(This is the third part of a three part series. The first two parts were published in our last two newsletters.)
Your behavior as an investor is the single largest determinant of your long-term investment return.* In our last two newsletters we discussed several common mistakes that investors make - greed, panic, overdiversification, underdiversification, speculating, and letting cost basis control your investment decisions.This final installment will conclude with two additional mistakes you should avoid if you want to increase your chances of achieving investment success.
Focusing on Yield Instead of Total Return
Investment returns are the result of two things: capital gains and yield. A capital gain occurs when an investment appreciates in price, and yield refers to the dividends and interest paid by an investment.Investors tend to shift their portfolios toward higher yielding securities and away from stocks as they approach retirement, but focusing on yield can be problematic since investments with high yields - like CDs and bonds - historically have not kept up with inflation over long time periods.
According to TIAA-CREF, a couple aged 65 has a 50% chance that one of them will be alive in 30 years. That’s a long time and a lot of inflation! Instead of focusing solely on “yield” investors living off of portfolio income would be better served focusing on “total return” and making sure they have a plan to keep up with – or outpace – inflation.
Buying on Margin (Using Leverage)
Investing on margin is similar to buying a home. Investors borrow money from their broker to purchase more of a security than they could afford to purchase without using borrowed funds for a portion of the total purchase.The problem with margin is that it’s a double-edged sword. Buying stocks on margin is great when prices go up because it magnifies your return. But, when stocks go down, your losses are magnified as well!
The use of margin can get out of hand not only during long bull markets - like the one we experienced in the late ‘90s - but also during volatile markets like we’ve experienced over the past several months.
In a bull market, the mistake investors make is believing that stocks only appreciate. Trying to increase your return using margin during long bull markets can lead to large losses when the market eventually turns around. In a volatile market, investors trying to earn huge returns on the next upward swing can be wiped out completely if a downturn comes first.
*A study conducted by Dalbar found that investors captured less than 40% of the actual market return during the 20-year time period that ended 12/31/2007. This is a phenomenon that has been repeated over and over with surprising regularity!
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