Know the laws of investing and quit following the herd into financial destruction

By Christopher Music

Do you know the irrefutable laws in investing?

This is not an article on different investment strategies, but rather more fundamental laws related to the subject of investing. Investors can be counted upon to make the same mistakes again and again.

Knowing what these are and how to avoid them can help you keep the long-term value of your nest egg intact rather than following the herd into financial self-destruction.

Mistake # 1 – Not adhering to a written investment policy.

Successful investors follow a well-designed, consistent investment policy.

This is a statement of how one will invest, regardless of short-term changes in the markets. It is written and signed after a thorough analysis is done with your financial advisor to determine your investment goals, tolerance for risk, and level of sophistication. Then it is implemented and maintained over the course of your life.

When an investor continually looks to change an investment strategy, he will inevitably make the wrong decision at the wrong time because there is no overriding policy in place to direct the actions of the investor in times of duress. Markets are volatile, but one’s approach to investing in them shouldn’t be. Untold wealth is lost through knee-jerk reactions like selling at market lows.

For example, when a cataclysmic market event occurs, many investors and investment professionals will seek some solution to the confusion created by the event. These solutions will be “alternative investments”, or changes in attitude toward well-proven long term strategies like “buy-and-hold is dead”.

Having a rational, appropriate investment policy can help an investor avoid mistakes during market turmoil.

Mistake #2 – Chasing investment performance.

A sure sign of a novice investor is one who makes his investment decisions based primarily on past performance.

This is folly, since the future is not the same as the past, no matter how much we want to use it to attempt to predict the future. Even the Securities and Exchange Commission requires that every prospectus (a document that explains the nature of the proposed investment) must state “past performance is not an indicator of future results”. Then why do people insist that it’s true anyway?

Many mutual funds use past performance almost exclusively to get you to invest in their fund. Just check out the financial pages of any newspaper or magazine and the ad touts “x% 3-year performance” as if that means anything to you. The only way it would impact your life is if you were actually invested in that fund during the last 3 years. Otherwise it’s irrelevant. As a matter of fact, most funds that have that great short term performance will usually underperform the next few years, right after you put your money in.

Past performance is only one factor among many in determining the correct investment strategy.

Mistake #3 -- Not determining the ultimate purpose of an investment before it is made.

Money is only invested so it can grow in value (or more importantly, RETAIN its value) so that something can be purchased at a future date. Every investment must have a clear and decisive purpose for which that money is accumulated. The purpose can be anything you want-- retirement income, a new car, college education for the kids, a dream vacation, whatever.

There are thousands of different investments and every one of them has an appropriate use, depending on the reason the money was set aside in the first place.

Example: If you wanted to save for a new car, then speculative stocks that will go up and down a lot in value will not be a smart choice. The odds are too great that you will have to cash it in at the wrong time. Moreover, if you wanted to invest for retirement income in 20 years, then keeping money in a savings account at the bank will not earn you enough interest to outpace inflation.

The reason why it is so important to know the ultimate purpose of an investment account is so that it will be invested to achieve the best risk-adjusted results.

The only time a person gets into trouble is when the purpose of the account changes.
Example: A person puts money in an IRA into stock and bond funds. After a couple years, the person overspent and now wants to cash in the IRA to pay bills. The account balance is down (which will happen in any speculative investment) and the person takes a loss.

The moral here is to determine the ultimate reason for making an investment and don’t change your mind midstream. Otherwise you open yourself up to taking unnecessary losses.

Mistake #4 – Not taking risk into consideration.

Probably the biggest problem that an investor faces is that he/she does not understand risk.

Risk comes in many forms and the most successful investment strategies will mitigate most of the risks.

The greater return one wishes to generate from an investment, the more risk one must assume. This is a law of investing. Irrefutable. However, the idea that “the greater the risk, the greater the return” is actually not true. There are countless examples where people assume a high degree of risk and receive low returns. Why? Because the subject of risk is not understood.

What constitutes risk?

In general, risk is the “possibility of loss” or the “chance of loss”. It’s the problem of putting money to use for some future purpose and the possibility of incurring some degree of loss in that investment.

Many investors think that the only risks are market-related such as the fact that the market can go down, or that the stock can go down in value.

But there are many more risks that people don’t often think about. These risks include:
• Inflation
• Taxes (on investment gains)
• Creditor exposure (incorrect titling of investment accounts)
• Herd mentality (doing what everyone else is doing—which is almost always bad)
• Lack of knowledge
• And many others

The truth of the matter is that you must truly understand the risks you’re taking with every investment you own. There are many other risks to consider than just the volatility of a particular stock, bond or real estate investment. Some of these risks can wipe out your entire investment plan if not managed intelligently.

In my experience, these are the 4 critical mistakes most investors make. If you avoid these mistakes, then you will be ultimately successful. If you violate these rules, then sooner or later they will kill you.

Happy Investing!

Author's Bio: 

After 15-plus years of being a financial planner, Christopher Music decided there had to be a better way. Witnessing financial debacles of big industry and government-driven economies caused Christopher to take action, developing an instrument that measures the success of any financial plan. The Financial Security AnalysisTM (FSA) is the back bone of Music’s firm, Wealth Advisory Associates (WAA). WAA is a financial planning firm focused on helping private-practice physical therapists understand and implement the most effective strategies to achieving financial success and security. Visit www.wealthadvisoryassociates.com