The Top 10 Mistakes Investors Make While Trying To Build Wealth
Mistake #1 — Not understanding the difference between average returns and annualized returns.
Some advisors report “average” returns and others report “annualized” returns. It’s important to know the difference. The difference between the two is that annualized returns include compounding interest and average returns do not.
For example, if you invested $100,000.00 and the first year it goes down by -50 percent, you would have $50,000.00. If in the second year your investment goes up by 100 percent, you would be back to your original $100,000.00. The “annualized” return over this two year period is 0 percent. The “average” return would be 25 percent.
As you already know, you did not have a 25 percent return. You actually broke even after the two years or, in other words, had an “annualized” return of 0 percent ($100,000.00 -50% = $50,000.00 + 100% = $100,000.00), not an “average” return of 25 percent.
To calculate the average return, we would take the return of each of the two years and divide the total by two. That would give us an “average” return of 25 percent (-50% + 100% = 50%, divided by 2 = 25%).
As you can see, it’s important to understand if returns being reported by an advisor are “average” returns or “annualized” returns.
Annualized returns are what should be reported.
Mistake #2 — Not using a firm that provides a GIPS audit repot.
When it comes to performance, make sure that the portfolios you are looking at have been audited by a third-party professional, such as Global Investment performance (GIPS). Many money managers, financial advisors, stockbrokers, and planners claim consistent, superior performance, but do not provide independently-validated evidence of that performance. It’s always in your best interest to ask for a GIPS audit report. For more information about GIPS, visit their website at gipsstandards.org.[1]
Mistake #3 — Not understanding what the best long-term indicator of portfolio success is.
“The smaller a fund’s expense ratio, the better the results obtained by its stockholders.”
-William Sharpe, Nobel Laureate
“The expense ratio is the most proven predictor of future returns. That’s also what academics, fund companies, and, of course, Jack Bogle, find when they run the data.”
-Russel Kinnel, Director of Manager Research for Morningstar Research Services, LLC
“Historical stock market data has shown that fees are the only long-term reliable predictor of future fund returns.”
-Ayton, Cohen & Newall, “Persistence is futile: Chasing of past performance in repeated investment choices”
It is as true now as it has ever been. Cost matters. Costs likely played a significant role in your past investment success. They’re also expected to have the most reliable impact on future performance. That’s why we are vigilant about costs. We are consistently pursuing ways to help improve the probability of success for you and your family.
Mistake #4 — Not understanding where to find the hidden fees in investments.
The hidden fees of investing are found in the supplements to the prospectus called the Statement of Additional Information(SAI). In the SAI you will find details about the transaction costs and bid/ask spreads. There are studies that show investors what these undisclosed fees cost investors. Typically, these undisclosed fees will cost investors between 1-3% per year.
The bid/ask spreads are in addition to the fund’s management expense ratio (MER,) found in the fund’s prospectus. In most cases, the MER includes management fees, 12b-1 fees, and other expenses deducted from fund assets or charged to investors accounts (U.S. Securities and Exchange Commission 2000.) The average MER for active mutual funds is 1.35% per year, which together with an estimated trading cost of 1.50%, renders a total annual fund cost of 2.85% per year for the average active mutual fund.
Ken French of Dartmouth’s Tuck School of Business estimates that investors collectively spent $102 billion per year trying to achieve above-market rates of return.
To find the fees in the SAI, you have to read through the entire document, around 400 pages, to find the numbers, add them up yourself, and divide by the number of outstanding shares (found in the prospectus.) This is how you determine the cost per share. This allows you to compare the SAI costs to the “annual expense ratio.” This is a time-consuming process and is one of the reasons why people hire us instead of trying to analyze mutual funds for themselves.
To learn more about this topic you can get a copy of my e-book, Hide & Seek, How to find the hidden fees in your investments.
Mistake #5 — Not using a Fiduciary.
In the investment industry there are two types of standards advisors are held to — Either a Fiduciary Standard or a Suitability Standard. For example:
Fiduciary Standard:
“A fiduciary is a person or organization that acts on behalf of another person or persons, putting their client’s interests ahead of their own, with a duty to preserve good faith and trust. Being a fiduciary thus requires being bound both legally and ethically to act in the other’s best interests.”
Suitability Standard:
“Broker-dealers have to fulfill what is called a “suitability standard,” which is loosely defined as making recommendations that suit the interests of their client. Some broker-dealers feel this is unfair as it may affect their ability to sell investment vehicles that benefit their bottom line, but all a suitability obligation means is that the broker-dealer needs to believe that the decisions they make truly benefit their client.”
A closer look at these two definitions reveals that simply put, a Fiduciary Standard is a higher standard. Basically, it’s the view that the client’s interest comes first and it’s the only interest that matters.
Secret #6 — Not using an advisor that follows the Uniform Prudent Investor Act (UPIA).
The UPIA is a legal document that was published by the American Law Institute in 1992, which outlines what it means to be a prudent fiduciary. The UPIA sets the standard to diversify investments which can be done by utilizing a concept called Modern Portfolio Theory.
