January 2006
 

All investors make mistakes, says Timothy Baughman, vice president and senior trust administrator at Northern Trust. But the better investors have learned how to keep their worst instincts from undermining their long-term goals.

Here are his rules for tackling the most common investor mistakes:
1. If you fail to plan, you plan to fail
For many investors, the greatest obstacle to achieving investment success is not having a clear investment plan or set of objectives.

“You wouldn’t build a house by throwing bricks in a pile, and neither should you build your financial security by compiling a set of random investments,” says Baughman.

So start by asking questions about your needs and preferences, then build a wide-ranging financial plan around the answers. (See “How Hard Can an Investment Plan Be?” on page 8.)

Baughman cautions that plans are only valuable if they are put into practice.

“The second most common problem we see is that people create good investment plans, and then forget they have them,” he says.

2. Better late than never — but not much
Perhaps the most common regret investors have is that they waited too long to start investing or they didn’t set enough aside early enough.

The longer you invest, the greater the opportunity for earnings in your portfolio to begin to make their own earnings. This compounding effect is a crucial ally for investors, and one of the surest means of achieving financial goals.

“Particularly in tax-deferred accounts, where your earnings are shielded from annual taxes, the effects of compounding can be quite startling,” says Baughman.

3. Get diversified — and stay diversified
Diversification is the only investment strategy with the potential to curtail risks while also enhancing returns. One of the benefits of an investment plan is that it can help you target a diversification strategy that is suited to your goals and risk tolerance.

Striking a balance between stocks, bonds and cash is only the beginning. There is also value in gaining exposure to various market sectors — large-cap and small-cap stocks, high-quality and high-yield bonds, for example — and in embracing global markets.

Once you construct a well-diversified portfolio, your work is not done. Remain vigilant and adjust your asset allocation as life circumstances change.

4. Know when to fold ’em
Many investors hold on to investments far too long.

“Some people become attached to winners,” Baughman says. “Many get stuck waiting for a loser to come back. Occasionally, investors may hesitate to sell a winner because they don’t want to incur capital gains tax.”

It’s easy to want to make a lifelong companion of a favored investment. But if a company is losing ground, the sooner you can break it off, the better. The same works in reverse: Knowing when to sell a winner and book its gain can make a big difference in your long-term success.

When should you pull the trigger? Know what you want from an investment before you buy. If the investment doesn’t meet your personal goal for it, it’s not right for your portfolio. If it hits the mark, be happy — and move on.

5. Think before you trade
The flip side of holding on too long is trading too often. Some investors quickly lose patience in their portfolios. But trading can be costly, and not just from an investment perspective. Portfolio trades often trigger taxes as well as transaction costs, such as brokerage commissions.

In general, says Baughman, an investor needs three to five years to assess the viability of a particular investment.

“Patience is an investing virtue, especially in the equity markets,” he advises.

6. Put facts before feelings
Money is an emotional subject, and emotions can greatly influence your investment choices. But emotions often work against sound investment fundamentals — especially when they’re not supported by complete information.

That’s another reason it’s so important to have an investment plan. Say the evening news features a negative story about a sector you’re invested in. Or maybe a friend offers a hot tip on a new technology stock.

It helps to be able to weigh that information against your plan before deciding what steps you should take.

7. Don’t try to trounce the market
Investing brings out people’s competitive instincts. It can be very satisfying to feel that your portfolio is a world beater. But outperforming the market consistently is a daunting task.

Trying to beat the market often leads people to chase after hot stocks or sectors or take on too much risk. And that can cause a lot of harm. When you’re tempted, it helps to fall back on the personal goals you’ve outlined in your investment plan.

The golden rule
If there’s a common thread in Baughman’s rules, it’s that investors benefit by putting a priority on their financial success. That means saving on a regular basis and adding to investments whenever possible.

“The phrase ‘pay yourself first’ has become a cliché, but it’s great advice,” says Baughman. “We consistently find that the people who do this are the ones who achieve their financial goals.”