How do mistakes happen with such a straightforward, set-and-forget investment strategy?
We are all liable to unconscious bias. We are just as irrational as the market itself. Being aware of the 7 mistakes below is the first step in avoiding them.
Let’s dive in.
1. Home bias
A common problem is that passive investors choose an index fund that is not globally diversified. They will convince themselves that a little bit of home bias is ok.
That means in the US, the VTSAX is deemed acceptable because, though it is mainly US stocks, these US companies have global exposure. In the UK, Vanguard’s Lifestrategy funds are incredibly popular despite their obvious UK weighting.
Why do we do this? There are three main reasons.
Generally, everyone loves the country they live in. We have been indoctrinated since birth to do so. We therefore convince ourselves that we should support our country with our dollars.
Secondly, it might also be that we simply understand our own country better than others, which makes us more comfortable with investing our wealth into it.
Thirdly, historically speaking, a little bit of home bias has been the correct call. The US stock market has performed tremendously over recent years. But that is no guarantee of future returns.
The US might not perform as well as other countries over the next decades – it’s impossible to say.
Global diversification is your friend. It helps defend against volatility and is the smart move.
2. Panic in recessions
You might think you’re ready to see your portfolio value cut in half. But it’s hard to know exactly how you will react when you see that big red negative number staring back at you.
When you sign up for passive investing, you are accepting that some years will be good, some years will be bad, but that generally, the market will go up.
But new passive investors will convince themselves it won’t happen to them. And if it does, it’ll be small and short.
“I didn’t think the leopard would eat MY face” says the person who voted for the ‘leopards eating people’s faces’ party.
Dread it, run from it, it will happen to you. Make sure you’re psychologically prepared. It might be years of falling investment value. Until you’ve experienced it, it’s difficult to know how you will react.
“Everyone is a genius in a bull market” – Mark Cuban
After a few months of recession, investors begin convincing themselves the stock market just isn’t going to recover or grow as it has in the past. Humans have a bias towards buying high and selling low.
It’s often said the best investors are dead. So, act as a dead person would in turbulent times, and don’t panic sell in times of difficulty.
Trust the process.
3. Not understanding the time horizon
Time is your friend in passive index fund investing. Hopefully, you’re aware that this is the longest of long-term plays. The time horizon is measured in decades, rather than years.
But your investment time horizon is probably much longer than you think.
You might default to an investment time horizon of about 30 years. That would mean you start investing at 20 and aim to be “done” at 50.
But even this is a relatively short time horizon!
The great billionaire investor Warren Buffett made 99.7% of his wealth after the age of 52.
Warren Buffett isn’t the best investor in the world. His actual annual returns are not groundbreaking. It is his longevity in the game which has built his wealth.
The longer you are in the game, the more time compounding has to take effect. That is what has built Buffett’s wealth.
You shouldn’t really be in the game for only 20-30 years. The best results come from much longer time horizons.
4. Timing their entry point
Waiting until ‘the time is right’ can be extremely costly. Two common perspectives are:
- “The market is on a bull run and stocks are at an all-time high. I don’t want to buy at the top, so I’ll wait for a ‘crash’.”
When the market is on a bull run, there is nothing stopping it going up higher. Identifying the ‘top’ of the market is impossible.
In fact, three out of four years, or three quarters of the time, the market is going up. By waiting, you are betting the smaller position of 25%, that the market will go down. Do you want to risk missing out on all that growth?
- “The market is down and we’re heading into a recession. I don’t want to lose money. I’ll wait for the economy to recover.”
Great! Stocks are on sale. Buy low and sell high is good advice, and it applies here. As passive investors, we should be praying for recessions. This is the time when we get more stocks for our money. So, when the market does go up, we will get higher returns.
Do not time the market, invest as soon as you capable of doing so.
That goes for dollar cost averaging, too. I am of the opinion that spreading out your investment to ostensibly reduce your risk is just another form of market timing.
By spreading out, or ‘delaying’ your investment, you might miss out on the majority of the growth. When you come to the end of your DCA period, there’s nothing stopping the market having a crash and leaving you much worse off.
Say it with me now:
“Time in the market beats timing the market”.
5. Choosing the wrong platform (or worse, their bank)
Don’t be fooled by fancy advertising, app features, or introductory offers. The only things that truly matter are:
- Access to the index fund(s) that you need.
- Low fees.
You might want to consider secondary factors such as what the customer service looks like & what the company standards for. But this is much less important.
Make sure you pick one of the established investment service providers, such as Vanguard or Fidelity. They offer the widest range of funds for selection, typically at the lowest cost.
Do not use your bank for convenience. Your bank likely has a limited selection of investment options (with a hefty fee attached), whereas the above providers offer whole-market selection.
Do not use the app you saw advertised on YouTube. You’re likely bankrolling their huge advertising budgets by paying their extortionate fees.
6. Forgetting their retirement accounts/pension.
You might diligently choose the funds for investments that you can access any time (before retirement age), but many forget about their pension.
Your workplace pension (UK) or 401k (US) are often invested in the default fund or target retirement fund (which automatically rebalances the closer you get to retirement age).
These funds may not be aggressive or diverse enough. If it’s an option, you can and should match the investment choices of your non-retirement accounts.
These retirement accounts are by default your longest of long-term investments, as you cannot access them before around 55-58 depending on the country. If you get set up these accounts correctly, it can put you on the path to wealth.
The important thing is to make sure you know at the very least what you’re invested in, because you can probably do a lot better.
7. Not staying open minded
This goes against everything that is preached about passive investing. You are told to pick a fund and stick with it for decades, no matter what. This is good advice as, if nothing else, it helps to stop panic selling in the bad years.
But the reality is, the world is constantly changing. Better investment options may open up in the future.
It might be minor improvements, such as a lower fee on an alternative investment provider. It might be a completely new investment vehicle to explore.
Remember, index funds did not exist until 1975. You would have had to be brave to take a leap from the old ways back then. There’s a chance the next ‘index fund’ could come along in the next 50 years; financial innovations are happening all the time.
I cannot see index funds every falling out of favor, and I am extremely confident I’ll be using them in some form over my entire lifetime. But I’ll never be shut off to new ideas. Keep an open mind.
The biggest mistake of all
Thinking that an expert active investor will do a better job for you, and paying them a hefty fee to boot.
If you are already passive investing, then you’ve made a great decision.
If you are not, learn about how you can get started with passive investing with our beginners guide.