Investment traps that could reduce earnings potential

Author: Ken L. White

After questions from individual investors for general advice on their investments, I have formulated some basic traps that could get them into trouble.

This applies to you if you are a speculative investor, a high net-worth individual,  have a defined contribution pension, are saving to send your kids to university or you just have a small amount of money to play with. There are some simple traps that you can avoid that will benefit your returns. 



1. Focusing on the Short-Term   

There is a tendency to fixate yourself on the latest hot trend in the market where there seems to be continuous growth (invest in technology stock in 1999). There was extraordinary growth in the technology sector from 1996-2000, this was expected to continue almost indefinitely by investors. However, the tech bubble burst leaving many investors to lose almost half of their wealth because their focus was on the short term. 

This applies to you the investor in many ways; you can avoid this by creating an investment policy statement (IPS). This is very important to all individual investors because it enforces logical, disciplined investment decision making, and it limits the temptation to make counter-productive changes to an investment programme during periods of market stress. 

Before you choose an investment, ask yourself: what is your attitude to risk? Would you be happy to hold it for the long-term? Do you think the shares represent fair value? Are there other overlooked areas which may offer better long term opportunity?


2. Putting your eggs in one basket

When creating your investment portfolio, consider that if all your assets are in a specific asset class, you are open to all the risks associated with that sector. This was the strategy used by many in the UK in the 90's and 00's where they allocated all their resources to purchasing real estate. When the housing bubble burst, they held limited portfolios and saw their wealth drop dramatically. 

Investors who took a more diversified approach would have seen a far smaller impact on their portfolio. Having a well-diversified portfolio is a key way to reduce risk.


3. Holding over-diversified portfolios


Just as holding an under-diversified portfolio is damaging, over-diversifying is dually as detrimental to an investors returns. Building a portfolio of similar stocks, earning similar returns is damaging because the rate of return for the sum of the capital would mean higher earnings if you invested it all in one stock. 

A more effective approach may be to focus on a handful of favourite fund managers investing in different areas of the market. This would provide you with a framework for limiting the risk associated with undiversified portfolios as well as increasing returns from not over-diversifying.


4. Paying too many charges


After creating an investment portfolio that brings you a value close to that of your expected return, it is counter productive to have fees and charges that reduce or eliminate the returns you achieved in the first place. 

Consider two funds, each delivering a return of 10% a year, but one with an annual charge of 1.5%, and the other with an annual charge of 1%. If you invested £10,000 in each:

• The fund with the lower annual charge would be worth £56,044 after 20 years
• The fund with the 1.5% annual charge would be worth £51,120 – or £4,924 less.

Keeping costs to an absolute minimum could mean thousands of pounds more added to the value of your investments over the long term. We can help you keep costs to a minimum by rebating part of the annual charges you pay on funds through our loyalty bonus service.

5. Not knowing your risk preference

It is interesting that many individuals do not consider risk as important as reward when creating their portfolios. If a stock gives you a return close to that of Treasury securities, it should be very close to the risk free rate of return associated with these securities. 

Your risk preference should be clear and understood; if you are a retired individual, purchasing and holding a risky portfolio, that determines all your possible consumption may not be the best idea. If you want a high rate of return, you should be aware that you are agreeing with the risk associated with this high expected return. 

There are also two phrases that all investors should know Ex Post and Ex Ante. The expected rate of return is ex ante meaning before the fact, whereas ex post means after the fact. When you are investing in assets you should be aware that very few if any are risk free and treat them accordingly. 

Ask yourself 'Can I really get a 10% return from this stock when the average rate of return in similar stocks is 3%?'. The only way to justify this higher expected rate of return is if you as an investor assumes considerably more risk than in vesting in the stock with the lower return. 

These are just five of the investment traps you could fall into. If you need any advice on other traps, just comment below. Let the conversation begin!!!!


Questions

1. What are some of the charges that you pay that reduce your overall earnings?

2. How have you reduced some of these fees/charges?