Statement No. 3: "I just hired a great new broker, and I'm sure to beat the market."
Misconception: Actively managed investments do better than passively managed investments.
Explanation: Actively managed portfolios tend to underperform the market for several reasons. Here are three important ones:
Instead of hiring a broker who, because of the way the business is structured, may make decisions that aren't in your best interests, hire a fee-only financial planner. These planners don't make any money off of your investment decisions; they only receive an hourly fee for their expert advice. (To learn more, Understanding Dishonest Broker Tactics and Words From The Wise On Active Management.)
What an experienced investor would say: "Now that I've hired a fee-only financial planner, my net worth will increase since I'll have an unbiased professional helping me make sound investment decisions."
Statement No. 4: "My investments are well-diversified because I own a mutual fund that tracks the S&P 500."
Misconception: Investing in a lot of stocks makes you well-diversified.
Explanation: This isn't a bad start - owning shares of 500 stocks is better than owning just a few stocks. However, to have a truly diversified portfolio, you'll want to branch out into other asset classes, like bonds, treasuries, money market funds, international stock mutual funds or exchange traded funds (ETF). Since the S&P 500 stocks are all large-cap stocks, you can diversify even further and potentially boost your overall returns by investing in a small-cap index fund or ETF. Owning a mutual fund that holds several stocks helps diversify the stock portion of a portfolio, but owning securities in several asset classes helps diversify the complete portfolio. (To get started, read Diversification Beyond Equities and Diversification: It's All About (Asset) Class.)
What an experienced investor would say: "I've diversified the stock component of my portfolio by buying an index fund that tracks the S&P 500, but that's just one component of my portfolio."
Statement No. 5: "I made $1,000 in the stock market today."
Misconception: You make money when your investments go up in value and you lose money when they go down.
Explanation: If your gain is only on paper, you haven't gained any money. Nothing is set in stone until you actually sell. That's yet another reason why you don't need to worry too much about cyclical declines in the stock market - if you hang onto your investments, there's a very good chance that they'll go up in value. And if you're a long-term investor, you'll have plenty of good opportunities over the years to sell at a profit. Better yet, if current tax law remains unchanged, you'll be taxed at a lower rate on the gains from your long-term investments, allowing you to keep more of your profit. Portfolio values fluctuate constantly but gains and losses are not realized until you act upon the fluctuations.
What an experienced investor would say: "The value of my portfolio went up $1,000 today - I guess it was a good day in the market, but it doesn't really affect me since I'm not selling anytime soon."
These misconceptions are so widespread that even your smartest friends and acquaintances are likely to reference at least one of them from time to time. They may even tell you you're wrong if you try to correct them. Of course, in the end, the most important thing when it comes to your investments isn't looking or sounding smart, but actually being smart. Avoid making the mistakes described in these five verbal blunders and you'll be on the right path to higher returns.
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