Emotional problems

In my work as an investment advisor, I see financial mistakes made on a daily basis. In fact, I commit mistakes more frequently than I would like to admit. A vast array of possible errors in operating an investment plan exists, but almost all such mistakes fall into one of six categories. Here are the first three:

Panic

Though it is part of human nature, few actions (or reactions) pose more of a threat to long-term investment performance than the investor's tendency to panic during hard times. An investor should set up a proper portfolio with such balance and diversification that when times of volatility inevitably arrive, he is prepared to navigate through them. Dalbar released a study in 2005 indicating that while the S&P 500 had achieved annual returns of over 10 percent in the last 20 years, and the average equity mutual fund had performed similarly, the average equity investor had only earned 3.7 percent. This is directly related to the tendency of investors to panic during bad times. Appropriate defensive responses are often in order, but panic is never one of them. Hastiness is not a biblical trait (Proverbs 19:2).

Euphoria

Sadly, the flipside of panic exists as often as panic itself. Euphoria tends to set in when really good times are taking place, and an investor ends up abandoning his plan for balance and diversification for that "hot dot." In recent years, the real estate bubble of 2004-2006 and the dotcom bubble of 1998-2000 serve as good evidence that investors are not immune to euphoric crazes. Adhere to your carefully designed plan even in good times, and avoid the euphoria (often another word for greed) that can lead to a destruction of your profits (Proverbs 1:19).

Under-diversification

Even after the saga of Enron and Worldcom several years back, a shockingly high number of investors continue to put "all their eggs in one basket." Whether it be an excessive amount of assets in one stock, or an excessive amount in one sector (i.e., technology), a lack of diversification can devastate a portfolio. While all investments are worthy of inclusion in a portfolio, prudence dictates that an investor diversify into multiple strategies. Think of a baseball hitting your front window: If it is one window, the whole thing must be replaced, but if it is a multiple pane window, only one will need replacing, while the others will still be in good shape. Proverbs 11:14 tells us that in a "multitude of counselors there is safety." This very same principle requires us to be properly diversified as well.

In the next column, I will examine mistakes 4-6 on our list: the errors of over-diversification, excessive leverage, and allowing tax decisions to guide investment decisions.