By Sean Condon, CFP®
Mistakes are a part of life. We all make them and hey, no shame, no blame. But it is important to understand how you handle the consequences of mistakes, and what can you learn from them. If we can do some of the learning for you, before you suffer a financial setback, even better.
When it comes to finances and managing money, most everyone has blind spots. It pays to have someone else help you see the mistakes you might make. Below are some of the biggest and most common money mistakes we have seen working with families for over three decades.
1. Not Anticipating The Difference Between “Risk Averse” And “Loss Averse”
Risk is fundamental to investing. Without risk there is no return, and smart investors build their portfolios based on how much risk they are willing to take. Using historical data, you can make some assumptions about how much downside risk will be expected in any specific portfolio, then modify it accordingly based on your needs. Focusing on risk is a sound process, but in practice, the real world can present difficulties. Here’s why:
Let’s say you had $100,000 to invest and when we asked you during our initial conversation what you would do if the market dropped 20% you confidently replied: “do nothing or buy more.” This is good information, as we know a 20% correction in the market is somewhat common and should be expected. Based on risk, you construct a portfolio that falls about 20% with the market, and you have lost $20,000. This $20,000 is certainly a lot of money, and you do not feel great about the short-term loss, but after reviewing your long-term goals, you realize that $20,000 could be made up with a nice year-end bonus, and you remain invested and stay on plan.
Now let’s say you receive an inheritance or sell a business for a large lump sum of $4 million. You invest the amount in the same portfolio as before, after all it has been working well for you and has been well-aligned to your risk tolerance. A year later the market drops 20% again, the exact same market decline as before with the same investment strategy. Only now, that 20% decline on a $4 million portfolio is $800,000. “Enough!” you say. You feel angry at your advisor and betrayed by the market. You sell everything and get out, taking the $800,000 loss with no chance of regaining it when the market eventually recovers.
This last example is one of “loss aversion.” Loss aversion is more than the desire to reduce risk; it is utter disdain for loss. In fact, individuals experiencing loss aversion have been shown to feel the pain of loss more than twice as strongly as any joy felt from an equally sized gain. Anyone can find themselves in a situation where they become loss averse. It is crucial to understand your own tolerance for not just market risk but dollar losses, especially how these can change over time.
2. Not Understanding Diversification
A lack of diversification is often the largest risk to wealth preservation. Large investments in a single stock or industry are inherently risky and far more volatile than the market. Without diversification, there is nothing to offset the risk of a bad event happening to a single company, potentially leading to a catastrophic loss of capital.
Diversification can be difficult to implement because it is inherently boring. After all, a diversified investment strategy will almost never be the best performing investment in a given year. But it will never be the worst, and by avoiding the types of extreme losses associated with concentrated investments you drastically increase your chances of compounding returns over time.
Take a look below at the chart of previously high-flying pandemic stocks as a great example of concentrated investment risk. During the pandemic, the stocks of many stay-at-home type companies did extraordinarily well. They certainly outperformed diversified portfolios and many investors likely decided to just put all their investments in these “obvious winners.” The other side of this experience is seen below with individual stocks losing as much as 90%. These types of steep losses are nearly impossible to recover from.
Source: YCharts as of May 22, 2022.
True diversification is a risk management strategy paired with a rebalancing process and not a “one-and-done” solution. When utilized properly, it can reduce risk and taxation while helping increase long-term profits. Diversification cannot guarantee a minimum level of return, but it will at least act as a buffer against the inherent volatility of the market by mixing a wide variety of investments and asset types into a comprehensive portfolio.
3. Not Developing An Income Plan For Retirement
Not having a plan for how to earn income during retirement is another common mistake we see with clients. Just like with knowledge, investing and saving for retirement is only part of the equation. Most people focus on how they need to prepare for a comfortable retirement and often neglect planning for what happens after they retire. Your income plan during your retirement years will also play a major role in how long your money will last.
A well-developed retirement plan should include both guaranteed income, such as a pension or Social Security, and investment income, such as real estate or income from your retirement account. Another important aspect to your plan is determining the timing of withdrawals. For instance, you can start withdrawing Social Security at age 62; however, if you delay taking benefits until you are 70, your benefit amount will increase. Assets like 401(k) plans, Roth IRAs, and annuities are each taxed differently. Timing your withdrawals wisely from each type of account can help reduce your overall tax bill.
4. Not Staying True To Objectives
Lastly, another major money mistake we often see is people getting sidetracked and not staying focused on their initial, long-term financial goals. They may start out with a great plan and are saving and investing, but somewhere along the way, they lose sight of the big picture and stop doing what is necessary to achieve their goals. Sometimes life happens and we need money now, and that can seem more urgent than our long-term goals that are far off in the distance. But if you are not disciplined about your financial situation, it is very easy to get distracted and lose sight of what matters most.
To help you stay committed to your objectives, set small financial goals that gradually add up to larger milestones. Also, make sure to always set aside your emotions when dealing with money. Addressing your feelings of insecurity, anxiety, and fear by speaking with someone you trust will help you stay focused on what is important to you.
Are You Making These Financial Mistakes?
Don’t let these common financial mistakes derail your wealth management plan. Windgate Wealth Management is here to help. If you have questions about how to plan for common mistakes such as these, you can reach us by calling (844) 377-4963 or emailing email@example.com. You can also book an appointment online here.