In recent days, queasy investors have run from stocks to bonds and cash -- and, as of yesterday, back to stocks again. But when investors get react to daily market moves, they often go too far, experts say, when there are smaller, hidden tweaks they could make that would bolster good days and bad.
Investing is inherently risky -- stock prices drop, companies default on their debt, even sitting in cash runs the risk of failing to keep up with inflation. And much of it, investors don't control -- including an unprecedented ratings downgrade for U.S. government debt, for example, or the precipitous, unforeseen market drops of the last two weeks. Even so, there is plenty that investors can do, including making sure that there's enough diversity in their investments, to prevent everything from moving in lock-step and having a clear, long-term plan, which can offer perspective when the short-term doesn't seem to be going your way. "If you focus on those big levers that you absolutely can control then you actually stand a great chance of being successful," says Chris Philips, senior investment analyst for Vanguard's investment strategy group.
Obviously, there's no way to eliminate all the risks in investing. Sometimes, surviving a market swoon feels like exactly that: Survival. But there's no reason to make it worse than it has to be. Here are four common investing mistakes that add unnecessary risk to a portfolio -- and how to fix them:
Mistake #1: Bonds equal safety
Reality: Some bonds are safer than others
Until last week, U.S. Treasurys were considered absolutely risk-free, with no chance at all that the issuer (a.k.a. Uncle Sam) would fail to pay up. Post-downgrade, investors may be able to see a bigger picture: Bonds of all kinds can carry hidden risks. They still have a place in a portfolio, advisers say, usually to generate income and to provide stability -- when stocks fall, bonds often rise, or at least don't fall by as much. But within the universe of bonds, there's a wide range of risks that make some issues far more vulnerable to big losses than others. One big one: The more a bond pays in yield, the riskier it is. High-yield corporate bonds, for example, commonly called "junk" bonds, can offer yields an average 6.6 percentage points above Treasurys. They also have a higher risk of default. Over the last 12 months, 2.2% of high-yield bonds defaulted, according to Standard & Poor's Global Fixed Income Research; during the same period, no investment-grade bonds did.
The fix: Don't chase yield.
Even with high-yield bonds, the odds are still in the investor's favor, but they're also some of the more volatile issues around, with prices that tend to rise and fall more like jittery stocks than mellow bonds. To reduce risk, investors should have no more than 7% of their bond portfolio in high-yield bonds, says Ron Florance, managing director of investment strategy at Wells Fargo Private Bank, and they should diversify with other bonds, such as municipal bonds, investment grade corporates and foreign issues. And while investors can't control rising interest rates, which also erode the value of bonds, Florance recommends sticking to bonds with low maturities -- about seven years or less -- because they will get hurt less if rates go up.
Mistake #2: You're plenty diversified
Reality: A dozen funds -- or even a mix of stocks and bonds -- may not cut it
Households that invest in mutual funds own about seven funds apiece, on average, according to 2010 data from the Investment Company Institute, a mutual fund industry trade group. That ought to be enough to get good and diversified, no? A closer look often reveals that even with a passel of funds, portfolios can be far more concentrated than they first appear. Investors often fail to realize that they can be holding two or more funds with very similar strategies, which isn't always apparent in a fund's name or track record, says Todd Rosenbluth, a mutual fund analyst for S&P Equity Research. An investor who owned the $61 billion Fidelity Contrafund and the $24 billion T. Rowe Price Growth Stock fund, for example, would end up essentially doubling down on information technology and consumer discretionary stocks, according to S&P.
Meanwhile, too many investors ignore the asset classes that could boost their portfolios when the typical mainstays, like stocks and bonds, aren't cutting it, says Robert Wiedemer, managing director of Absolute Investment Management, a Bethesda, Md.-based wealth management firm. He says he uses exchange-traded funds to allocate about 20% of his clients' portfolios to gold and silver, which tend to hold up when stocks are tanking. And at a time when growth in the U.S. is sluggish, it may be smart to increase exposure to international stocks and says Eleanor Blayney, consumer advocate for the Certified Financial Planner Board of Standards, a nonprofit that certifies advisers.
The fix: Look beneath the hood.
Investors should take a look at the holdings in their mutual funds to watch for overlap in sectors or company names, says Rosenbluth. The fund's website should list the fund's top 10 holdings and break down its allocation to certain sectors, he says. Morningstar and S&P also offer online tools that help investors review the holdings in their portfolios.
Mistake #3: You'll know when to sell
Reality: Most people sell too late
No one plans on riding a losing stock all the way to the basement. To the contrary, many investors plan on selling out of positions when a stock or index falls below a certain point. Then the time arrives, and they find they can't pull the trigger, says Nate Peterson, senior derivatives analyst for Charles Schwab. And it only gets worse: Eventually they sell, locking in large losses, and thus burned, they often wait far too long to get back into the market. With that kind of pattern, it can take a long time simply to get back to even, says Stephen Horan, head of private wealth management for the CFA Institute.
The fix: Make it automatic
That point at which you'd plan to sell? Set what's called a stop-loss order on your stock or fund positions, which instructs your brokerage to automatically sell stocks once they fall below a certain price. They're free to set up and they help you avoid the emotional paralysis that sets in when it's time to make a trade, says Peterson. The catch: investors who use stop-loss orders can miss out on market rebounds if they don't have a strategy for getting back into the market, says Brent Burns, president of Asset Dedication, an investment adviser firm in Mill Valley, Calif. Investors should set up stop loss orders for when certain holdings fall between 10% and 30% below the purchase price, says Horan, and rebalance their portfolios after big market movements to make sure their target allocations are in place. Taking those losses isn't all terrible, he adds, because investors can take some of the investment losses as a tax write-off.
Mistake #4: You think you have a plan
Reality: You make investment decisions on a whim
When the market had one of its worst days in history this week many investors may have found themselves without a blueprint for what to do next, says Horan. In fact, most investors tend not to have a long term investment plan at all, he adds. And even those who are working with a pro may find themselves without a concrete plan they can turn to. A June survey of 1,011 adults by KRC Research for the Certified Financial Planner Board of Standards found that just 42% of those surveyed had a written document outlining their financial plans; another 11% barely had more than a few notes and ideas. But experts warn investors can shortchange themselves in the long haul if they are too reactionary with their decisions. Says Vanguard's Philips: "If they're focusing on the here and now and lose sight of that long term objective then they could end up doing more harm than good."
The fix: Put it on paper
It can help to list out your investment preferences and outline the parameters you want to set on your portfolio, says Horan. That includes laying out how much equity exposure you can tolerate along with minimums for what you want to hold in other sectors like bonds or cash. Your financial plan can also detail what adjustments, if any, you'd like to make after a large market movement -- before it happens, says Horan: "It helps keep a much steadier hand at the wheel."