3 Investment Extremes to Avoid in Any Market

Lloyd Litke | Apr 24, 2020

1.Over- or Under-Diversification

You likely know that diversification means investing in different asset classes like stocks, bonds, and cash to avoid large losses. Diversification can be a powerful tool, just be sure not to under or even over diversify your portfolio.

Under-Diversification

This refers to having excessive amounts of your funds invested in one stock or asset class. One common example is having a large concentration of company stock. Companies, especially tech startups, reward hard-working employees with stock awards like NQSOs, RSUs, ISOs, and Restricted Stock. This might seem like a good deal until the company stock severely declines or becomes worthless.

For example, Enron was considered to be a robust company back in the 1990s. Yet, it was discovered that they committed serious accounting fraud and its stock went to 0. This caused many employees to lose their retirement savings, which were heavily invested in Enron stock.

Over-Diversification

Wait, how can over-diversification be a bad thing?

Yes, you can be overdiversified, and this applies to mutual funds along with ETFs. For example, you might think you’re diversified by buying various large-cap, mid-cap blend, and small-cap mutual funds/ETFs. After all, diversifying by investment style (growth or value) vs. company size (market cap) might seem sufficient.

This is a common misconception. Instead, be sure that you have mutual funds or ETFs through various sectors such as consumer staples, real estate, and healthcare.

Over diversification also applies to single stock investments. Having 100 single stocks will make it harder to have significant gains. Sure, you’ll have less risk than if you just had 5 stocks, but the gains and losses from a large pool of different individual securities can cancel themselves out.

2.Jumping on Hot Fads or Stock Tips

Many investors who report significant investment losses fall prey to investing in any “hot” investment from start-up stocks to complex cryptocurrencies. Yet, the best investing minds like Warren Buffett conclude that simplicity is the key.

In fact, he made a bet with a prominent hedge fund manager that he could produce superior returns by investing in an S&P index fund. Mr. Buffett won this bet since his index fund investment increased by 126% over 10 years compared to the hedge fund’s 10 year gain of 36%.

Mr. Buffett is an extremely intelligent, world-renown investor. However, he doesn’t chase fads like high growth tech start-ups, cryptocurrency or anything he doesn’t understand. Instead, he invests in companies that are simple and straightforward like Coca Cola, Kraft Heinz, and General Motors.

He encourages investors to be wary of anything that sounds too good to be true like over convoluted ideas, “guaranteed” high returns, and random stock tips. If you really want to risk your capital with these “hot” investments, do your due diligence. Due diligence can include actions like researching fundamental ratios, learning about the sector and company team, along with inspecting financial statements, which can be done via Morningstar.

3.Buying Low and Selling High

Buying low and selling high is very common during severe market crashes. For example, many people have sold their investments and never re-entered the market. This has been seen during the 2008 crisis and the more recent COVID 19 crash.

It might seem scary to watch your portfolio drop by thousands or even tens of thousands of dollars per day. But, assess your asset allocation, risk tolerance, and time horizon for your goals. If your funds are meant for long term goals like retirement, refrain from premature selling.
Yet, if your investments are for more short term goals, consider allocating some funds to more secure investments like bonds and CDs. Be sure to speak to a competent, trustworthy financial advisor before making any sudden moves.

Dollar-Cost Averaging

Another strategy to avoid “market timing” along with buying high and selling low is to practice dollar-cost averaging. Dollar-cost averaging means that you buy the same dollar amount of the investment, regardless of its share price.

If you invest $100 per month into fund XYZ, you’ll buy 2 shares when the price is $50. If the share price decreases to $25, you’ll buy 4 shares. It might not seem like it, but falling markets can be a great opportunity for buying quality companies and funds at a discount. Doing this, could enhance your returns via asset appreciation or even compounding dividends.

Just be sure to throughout research the company and consult an advisor before investing in assets trading at a discount.

Key Takeaways

High fluctuations in public markets and stocks can make it easy to think irrationally and commit errors. It can be tough to keep calm and stick to your roadmap when media pundits act as if the sky is falling. But, the best course of action is to rise above the hype and block out the noise. Always consult with your advisor right away should you have concerns or worries regarding your portfolio.
Afraid you may be committing these mistakes or need a second opinion to avoid these perils? Schedule a free, no-hassle 30-minute consultation with one of our CFP pros today.

*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites to provide information on a topic that may be of interest. Copyright 2014-2020 Advisor Websites.

3 Investment Extremes to Avoid in Any Market