I believe that very few investing mistakes are the result of random bad luck. Most mistakes are predictable and preventable. And there are some mistakes that are very common amongst novice investors.
My belief is that if you can avoid these most common three mistakes then you will have a very high probability of being a very successful investor.
Simple does not equal worthless
Often the simplest concepts in life are the most powerful and valuable. However, often, people discount simple concepts believing that something so simple cannot possibly solve a complex problem. It’s not true.
Also, knowing and doing are two very different things. If you find yourself thinking “oh, I already know these simple rules” then ask yourself, “do you follow them with unwavering discipline?” Sometimes we need to be reminded of simple rules to keep us on the straight and narrow.
Mistake one: Don’t lose money!
American investor, economist, and professor, Benjamin Graham taught Warren Buffett at university that there are only two rules to investing: Rule # 1: never lose money; and Rule # 2: refer to rule number one. Buffett has lived by these two rules. He always thinks about his down-side first. What can go wrong? Can he lose money? What doesn’t he know that could hurt him? And so on.
You probably agree that it’s hard enough to earn money that you certainly don’t want to give it away. A financial loss could take many years to recover from (not to mention the hit to the ego).
Therefore, when considering an investment, spend 80% or more of your time and energy working out what can go wrong and what you can do (if anything) to avoid it. Get independent advice. If there is any reasonable chance of incurring a loss, walk away.
Mistake two: Will you be rewarded for the “time” you invest?
The most important ingredient for a low-risk, high-reward investment strategy is time. But time is a scarce resource so you need to invest it wisely. You can always make money to recoup losses but you can never get time back.
Therefore, if you are going to spend the next 10 years in an investment, you need to be very certain that you will be adequately rewarded. That is, you want to be in a position where you can say that you are “very confident” you will achieve excellent investment returns over the next 10 to 20 years. Who cares what happens in the next 5 years but in 20 years you need to be very confident that you will be significantly better off (financially).
The mistake people make is that they don’t think long term. Short term thinking often results in investment mistakes. Consequently, they find themselves suck in an underperforming investment and before they know it, 10 years has passed and they have paid a very big price i.e. missed returns that they could have otherwise generated (opportunity cost). They can never get that 10 years back again.
Knowing that you will be invested in an asset for the next 20 years or more might force you to think very carefully about whether you will be adequately rewarded for such an investment of time.
Mistake three: How tax-efficient is the investment?
You can rarely avoid paying tax, but you can sometimes delay it. When investing, the goal is to delay paying tax for as long as possible. Doing so will leave you with more money to reinvest each year and that helps the impact of compounding capital growth.
For example, some managed funds (due to turnover and a flawed strategy) provide most of their return in income each year (including realised capital gains). Take this popular Colonial managed fund for example, its total return since inception is 8.13% p.a. consisting of 7.93% p.a. in income and 0.20% p.a. in capital growth. You have to pay tax on the income each year leaving you a lot less to reinvest. Compare that to an investment in the US market (such as this one for example) where you will likely receive between 2% and 2.5% p.a. in income and the rest in capital growth. Or a residential property will typically provide 20% of its total return in income and 80% in capital growth. These are more tax effective for investors that need to grow their asset base.
If you are retired and draw a pension from super then investing in high dividend paying companies (fully franked) like Telstra will see you generate an income of approximately 10% p.a. (after the refund of imputation credits). That is a tax-effective investment (in super). As an alternative, these investments provide more diversification and are low-cost (see here and here).
The mistake that many people make is that they invest in the wrong types of assets at the wrong stage of life (as explained in this video) and lose a lot of their returns in taxes.
Four steps you can take to avoid these mistakes
To avoid these three common mistakes, you need to take a few simple actions:
- Think long term. Ask yourself what you can do today that will make you financially stronger in 10 and 20 years.
- Obsess about asset quality. You cannot expect excellent investment returns from a below average quality investment. Your returns will be commensurate with the investments quality.
- Invest in assets that are appropriate for your stage of life. Consider tax outcomes.
- Get independent advice from an advisor you trust as you will greatly benefit from their experience and unemotional approach to managing your finances. They won’t let you make one of these mistakes.
Of course, if you have any questions or would like to discuss the above, do not hesitate to reach out.
