IN THIS CHAPTER

Paying and risking too much

Trading too frequently

Saving too little and expecting too much from the market

Ignoring inflation and IRS rules

Remember that personal investing course you took in high school? Of course, you don’t! If you’re a middle-ager like me, then your high school probably didn’t offer such a course (although people who’ve graduated very recently may have had the opportunity). And that lack of education — combined with a surfeit of cheesy and oft-advertised investment industry products, plus an irresponsible and lazy financial press — leads many investors to make some very costly mistakes, such as the ones I share in this chapter.

Paying Too Much for an Investment

Most investors pay way, way too much to middlemen who suck the lifeblood out of portfolios, leaving too many folks with too little to show for their investments. By investing primarily in indexed ETFs, you can spare yourself and your family this tragic fate. The most economical ETFs cost a fraction of what you would typically pay in yearly management fees to a mutual fund company selling “active management.” You never pay any loads (high commissions). And trading fees, which never were very much, have all but disappeared in the past year or two.

Failing to Properly Diversify

Thou shalt not put all thine eggs in one basket is perhaps the first commandment of investing, but it is astonishing how many sinners there are among us. ETFs allow for easy and effective diversification. By investing in ETFs rather than individual securities, you have already taken a step in the right direction. Don’t blow it by pouring all your money into one narrow ETF representing a single hot sector! You want to invest in both stock and bond ETFs, and both U.S. and international securities. You want diversification on all sides. Invest, to the extent possible, mostly in broad markets: value, growth, small cap, large cap. On the international side of your portfolio, aim to invest more in regions than in individual countries (see Chapter 9). ETFs make such diversification easy.

Taking on Inappropriate Risks

Some people take on way too much risk, investing perhaps everything in highly volatile technology or biotech stocks. But many people don’t take enough risk, leaving their money to sit in secure but low-yielding money market funds or in the vault of their local savings and loan. If you want your money to grow, you may have to stomach some volatility.

In general, the longer you can tie your money up, and the less likely you are to need to tap into your portfolio anytime soon, the more volatile your portfolio can be. A portfolio of ETFs can be amazingly fine-tuned to achieve the levels of risk and return that are appropriate for you.

Selling Out When the Going Gets Tough

It can be a scary thing, for sure, when your portfolio’s value drops 10 or 20 percent…never mind the 40 percent that an all-stock portfolio would have lost in 2008 (demonstrating graphically why you shouldn’t have an all-stock portfolio). Keep in mind that if you invest in stock ETFs, that scenario is going to happen. It has happened many times in the past; it will happen many times in the future. That’s just the nature of the beast. If you sell when the going gets tough (as many investors do), you lose the game. The stock market is resilient. Hang tough. Bears are followed by bulls (right now we are in one of history’s longest bull markets). Your portfolio — as long as you are well diversified — will almost surely bounce back, given enough time.

Paying Too Much Attention to Recent Performance

Many investors make a habit of bailing out of whatever market segment has recently taken a dive. Conversely, they often look for whatever market segment has recently shot through the roof, and that’s the one they buy. Then, when that market segment tanks, they sell once again. By forever buying high and selling low, they see their portfolios dwindle over time to nothing.

When you build your portfolio, don’t overload it with last year’s ETF superstars. You don’t know what will happen next year. Stay cool. You may notice that in this book, I do not include performance figures for any of the ETFs discussed (except in just a few circumstances to make a specific point). That omission was intentional. Many of the ETFs I discuss are only a few years old, and a few years’ returns tell you nothing. On the other hand, the indexes tracked by certain ETFs go back decades. In those cases, I often do provide performance figures.

Not Saving Enough for Retirement

Compared to spending, saving doesn’t offer a whole lot of joy. But you can’t build a portfolio out of thin air. If your goal is one day to be financially independent, to retire with dignity, you probably need to build a nest egg equal to about 25 times your yearly budget (more on that subject in Chapter 24). Doing so won’t be easy. It may mean saving 15 percent of your paycheck for several decades. The earlier you start, the easier it will be.

Savings come from the difference between what you earn and what you spend. Remember that both are adjustable figures. One great way to save is to contribute at least enough to your 401(k) plan at work to get your employer’s full match, if any. Do it! Another is to remember that material goodies, above and beyond what it takes to be comfortable, do not buy happiness and fulfillment. Honest. Psychologists have studied the matter, and their findings are rather conclusive.

Having Unrealistic Expectations of Market Returns

One reason many people don’t save enough is that they have unrealistic expectations; they believe fervently that they are going to win the lottery or (next best thing) earn 25 percent a year on their investments. The truth: The stock market, over the past 100 years, has returned roughly 10 percent a year before inflation and 7 percent a year after inflation. Bonds have returned about 5 percent before inflation and 2 to 3 percent after inflation. A well-balanced portfolio, therefore, may have returned 7 or 8 percent before inflation and maybe 5 percent or so after inflation.

Five percent growth after inflation — with interest compounded every year — isn’t too shabby. In 20 years time, an investment of $10,000 growing at 5 percent will turn into $26,530 in constant dollars. Most of us in the investment field expect future returns to be more modest. But with a very well-diversified, ultra-low-cost portfolio, leaning toward higher-yielding asset classes (see Part 2), you may be able to do just as well as Mom and Dad did. If you want to earn 25 percent a year, however, you are going to have to take on inordinate risk. And even then, I wouldn’t bank on it.

Discounting the Damaging Effect of Inflation

No, a dollar certainly doesn’t buy what it used to. Think of what a candy bar cost when you were a kid. Think of what you earned on your first job. Are you old enough to remember when gas was 32 cents a gallon? Now look into the future, and realize that your nest egg, unless it’s wisely invested, will shrivel and shrink. Historically, certain investments do a better job of keeping up with inflation than others. Those investments, which include stocks, tend to be somewhat volatile. It’s a price you need to pay, however, to keep the inflation monster at bay.

The world of ETFs includes many ways to invest in stocks, but if you find the volatility hard to take, you might temper it with a position in Treasury Inflation-Protected Securities (TIPS). You can buy a number of ETFs that allow for very easy investing in TIPS. Read about them in Chapter 14.

Not Following the IRS’s Rules

When they leave their jobs, many employees cash out their 401(k) accounts, thereupon paying the IRS a stiff penalty and immediately losing the great benefit of tax deferral. The government allows certain tax breaks for special kinds of accounts, and you really need to play by the rules or you can wind up worse off than if you had never invested in the first place.

People beyond 72 must be especially careful to take the Minimum Required Distributions (MRDs) from their traditional IRAs or 401(k) plans. Calculators are available online; simply type “MRD calculator” into your favorite search engine. Unlike a retirement calculator, based on all kinds of assumptions, the MRD is a straightforward equation. Any online calculator can take you there, or ask your accountant or the institution where you have your retirement plan.

Failing to Incorporate Investments into a Broader Financial Plan

Have you paid off all your high-interest credit card debt? Do you have proper disability insurance? Do you have enough life insurance so that, if necessary, your co-parent and children could survive without you? A finely manicured investment portfolio is only part of a larger picture that includes issues such as debt management, insurance, and estate planning. Don’t spend too much time tinkering with your ETF portfolio and ignoring these other very important financial issues.