets up his shots with care. He looks for a clear basket or a teammate who can penetrate the defense.
The trick is to recognize when your investments are looking like wild, half-court shots with no purpose. Here’s some examples:
1. Company stock is a giant slice of your 401(k) or IRA. We know you know the firm forward and backward. Familiarity with your investments is no sin. But would you own so large a position in, say, a competitor? How about a single Dow blue chip?
If the answer is “heck no,” you probably shouldn’t own so much of your own employer, either. Concentration risk is concentration risk. Your proximity to the company does not reduce this risk.
2. Very small-cap stocks of any kind. Owning small caps is an important part of a balanced portfolio. In moderate doses (according to your investment time horizon) they can give your return some needed oomph.
But own them through an index fund or ETF, not by individual tickers. Microcaps are inherently risky and penny stocks are just straight-up betting.
3. Being 100% stocks in all markets. Yes, you should own stocks, especially when you are younger. Rising earnings translate into a useful hedge against inflation over long periods.
But even younger investors should own a small bond position and a mix of non-equity assets such as commodities and real estate. A rising tide lifts all boats, but it works the other way, too.
4. Being 100% bonds in all markets. Here, the problem is inflation. You know for a fact that inflation is around 3% over long periods. If long bonds pay less, you are guaranteed a loss.
It might make you feel better that bonds will, in fact, pay you back. But in that case why not just hold cash?
The bigger problem is selling a bond in a rising interest-rate environment. If new bond issues pay more, your aging bonds lose value and become harder to sell without taking a hit on the price.
Bonds are ballast in your portfolio, a useful counterweight, not a retirement strategy all by themselves.
5. Being uninvested. Did you sell your positions and go to cash last year? Too bad you missed the double-digit move in stocks that followed. As financial advisors often point out, it only takes missing a few key trading days of the year to miss the biggest moves.
Overconfidence in our own ability to predict the general direction of the markets is a widespread malady. One of the symptoms of overconfidence is sitting on cash for for long periods.
As you wait, not only do you miss the upside (and, of course, the downside), inflation is sapping away your purchasing power anyway.
So what’s the “ideal” investment? A balanced portfolio will include foreign and domestic stocks, a variety of bonds, commodities and real estate. Rebalancing is the key, as well as staying in the market long enough to realize the advantage rebalancing can provide for the retirement investor.
Done well, asset allocation dampens risk while allowing room for reward as markets churn through the normal ups-and-downs one would expect over long periods.