The saying You Don't Know What You Don't Know can be applied to many topics, especially personal finance. Investors managing their own finances or working with a financial advisor who isn't a full-time fiduciary may need to take extra steps to educate themselves about what not to do financially and investing pitfalls to avoid. Here are five common personal finance and investing mistakes and misconceptions.
Not understanding investment fees and advisor compensation
Cheaper doesn't always mean better. When it comes to financial and investment advice, the cheaper something is the more expensive it may be in the long run. There's no such thing as a free lunch: there's a cost to nearly every decision we make.
Whether you're working with a financial advisor or investing on your own, there's a fee associated with the investments you select, called an expense ratio. Fund expenses directly reduce your return, as do trading costs. Mutual funds may have different share classes with varying fee structures.
Retail investors not working with an advisor can actually end up paying more due to the share classes that are available to them which may also include sales loads. These sales loads can be 4% or more.
If a financial professional is offering a service for free or significantly discounted compared to their peers, that's an indication to dig a bit deeper. Perhaps the individual is being compensated by commission from selling you products or from 3rd parties or they could even be selling your data or personal information. Everyone has to make a living, so if you're not paying them - who is?
In contrast, fee-only financial advisors do not receive commissions or sell investment products. They're only paid by their clients, typically as a percentage of the assets they manage for the client. Many fee-only advisors are also registered investment advisors, the only type of financial advisor with a fiduciary duty to always act in their clients best interest, the highest standard of care under the law. Darrow Wealth Management is an independent, fee-only registered investment advisor.
At the end, it should be about more than the fees, but also the quality of the advice itself. Not seeking advice from a CERTIFIED FINANCIAL PLANNER™ professional only because of the cost may be short-sighted. It's also important to recognize that different fee arrangements can also mean different standards of "acceptable" advice and client care. A fiduciary duty is the highest standard of care under the law.
Forgetting to act after finalizing an estate plan
After working with an attorney to draft your estate plan and perhaps set up a revocable trust, most investors will need to update their beneficiary designations and/or retitle assets to actually put that plan into action. Otherwise, your assets won't flow as you intended or according to your estate plan or trust documents.
Once a trust is set up, it also needs to be funded in order for the assets to pass as directed. Typically, funding the trust by retitling assets in the name of the trust is outside the scope of standard attorney agreements. If you are working with a financial advisor, you will likely have the benefit of their oversight and assistance to help ensure this is done properly. If you're managing your own investments, you will want to make close attention to make sure you're doing this step properly.
One of the biggest mistakes investors make with trusts is forgetting to actually fund it and retitle assets in the name of the trust after it is set up. Forgetting to retitle your assets typically means they will be included in your probate estate instead of your trust. Another way individuals can inadvertently derail their estate plan is by making contradictory beneficiary designations.
Misjudging the cost of an annuity
Annuity salespeople have a great story to tell: the promise of lifetime income and market growth could calm even the most nervous investor. What isn't as clear to the investor is the cost of such a magical product. Annuities are very complex instruments with very technical fee structures and terms, making it nearly impossible for an individual investor to really understand what they're buying.
As this author points out, after reviewing his client's annuity fees he realized she was paying 4.4% in annual fees on a $1 million dollar annuity - and that doesn't include the 9.5% surrender charge she would be hit with if she tried to get out of the policy in the first year. Annuity commissions are very large (even 15%!) so the buyer should definitely beware.
Before locking your money up in an annuity, consider what alternatives can help you meet your goals. Building a diversified portfolio can help manage investment risk and can offer cash flow flexibility throughout your life. Further, depending on the type of annuity you choose, the balance may be forfeited at your death instead of left to your heirs.
Diversifying in all the wrong ways
The internet is a wealth of information - but it's not all good. Investors looking for personalized finance tips can't always discern the good advice from the bad. To clarify:
What diversification is: Diversification means allocating a percentage of your portfolio (including real assets) to different asset classes (e.g. equity (stocks), fixed income (bonds), cash, and real estate) to reduce investment volatility and risk of loss. Put another way: unless you can predict the future, you probably don't want to put all of your eggs in one basket or bet the farm on only one company.
What diversification isn't: Keeping cash at multiple banks or accounts with several financial institutions is not a prudent way to diversify. Though there are sometimes reasons to have accounts spread out, such as to stay within FDIC limits, in general it's best to simplify and consolidate your finances as much as possible to help ensure you know where you stand financially. All else equal, the institution itself does not offer diversification.
Working with multiple financial advisors is also generally not the best diversification strategy. Though an argument could be made that each professional is a specialist in their particular area of focus, this strategy can also create big gaps and holes in the oversight and management of your entire financial situation. Having more than one wealth advisor can also lead to multiple (and sometimes conflicting) opinions about the best course of action. This doesn't automatically mean anyone is wrong either - conflicts can simply arise from differing philosophies with each advisor trying to do what they feel is in the client's best interest. In any case, the investor may still need clarity and guidance about how to proceed.
Trying to time the market
Investors who try to 'beat' the market by timing when to buy and sell are faced with several difficult tasks:
- Trying to spot the market high in order to sell
- Identifying the floor to get back into the market after the predicted downturn
- Implementing steps 1 and 2 above with such precision and regularity that you earn a greater return, net of trading costs, taxes, dividend and interest income that was missed while waiting in cash
To effectively 'beat' the market, investors generally need to succeed on all three steps above to be successful.
It may come as a surprise that the best days in the market often happen very close to the worst days: between 1999 and 2018, 60% of the best 10 days for the S&P 500 occurred within 2 weeks of the 10 worst days. Investors who missed the 10 best days earned a total return of 2.01% over the 20-year period, -3.61% less than investors who stayed fully invested. Market timing is very difficult, even for professional money managers.
Managing your financial life can be complicated: laws change, strategies shift, and your situation will change as you move through life. If you've never done something before how do you know you're on the right track or going to get the best outcome? Not sure when it's worth it to work with a financial advisor? Read Kristin McKenna's article on the subject written for TheStreet.