The Six Biggest Money Mistakes [And How To Avoid Them]
Our exclusive survey identifies six common errors that could cost your family $250,000 in the long run. New Year's resolution No. 1: Stop making them
(MONEY Magazine) – Buy what you know. It's one of the great axioms of investing. And so Mitchell Marks did. Over the five years that the organizational psychologist worked for a unit of Marsh & McLennan, he accumulated 10,000 shares of the insurance broker's stock. After he left Marsh in 1993, the stock continued to outpace his other investments, and Marks never sold, even as the shares grew to account for 20% of his portfolio's value. "I knew this company," he says. Then came the thunderbolt. New York State attorney general Eliot Spitzer filed a lawsuit against Marsh on Oct. 14, alleging that its main insurance business engaged in payoffs and bid rigging. The stock collapsed. Marks lost $200,000 in three days.
Marks for years had told himself he was right to put his faith and his money in a company he believed in, even though he knew prudent financial planning suggested that he diversify. It's so easy to talk yourself down similar wrong paths. Ever jump into a hot stock or mutual fund because it seemed like a smart way to boost your returns? Or swear that you're really going to start ramping up your saving—next year? Or, like Marks, have you ever bulked up on your company's stock because you believed in it? If you've never done any of these things, then by all means stop reading here. You're a perfect manager of your money, and you don't need this story. But if you answered yes at least once, then it's time to stop and take stock of what you might be doing wrong. And then make sure you don't repeat any of those mistakes in 2005.
Actually, there are six errors in particular that you should concentrate on, because they're the ones most likely to cost you in the long run. How do we know? We asked. Joining with Merrill Lynch Investment Managers, we surveyed readers like you, as well as 1,000 other investors and more than 300 financial advisers, probing to identify what mistakes people are most likely to make and why. We then asked Burton Malkiel, author of A Random Walk Down Wall Street, and his colleagues at the Bendheim Center for Finance at Princeton University, to calculate how much these errors actually cost the average MONEY family. The results: We make, on average, two or three big mistakes over the years that could drain an estimated $250,000 or more out of our nest eggs by the time we reach retirement. (For more on the math, see "How to Keep a Million" on page 101.)
There's nothing particularly esoteric about any of these errors. Most of them originate in ordinary, understandable human tendencies—ones you're as likely to find described in Aesop's fables as in Graham and Dodd's Security Analysis. That doesn't necessarily make them easy to avoid, but it does mean you don't have to be a Wall Street genius to correct them. And as Michael Sivy points out in "Build the Goofproof Portfolio," which follows this story, once you stop shooting yourself in the foot, you've eliminated the single biggest obstacle between you and your investment goals.
You can dig deeper into the MONEY/MLIM Survey of Americans and Their Money Mistakes by going to hindsight2insight.com. In the meantime, read on, and if you're guilty of any of these mistakes, put yourself on the road to fixing them. Even if it's the last thing you do for your money in 2004, it might just be the best.
1. Not saving enough It's one of the most frequently made New Year's resolutions: I'm going to save some serious money. No wonder. Nearly half of those who took the MONEY/MLIM survey confessed that they had waited too long to start saving and investing, and more than a third said that when they did, they didn't put enough away. "Our survey results are a wake-up call to people in their twenties and thirties: Get going," says Robert Doll, president and chief investment officer of Merrill Lynch Investment Managers.
Certainly there's opportunity. The 2001 tax law cleared the way for Americans to sock more in their 401(k)s each year through 2006—for 2005, the limit goes up to $14,000 per account holder (plus an additional $4,000 if you're 50 or over). IRA contribution limits also go up in 2005, to a maximum $4,000 (this year the $500 catch-up provision for those 50 or over remains the same). Unfortunately, most households don't come near to maxing out. The average personal savings rate is now less than 2% of income, and the average household has a net worth of just $264,000 at retirement, not including home equity. That's not going to get you very far. How come we're not doing better? Many of us still have it burned into our brains that stocks will deliver the 18% annualized returns of the '80s and '90s. So deep down, we figure we can start later and save less.
That was Talib Horne's attitude. When he started working for an educational services company in 1993, the stock market was riding high, and Horne figured he had plenty of time. He moved in with his mom and used his $25,000 salary to live it up without saving a dime. He bought a silver Mitsubishi Eclipse and vacationed in Cancún and Vegas. As his salary climbed, he moved into an apartment of his own but saved little. By age 30, he was making $45,000 but putting just 3% of his pay into his 401(k) and earning only half the matching dollars that his company offered. "My priorities were mixed up," admits Horne, now 33 and the director of the East Harbor Community Development Corp. in Baltimore. He has since mended his ways but estimates that he left $51,000 on the table by not maxing out during all those years. If he had let that money ride to age 65, he could have had an extra $600,000 if his investment returned 8% a year. Ouch.
