Editor’s note: Chuck Jaffe was out sick last week; this is a column from his archives.
There’s a difference between trying to do the right thing and actually getting it done. The biggest mistakes mutual-fund investors make fall right in the middle, where an investor trips over the fine line that separates good investing habits from bad.
In talking to financial experts and fund specialists, as well as reviewing industry statistics about ownership and asset flows, it’s clear that the investing public keeps trying to do the right thing, it just doesn’t always get the best results.
Here are the seven biggest mistakes fund investors make. If they describe the way you have been investing, it might be time to check your portfolio — and your mindset:
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1. Chasing returns: Buying what’s been hot makes intuitive sense — you’re riding the express train — but all too often results in disappointment. Ideally, the idea is as simple as “buy low, sell high,” but investors who chase performance typically are late to whatever market sector or investment style is hot. As a result, they buy at high prices, and when the market turns and starts to favor something else, these investors then sell low.
2. Rearview-mirror investing: It’s hard to go forward when you are only looking backwards. This problem is related to performance-chasing. You can’t just buy funds that did reasonably well in the past; you need to invest in parts of the market that are likely to do well going forward. Too many investors know what a fund has done recently but have little idea of the fund’s prospects.
3. Overreliance on rankings and ratings: More than 90 percent of all new money into mutual funds go to issues that carry Morningstar’s four- and five-star rating. Yet the investment research firm is quick to note that its star system is more “descriptive” than “predictive.”
There is nothing wrong with buying only funds that do well according to stars, numbers or any system, but make sure the fund adds diversification and strategy to your portfolio, rather than bringing only a past that was good enough to earn a top grade,
4. Assuming you can buy and hold a fund forever: Funds change, markets change, people change; what’s appropriate to buy at one point in your life may not be right later. Yet too many investors are married to their funds, hanging on in sickness and health, for richer or poorer, rather than always considering whether they would still buy the fund today. If key buying factors change — everything from the manager, the asset class, costs and track record and ratings — you shouldn’t blindly stay put .
5. Failing to understand what the fund does, how it invests or what it buys: When investors are surprised by a fund’s lagging performance, it’s often because they never clearly understood the fund’s objective.
Too many investors can’t explain what their funds do and why. They may know they own a large-cap growth fund or an index fund, and they’ll review the ratings and performance, but when it comes to the nuts and bolts, they don’t know where to start. For example, a mutual fund is considered “diversified” once it has more than 16 stocks, but it can still be concentrated or focused in a certain market sector. Likewise, investors who buy funds that top the charts don’t necessarily know what those funds did to stand out from the pack.
6. Letting emotions rule: It’s hard to prove a system or stick to a discipline if you make changes on a whim or with every market hiccup. There’s a natural human tendency to let the most recent experiences color judgment; as a result, investors typically give too much significance to current events and expect that trend to continue. Wanting to cash in on those trends or protect against them, they’ll let fear or greed rule the day and invest with emotion rather than intellect.
7. Focus too much on a fund, and not enough on the portfolio: Finding good funds isn’t that hard; putting them together in an effective, low-maintenance, diversified portfolio is a lot more difficult. Too many investors have a collection of funds, rather than a strategic portfolio, where every fund has a role and every new addition is evaluated not just on its own merits, but on what it adds to the big picture.
Owning five or 10 mutual funds does not make an investor diversified if most of those issues reflect one or two asset classes. Investors need more than a “good” fund; they need funds that enhance their holdings, diversify risk, bring additional asset classes into play and help the portfolio achieve their goals over time.
Chuck Jaffe is senior columnist for MarketWatch. You can reach him at firstname.lastname@example.org.