As a financial advisor, I routinely see how portfolios were put together before I stepped into the picture… and often see common mistakes repeated over and over in about 4-out-of-5 of the portfolios I review. Some of these really defy investing logic – by financial planning professionals, no less – because they have virtually no chance of working for the client.
So I wondered if these mis-investments were caused by skewed incentives such as fees or active portfolio management strategies, but am inclined to think that many of these were not deliberate screw-ups because financial advisors, by and large, are well-intentioned… so my guess is that they themselves weren’t really aware that they were executing some of these flawed strategies – but I don’t think that will console their clients any!
So I started compiling a list of these logic-defying investing goof-ups… and as I looked around to see whether other advisors also saw the same mistakes, I came across a rather relevant article titled “5 Dumbest Investing Bets” by Allan S. Roth who is a contributing writer to Financial Planning magazine – and plan to share these mistakes with you today.
So here are five flawed investment strategies that you should be aware of, and check to make sure they’re not part of your investment portfolio.
#1. INVESTING IN ALTERNATIVE FUNDS
Now, clients are always looking for a balanced portfolio and are happy diversifying their assets across some mix of stocks and bonds. Often times, clients put some money aside for higher returns… and understand that an advisor needs to take higher risk to get those higher returns… and that’s fair… but some advisors take this to the extreme and think that gives them carte blanche to literally gamble that money away – and invest in strategies such as managed futures and market neutral funds that are more likely to become money losers for their clients after all commissions and fees are paid. For example, market-neutral funds have an expected return of the risk-free rate, which is currently about 0.01% — close to zero, for all practical purposes – and a negative rate of return after you factor in fees and expenses.
In a related survey, only a third of all financial advisors said they understood alternative funds “very well”, yet nearly 90% invest their client’s monies in these funds… so it’s not like they’re deceiving you… it’s just that many of them simply do not understand the risk-reward tradeoffs on these alternative investments… so make sure you know how your money is invested and take a close look at anything that’s out of the ordinary.
# 2. BET ON BOTH SIDES
Another common strategy is betting against the market… this is done through securities such as exchange traded funds that promise inverse returns – so if the market is down 4%, these inverse securities gain 4%, and vice versa. Sometimes, these funds use leverage… and give you double or even triple the inverse returns to the market where a 4% dip in the market gives you an 8% or 12% gain.
Now, there’s nothing wrong with betting against the market per se but this strategy makes little sense if you’re also hold stocks for long-term gains… because then you’re betting against with inverse funds and for with core stock holdings… and these gains and losses essentially cancel out.
Sometimes, these strategies make sense if the market is expected to go down after a prolonger bull run, especially when you don’t want to sell some of your core holdings such as strong dividend stocks that provide investment income… but you then end up cutting into your returns because of the management fees associated with these double-edged strategies.
So as opposed to betting against the market, consider hedging your portfolio by increasing your cash allocation… which you can do by holding off on your monthly stock purchases if the market is too high and saving some dry powder for when shares come down to reasonable valuations… that way you don’t have to time the market and can just wait it out. And park your cash in an FDIC-insured deposit that gives you about a 1% return… which isn’t great but is better than earning nothing while you wait out market volatility.
#3. BORROW AT 4%, LEND AT 2%
Banks borrow low and lend high… in other words, they pay you say 1% on your deposits but charge you 4% or a lot more on loans – and that’s how they make money. But, often times, investors carry loans such as home mortgages at 4% or so and own bonds that pay no more than 2%, with taxes paid on interest income… so they are effectively borrowing high – the 4% mortgage loan – and lending low – the less than 2% after-tax interest they are earning on bonds – which are essentially loans made to others.
Of course, the interest on a home loan is tax-deductible so your effective rate is probably close to 3%, but the math still does not work in your favor and you’re paying more than you are receiving.
The logic of locking in a low interest mortgage, of course, is that when rates go up, it’s great to be locked in to a lower rate. But if rates go up, the bonds you hold will lose value because bond prices move in the opposite direction of interest rates. So if you have a mortgage, your actually better off breaking your low-interest bond investments and using the proceeds to pay off your mortgage.
# 4. IGNORING FEES
Now, I am a big fan of passive investing through Index funds because they tend to outperform most active fund managers. But not all Index funds are equal, and a high-cost index fund rarely beats a lower-cost fund. See, bigger is typically better because small funds need to use a host of derivative strategies to fully mimic the index’s performance, and that means more in fees and expenses.
For example, I know of one S&P 500 Index fund that has an expense ratio of 2.32%… which is 46 times the 0.05% expense ratio of bigger, lower cost S&P 500 Index funds.
That, of course, is an extreme example… but, in general, when it comes to index funds, you actually get more by paying less because larger, lower-cost funds tend to be far better at indexing.
But before you rush to make a switch, make sure you understand the tax consequences of moving to a lower-cost fund and don’t end up spending more to make the switch than the fee differential.
#5. LEAVE CASH UNINSURED
Make sure all your cash is in FDIC insured deposits… and open accounts in multiple banks to get this protection if you have to. See, I have several high net worth clients with tens of millions of dollars sitting in bank or brokerage accounts without proper insurance – that’s a risk that’s just not worth taking, especially when you can safely and transparently get millions of dollars in FDIC insurance by titling your accounts correctly. Moreover, make sure you earn close to 1% on these deposits because I know many banks offer that rate now – so use the Internet to look for the best rate.
So I want you to get smart about your money, and make sure your financial advisors interests are not contrary to yours. For example, advisors who get compensated based on a percentage of assets under management may not want to tell their clients to reduce those assets by paying down a mortgage or keeping cash outside the advisors’ custodian – but know… and exercise your rights in this matter – and look for a fiduciary who is legally required to place your financial well-being above his own financial interests. So go through your asset allocations, pay close attention to fees and expenses – and make sure you’re not a victim to the 5 points I spoke about today.