GET IT RIGHT Between your retirement plan at work, your IRAs and fully taxable investments, you should be putting aside at least 10% of your gross income—15% if you're over 50. Anything less and you're kidding yourself. And the sooner you start, the better. Assuming an 8% return, every dollar put away at age 30 is worth more at retirement than $3 saved at age 50.
If you're not anywhere near those savings targets, resolve to start somewhere in 2005. Begin with, say, 3% of your income. Then raise that figure by a percentage point on specific dates, like next Fourth of July and then the following Christmas. (Some employers offer a service that automatically ups your 401(k) contributions at certain intervals; if yours has it, sign up.) Or resolve right now to put half of your next raise or year-end bonus into savings. Then do it.
2. Taking too much (or too little) risk A 40-year-old whose portfolio is in fixed income and cash is playing it too safe. A 60-year-old with the vast majority of his assets in aggressive growth stocks is playing with fire. That's what Greg Choban was doing, but he didn't realize it. He felt like nothing could possibly go wrong.
Back in March 2001, Choban, then 57, a former Army lieutenant colonel, retired as an information technology consultant. He and his wife Nancy had amassed a $750,000 portfolio that, along with his army pension, they figured would support them in style. The Austin couple spent the first year of retirement traveling, and Choban bought and restored a Shelby Cobra convertible. "I told my broker the only thing that could ruin my retirement was if we had a big crash in the stock market and I was to lose 20%, 25%, 30% of my holdings," recalls Choban. The broker's response: Can't happen. But with the Chobans' racy mix of assets—77% in equities and 30% of that in tech stocks—it could and did. By mid-2002, the Chobans' portfolio was down to $500,000. A financial planner rebalanced their holdings, putting 57% in fixed income, the rest in conservative stocks. Still, Choban has gone back to work for now, and he's selling his favorite toy, worth $35,000. "It's a waste of time to cry over all that spilt milk," he says, sounding Army through and through. "You just have to move forward and try to rebuild."
GET IT RIGHT To prevent the kind of mistake the Chobans made, you need to hold a mix of stocks (or stock funds), bonds (or bond funds) and cash that's neither too daring nor too conservative for a person with your goals at your stage of life. Choosing that asset allocation may be the most important investment decision you'll make for 2005, so don't hesitate to seek advice. Many professional financial planners will help you set up a portfolio for an hourly fee. For example, the fee-only planners in the Garrett Planning Network (garrettplanningnetwork.com) will work with you on an hourly basis or charge you by the plan. Expect to pay $1,000 to $2,000.
If you'd rather do it yourself, log on to money.com/tools, click on Asset Allocator, and use the Fix Your Mix calculator developed by MONEY senior editor Walter Updegrave. It requires only that you answer a few simple questions about your investing time frame and your appetite for risk, and then it tells you how to allocate to better your chances of reaching your goals without taking on undue risk. If you already have an asset mix that makes sense for you, remember that market movements will favor one kind of asset over another and, in time, they will push things out of balance. So be sure to reset the mix periodically and rebalance as necessary.
3. Overconcentration Taking too much risk often goes hand in hand with another big mistake: putting all our eggs in one basket. We tend to invest too much of our money in the stocks of our employers, the industry we work in or the company with a big operation close to our homes. We feel safer, and we figure that concentrating our investing in what we "know" gives us a better shot at striking it rich. Ironically, financial planners had warned Mitchell Marks—mentioned at the beginning of the story—that he had too much of his portfolio in Marsh & McLennan stock. But Marks decided he knew the company, and he knew better. "That investment was very good to me," he says. Until, of course, it wasn't, and his stake was nearly halved.
GET IT RIGHT To avoid the same fate, never hold more than 10% of your money in a single stock or mutual fund that holds only a small number of stocks, no matter how sure of it you think you are. Lower the ceiling to 5% for investments in your own or related industries. Don't load up on biotech, for example, if you work for a drug company. Instead, consider the stocks of oil companies, manufacturers and financial services firms, whose fates are entirely independent of the pharma trade.
4. Chasing what's hot We see our friends, colleagues and, worst of all, brothers-in-law making a bundle on a stock or a mutual fund, and we start to wonder why we should plod along with merely average investments. That's what Anera Shell thought. The Cincinnati C.P.A. had an IRA worth about $20,000 in the late '90s. She invested it in an assortment of mutual funds, where it grew too slowly for her liking. So on a bit of a whim, she put the entire balance into the stock of Yahoo. "At the time it was a pretty strong stock," she recalls today. "It had a lot of upside potential." Shell's $20,000 grew to $40,000. Then she decided to use the money in the account not for retirement but to help her husband, the crew chief for a professional race-car driver, buy a partnership interest in his team. Yahoo, of course, tanked, falling by more than half from December 1999 to September 2000. And the money left wasn't enough to make payments on the loan Shell and her husband took out to buy into the team. Eventually they needed to sell property to repay the loan, and Shell, now 35, figures she's out about $50,000 in total.
