This article is an excerpt from the Shortform book guide to "The Simple Path to Wealth" by JL Collins. Shortform has the world's best summaries and analyses of books you should be reading.
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Are you considering getting into investing? What are the most common investing mistakes beginner investors tend to make?
In his book The Simple Path to Wealth, blogger and financial expert J. L. Collins warns new investors of four pitfalls they should know about before investing their hard-earned money. These include financial advisors, winning stocks, dollar-cost averaging, and common investment cons/scams.
In this article, we’ll look at four pitfalls investors should beware of, starting with financial advisors.
1) Financial Advisors
Financial advisors include money managers, investment managers, brokers, and insurance salespeople (who sometimes masquerade as financial planners).
- Managing other people’s money is extremely profitable. Financial advisors profit from people’s insecurities by making investing seem complicated and intimidating.
- Although most advisors promise to get better results by actively managing mutual funds, they don’t. Simple index funds perform better and cost less.
- Financial advisors are costly at best and ripoffs at worst.
How Advisors Earn Their Money
Advisors earn their money in three basic ways, which influence the advice they give to clients.
An advisor gets paid a commission, also known as a load, whenever you buy or sell an investment. For example, major loads are charged for American Funds, but no loads are charged to buy Vanguard funds.
In addition, some funds charge a yearly 1% management fee for the advisors who sell the funds. Because they’re actively managed, these funds carry a high expense ratio and typically underperform low-cost index funds.
Advisors are motivated to put their interests ahead of client interests and push the investments that pay high commissions and management fees. For example, insurance investments such as annuities and whole or universal life pay advisors some of the highest commissions, therefore advisors aggressively recommend them.
The commissions and fees you pay an advisor are typically hidden so you don’t notice them. Further, advisors can make more money by buying and selling investments in your accounts (“churning”) to generate commissions. This is illegal although it can be justified as adjusting your asset allocations.
2. The “Assets Under Management” (AUM) Model
The second way financial advisors make money is by charging flat management fees, usually 1-2% of your total assets. While this is presented as more “professional” than the commission model, this undercuts the growth of your nest egg and, later, your income in retirement. Your advisor is basically skimming your investment returns, which could have earned you more when you reinvested them.
For example, if you had a nest egg of $100,000, and you invested it for 20 years for a return of 11.9% a year:
- You’d end up with $947,549.
- Factoring in a 2% management fee, your return would be 9.9% a year and after 20 years, you’d have $660,623—which is $286,926 less.
- In addition, you’d have given up the interest that $286,926 could have earned, compounded over 20 years.
Under the AUM model, your advisor’s personal interests can still influence her advice. For example, if you want to withdraw money for a child’s education, she may advise against it because her annual fee will decrease.
3. Hourly Fees
Many advisors shun this model because it generates less money for them than commissions and fees. When advisors charge an hourly rate, clients are more time-conscious because they have to write a check for each visit, and therefore are less willing to spend time with their advisor. In contrast, clients don’t notice commissions and fees as much. Still, advisors may charge as much as $200 to $300 an hour.
Paying an hourly rate is the most transparent way to buy financial advice—however, you still have to determine whether the advice is in your best interest.
Some advisors use a combination of these payment methods, making it even more difficult for the client to understand what she’s paying. Rather than trying to find the rare good advisor, you’re much better off going with an index fund that costs you less and returns more.
2) Attempts to Pick Winning Stocks
Besides costly advisors, another pitfall for investors to beware of is the temptation to try to pick winning stocks, or to believe an analyst who says he can.
Analysts study industry sectors and companies to try to predict stock performance. But their predictions aren’t typically accurate because they’re based on companies’ own internal performance forecasts (sales predictions), which are guesses. Further, these guesses are often inflated by managers and CEOs so they look better for Wall Street.
No one can make accurate predictions and pick winning stocks from reading company reports and analyses. Nor can you do so by reading books on valuing stocks like The Intelligent Investor, which was written by Warren Buffett’s mentor in 1949, when there weren’t many managed mutual funds available (so if you wanted to invest, you had to pick stocks). If you’re interested in stocks analysis, the book is worth reading, but it won’t teach you how to consistently beat the market.
