After two straight calendar years of strong equity market returns, some individual investors may not only be tempted to get back into the market, but they also may be feeling that they can do it all themselves. While it is only human nature to get swept up in the momentum of a good thing, it is important to consider all of the risks of a go-it-alone approach. Studies have shown that individual investors tend to significantly lag the returns of the overall market, generally due to a few common mistakes.
Failing to lay out a sound long-term strategy, creating a less than fully diversified portfolio, chasing the hot stock, mutual fund or asset class, and not understanding all types of investment risk can all lead to an underperforming investment portfolio.
Setting a long-term investment strategy involves quantifying a level of risk that is acceptable for the investor. From there, the investor must decide how assets (stocks, bonds and cash) should be allocated within the portfolio. Without this important set of parameters, short-term market movements can substantially deteriorate the value of the portfolio during extreme circumstances.
Similarly, holding too few securities within the portfolio may lead to drastic underperformance. While an individual security may have very strong prospects based upon the fundamentals, there are always unforeseen factors that can lead to severe underperformance. A diversified portfolio has little exposure to this type of security-specific risk.
The trailing returns of a security are very often not indicative of future returns. For instance, the strong performance of high-yield bonds over the past two years coincided with a narrowing of the yield spread between corporate and government bonds. With treasury yields now on the rise, it is not likely that we will continue to see these strong returns persist within this asset class. Without knowing the relationship between high-yield returns and the level of credit spreads, an individual investor may simply rely on recent returns in order to make an investment decision.
While there are always opportunities to be had in the markets, individual investors need to keep in mind that there is an entire industry full of experienced professionals devoted to exploiting these opportunities. There are also a multitude of risks that are at play at any one time in the markets, and each asset class has its own set of investment risks that need to be considered. Going it alone may seem like a low-cost way of getting great returns, but over the long-term this strategy has left many individuals earning less than the market.
For more information, contact Pat Fisher at firstname.lastname@example.org or (412) 697-5301.
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