GET IT RIGHT Daily newspapers and financial magazines will soon begin the ritual of listing the top-performing stocks and mutual funds of 2004. Your first impulse may be to plow your money into the names at the top. Don't. Many studies on the subject show that last year's top performers tend to be laggards within a few years. And you never know when the fall will start. Take a cue from a far wiser Shell: "I am much less willing to listen to the hype."
5. Raiding retirement accounts Nearly half of all retirement plan participants who change jobs fail to roll over their accounts, according to Hewitt Associates. They take the dough instead, incurring unnecessary taxes and penalties for doing so. And another 25% have outstanding loans or have taken withdrawals on the job. What gives? Part of the answer lies in how itinerant the U.S. work force has become. The average worker changes jobs more than 10 times over a career, so the 401(k) balance from a single job often doesn't look like much. It's tough to envision that $5,000 or $10,000 might be worth $25,000 or $50,000 at retirement. But hey, it might make a nice down payment for a car right now.
Or better yet, a house. That's what John McGlade thought, anyway. He was 38 and working as an adjuster with Reliance Insurance outside Philadelphia in the late 1980s. He had racked up a 401(k) balance of $18,000. At the time, McGlade recalls, he was trying to buy his first house. So he emptied the account to pay his closing costs, forking over taxes and penalties to Uncle Sam. "I didn't even need all of it," he says. "And it really set me back. It was one of those things where you don't realize until 15 years later how important it was to keep the money in there." Total damage, assuming McGlade would have made 8% a year on that money, had it remained invested until retirement: about $144,000.
GET IT RIGHT The key to managing retirement assets is convincing yourself they are absolutely hands-off. If you need cash in a crunch, think about tapping a home-equity line of credit (or better yet, deferring that new-car purchase into 2006). And when you leave a job, pick up a rollover kit (nearly every broker has one). If you're too busy to bother with a rollover, and you have more than $5,000 in your previous employer's plan, leave the money where it is.
6. Overtrading and ignoring expenses Trading stocks is easy and fun, right? But frequent traders earn less than buy-and-hold investors, and they have dramatically higher costs, as Patrick James learned the hard way. A cardiovascular technician from Shreveport, La., James was bitten by the online-trading bug but good in 1999. He opened an online brokerage account with TD Waterhouse and started trading at least three times a week, sometimes more. Looking back at his records recently, James, 51, found instances when he swapped in and out of the same stock five times in two days. "Whenever I was sitting around the house, I was at the computer," he recalls. At $12 a pop, the transactions seemed cheap. And he was making money, at first. By the end of 2001, though, he was down $16,000 on his stocks and had shelled out nearly $10,000 in commissions. "It really depressed me to see how much I'd spent," he says today.
GET IT RIGHT The most frenetic traders earn only 69% of the market's return, according to Harrison Hong of the Bendheim Center, so if you invest in individual stocks, trade infrequently. If you're a fund investor, seek out portfolios with expenses that run below 1% of assets. You'll find the expense ratio listed in the first few pages of the fund's prospectus, or you can scan expenses for the entire fund universe using the mutual fund screener at money.com. Why bother? According to Hong, your best chance of owning an equity fund that lands in the top 25% of performers over the long run is to buy one that has expenses in the bottom 25%.
James, after realizing how much he's frittered away on commissions, has made his own resolution—to invest exclusively in index funds that have rock-bottom expenses. "The balance in my 401(k) is now creeping up fairly quickly," he says. "And I'm not spending money on trading—so I'm not just getting ahead, I'm staying ahead."
How to Keep a Million
Mathematically speaking, retiring with $1 million is no great feat. Say you start at age 30, make $50,000 a year and get a 3% annual raise. If you put aside 7% of your salary, raise that gradually to 10% and earn 8% a year on your investments, you'll hit $1,042,189 by age 65.
Between the arithmetic and the reality, however, lie limitless opportunities to mess up. We asked Harrison Hong of the Bendheim Center for Finance to quantify how the six biggest money mistakes might affect the million-dollar scenario above. The numbers below assume you make the same mistake year after year. In reality, says Hong, you wouldn't—but you also might make two or three different mistakes over the years. Hong estimates that for the typical MONEY family, the real cost of those errors adds up to $250,000 to $300,000.
NOTES: 1. Savings rate remains fixed at 7%. 2. Household invested in a risk-free money-market fund rather than the equity markets. 3, 4. Households that fail to diversify or that chase hot stocks underperform the market by approximately the same amount. Performance chasers were assumed to continually purchase the prior year's top-performing stocks. 5. Individual cashes out of 401(k) after 15 years with a balance of $120,000.