Everyone knows that money correctly invested in the stock market will, over time, compound very nicely. However, it’s also true that not everyone makes money in the stock market. If it were easy, everyone would do it. The good news is that most investors lose money because of easily avoidable mental errors.
Here are two mistakes that I think could be holding your retirement plan back.
Not being diversified enough
Investing is a tricky thing. On the one hand, you need to have enough confidence to decide that a stock is worth buying – while other people in the market are selling it; but on the other hand, you need to have a large dose of humility and accept the fact that you will sometimes be wrong. Good investing is being wrong less than 50% of the time. In other words, you can’t always be right, but you should aim to make the odds work in your favour.
Diversification is a central concept to investing because it minimises the extent to which any one stock can affect your portfolio. True, this means that you will sometimes have to limit your exposure to a given company, which can be difficult if you really believe in it. But I would much rather have a slightly lower rate of return and insulate myself from a freak wipeout, than tack on a few extra percentage points by concentrating my portfolio in one area and risk losing it all in a day.
Excessive activity
Overtrading has historically accounted for some of the biggest losses suffered by ordinary investors. While you may think that being proactive in the management of your portfolio is the right thing to do, sometimes inaction is the best form of action. In the past, when trading commissions were much higher, retail investors would sacrifice whole percentage points of return due to brokerage fees.
To put this into perspective, the difference between £10,000 invested for 40 years at 5% (compounds to £70,400) and 7% (compounds to £149,744) is £79,344. Losing 2 points of annual return more than halved the compounded amount!
Nowadays, brokerages do not charge anywhere near as high fees as they used to. However, you may still incur taxes on share dealing that could eat into your returns in a similar fashion. Moreover, by constantly trading in and out of stocks, you run the risk of missing out share price appreciation. Studies have consistently shown that investors, both amateur and professional, are not good at timing the market or identifying tops and bottoms in stock prices. It appears that doing so is almost impossible.
What is possible, however, is identifying stocks that are priced cheaply relative to intrinsic value. If you can do that, and hold onto your portfolio for a long time with minimal churn, you will be well on your way to building that retirement pot.