(Shortform note: Read our summary of The Intelligent Investor by Benjamin Graham here.)
Buffett is one of a handful of rare exceptions—believing you can be like him is like believing you can learn to box like Muhammad Ali. Anyway, Buffett recommends low-cost index funds for individual investors.
3) Dollar-Cost Averaging
The third most common investing mistake is failing to take full advantage of a windfall. People who find themselves with a lump sum to invest due to something like an inheritance or real estate sale often handle it too timidly. Investing it all at once seems intimidating or risky, so advisors often recommend dollar-cost averaging or DCA. Under this strategy, you invest the money in chunks over time, so that if the market tanks, you haven’t lost your whole sum. But Collins opposes DCA for several reasons.
Dollar-cost averaging does work for a sustained downturn, but the market is more likely to rise than fall. From 1970 to 2013, it rose 33 out of 43 years, or 77% of the time. With DCA, if the market rises, you’ll miss out on gains and you’ll pay more to buy shares with each chunk you invest.
Other downsides of DCA are:
- You’re basically trying to time the market, which (as explained previously) is a losing strategy.
- DCA interferes with asset allocation—you’ve allocated money to the sidelines where it’s not doing anything for you (a poor allocation strategy).
Instead, do the same thing with a lump sum of money as you do with your earnings:
- In the wealth accumulation phase, put your money in stocks as soon as you get it, so it’s growing for as long as possible.
- In the wealth preservation phase, invest your lump sum in stocks and bonds, according to the asset allocation plan you have in place.
Dollar-cost averaging isn’t the worst thing you can do, but by doing it, you’ll be letting your feelings drive your investment decisions rather than adjusting your mindset so you can make good investment choices.
If you want to avoid being conned, you must understand the following rules:
1) Anyone—even you—can be conned. When you think it can’t happen to you, you make yourself an ideal target. People who think they’re too smart to be fooled are the easiest to con.
2) You’re most vulnerable to a con in the area of your expertise. Con artists look for people who are likely to find the scam appealing—typically those who feel knowledgeable and confident due to ego and let down their guard. For example, many of the victims of financier and marketer Bernie Madoff’s massive Ponzi scheme were financial professionals.
3) It’s difficult to spot a con artist. They don’t look shifty; they look honest, trustworthy, and reassuring. You’ll be more inclined to welcome them than to run from them.
4) Most of what a con artist says is true. The most effective lies are buried in truth or hidden in the fine print.
5) There’s never a free lunch. As your mother warned you, if it looks too good to be true, it is.
Some cons are laughably obvious, like the Nigerian stranger’s offer of millions if you’ll help with a money transfer. Most people can spot these. The pitch that snares you will be more subtle.
Here’s an example of a common investment scam:
- You receive a letter or email from an investment advisor, which offers a stock tip.
- You watch the stock for a few days and, indeed, it spikes. You could have made money on it had you invested days ago.
- Then you get a second letter, this time with a tip about a stock that’s about to fall. The letter recommends that you “short-sell” the stock (a tactic of borrowing, selling, and re-buying a stock on a bet its price will decline).
- You watch what happens and the stock drops. Again, you could have profited.
- You get additional letters making predictions that come true (maybe you try one and benefit).
- Then you get an invitation to an exclusive dinner (just for you and a few other “executive-level investors”) to meet the advisor and learn about his proprietary metrics.
- You attend the dinner, which features a vague presentation but impressive charts. The advisor has a few spots left in an investment pool (if you hurry).
Here’s how the scam works. The con artist chooses a volatile stock and sends out 1,000 letters; half predict the stock will rise and half predict it will fall. The half of recipients who got the correct prediction, then get letter #2, and so on, until the con artist ends up with 15 people who received six accurate predictions and are eager to give him their money under false pretenses.
One good way to avoid cons of all kinds is to maintain a simple portfolio of index funds so your money grows without you having to do anything.
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Here's what you'll find in our full The Simple Path to Wealth summary :
- A simple road map to achieving financial independence and a secure retirement
- How to put your money to work for you as your “servant”
- Why you don't need a financial advisor to help you invest