UPIA states that the fiduciary’s role is to manage risk and expected returns by developing and monitoring the trust portfolios. Modern Portfolio Theory is the idea that you should diversify, measure risk, and account for all costs. Not only are these the primary responsibilities of a fiduciary, but the great news is that there is an academic and scientific method, which if applied appropriately, can give you very good solutions and prudent reasons for making an investment decision.
Mistake #7 — Not understanding the different ways advisors are paid.
There are a few things you should know when it comes to compensation when comparing advisors. Technically, there are only three types of advisors.
1. Commission-based
2. Fee-based
3. Fee-only
Commission-based advisors make their living selling commission-based products.
Fee-based advisors try to get both commissions and fees. They charge a fee for a financial plan and then sell commission products to get a commission.
Both commission and fee-based advisors have their license held with what is called a broker-dealer. Also, they are typically not a fiduciary.
Fee-only advisors work on fees only, and earn no commissions at all. They derive their income from client-management fees, like an attorney
or a CPA. They don’t get any kickbacks for using any particular product or company.
This advisory fee appears directly on your statement and in some cases is tax deductible. With this compensation arrangement, you know that they are just as interested in your account growing as you are. As you do better, they do better. In most cases, a fee-only advisor can provide you with investments that cost less than the investments you might choose on your own, through a bank, brokerage house, or other advisors.
Mistake #8 — Not understanding Style Drift and how it effects investment performance.
Here is a short example of what style drift is. One of my favorite movies is “Escape from Alcatraz” with Clint Eastwood. I was very excited when I had the opportunity to go to San Francisco for a conference. I now had the chance to visit this historic prison and see where the movie was filmed. If on my flight to San Francisco, the captain had announced that he was going to change the direction of our flight and head to San Diego instead because he thought the weather was better there, I would have been upset. Surely you would have been too. What would have been worse is if the pilot had gone to San Diego without even telling me. In the investment world, we refer to this as style drift. It occurs when a fund manager—your pilot—is buying stocks for a fund and drifting away from what you thought he should be buying. This happens all the time with actively-managed mutual funds. It is like a pilot flying to a different destination without you knowing it. This is the power that active fund managers have over the accounts they are managing. They can change the destination or the stocks of the fund without you even knowing it. According to Investment News, style drift is a big problem with most consumer mutual funds.
A perfect example of style drift and overlap is if you were to own several different mutual funds and these mutual funds were buying many of the same stocks. Therefore, you may have a fund that has Small Company in its name, but actually owns Large Company stocks. The ordinary investor would think they are buying small stocks to better diversify, but they could actually be buying more of the same Large Company stocks. This increases their portfolio risk by owning more of the same market. This happens all the time. People don’t even realize that they are “putting all their eggs in one basket.” If people understood what they actually had, they could reduce their risk by properly diversifying among many capital markets.
Mistake #9 — Not understanding the 20% Tax Trap when rolling a 401(k) to an IRA.
If you or your beneficiary transfer your 401(k) the wrong way, you or they could end up paying 20 percent of your retirement account to taxes during this rollover process.
The mistake that can be made here is letting the employer write the check out to you or your beneficiary instead of the custodian of the IRA. If you or your beneficiary don’t roll over the entire amount, within 60 days, all of that money will be taxable. If you rollover your 401(k) the wrong way and 20% is withheld, the amount not rolled over is taxable, even subject to the 10 percent early-withdrawal penalty if they’re under 59½.
Instead, what needs to be done is a trustee-to-trustee transfer. Doing it this way, is the safest way to get the 401(k) money into the IRA. If your employer will not do a trustee-to-trustee transfer, the next best thing is to advise them on how to make the check out when they make the distribution. If it is done correctly, you can still avoid the 20 percent withholding.
Mistake #10 — Not calling me for a first appointment.
Over the last 25 years I have developed and refined a process I refer to as The Introduction To Prosperous Investing. It’s a four step approach that includes 20 must answer questions for peace of mind in retirement. Few people can successfully answer “yes” to all, or even a majority of these questions, the first time they see or hear them. My goal is to get you to the point where you can answer “yes” to every one of them. The answers to these questions are critical for your success.
This four step approach lays the groundwork for a prosperous investment strategy to meet your personal needs, your goals, and your vision, whatever that may be.
Best Regards
Mark K. Lund
Wealth Manager
Sources
1 Virginia Tech University and Boston College “Scale Effects in Mutual Fund Performance.” The role of Trading Cost” examined 1,706 U.S. stock funds from 1995 to 2005. Another study by Edelen, Evans, and Kadlec (2009), in a survey of 1,758 U.S. equity funds, found that trading costs were 144 bps.
2 Morningstar Principia dated 12/31/13 and DFA Return Software dated 12/31/2013
3 Barras, Laurent, Scailet, wermers, and Russ, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas” (May 2008). Robert H. Smith School Research Paper No. RHS 06-043 Available at SSRN: http://ssm.com/abstract=869748
4 http://www.investmentnews.com/article/20120715/REG/307159982#
5 Diversification does not guarantee a profit or guarantee against loss
6 IRS Publication 590, 2010
7 The 20 percent withholding tax requirement applies to rollovers from company plans to IRAs, but not to rollovers from IRAs.
