As a financial advisor I'm frequently asked: "Why should I pay someone to manage my investments?"
You may think an advisor should find "the next hot investment." Increasingly, though, I've come to believe the real value is in helping clients avoid painful, crippling, "WHAT-was-I-thinking?" mistakes. One of my mentors says it best: "Sometimes you need to save yourself from yourself."
Investors are human. Our short-term emotions can influence decisions that are not in the best long-run interest of our portfolios. A good financial advisor will help you detect and manage that emotional component -- and potentially avoid actions that cost both heartache and money over the long haul. Here are five of the most common mistakes I've seen investors make:
1. Not gauging the proper level of risk for your stage in life. The classic example is an investor who "makes it" -- accumulates enough assets for a comfortable retirement -- yet sticks with unnecessarily risky investments that could create a game-changing decline in portfolio values. Conversely, younger folks, who should be aggressive fighting inflation and preparing for longevity, often are too conservative with their asset allocation. In this case, even if they save plenty, they will lack the purchasing power growth to show for it.
2. Failure to analyze risk. This mistake occurs when you don't consider the full range of factors that determine your risk tolerance. My colleague Larry Swedroe at the BAM Alliance has developed an excellent framework to think about a person's ability, willingness, and need to take on risk. Ability is based on time horizon; willingness measures how much volatility you can stomach; need refers to the level of return required to meet spending goals. Ideally, a portfolio incorporates all three factors while seeking the least amount of risk necessary for sufficient growth.
3. Ignoring the math of losing money. Quick test. You have an investment that drops 50 percent. How much must it then gain? The answer may surprise you: it's 100 percent, just to break even. Now imagine an investment drops 80 percent; you'll need a whopping 400 percent gain just to get back to where you started. Daydreaming about cashing in on the next hot IPO is fun, but before you commit hard-earned money, do your homework and determine if you have the resources (and stomach) to endure the worst-case scenario.
4. Over-investing (yep, like over-eating). It is possible to get financial indigestion! This happens when you invest money needed for maintaining your base standard of living in the near term. Your physical health depends on a diet with the right mix of proteins, fats and carbs. Your financial health relies on the proper balance of stocks, bonds, and cash. If you're overcommitted to stocks and bonds in a volatile market, you could find yourself cash strapped and financially undernourished in your day-to-day life.
5. Relying on polysyllabic advice. You probably have a neighbor, colleague, friend or relative who is fluent in Fancy-Money-Speak. Their extreme eloquence indicates good financial sense, right? Not necessarily. Familiarity with knotty investment jargon isn't the same thing as understanding how to construct a logical portfolio. If an investment idea can't be explained to you in plain English, be skeptical. Truly solid investment advice should be comprehensible to a sixth grader.
To answer the original question -- succumbing to any one of these five pitfalls can cost you far more than the 1 percent per year many financial advisors charge for their work. Whether you invest on your own or with professional, help keep these five common mistakes in mind to increase your financial well-being.
[This post originally appeared at MoneyZen.com. Photo credit Louis Leray]. For more MoneyZen in your life, follow Manisha on Twitter at @ManishaThakor, on Facebook at /ManishaThakor, or sign up to receive Manisha's MoneyZen blog via email by clicking here.