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Common Mistakes in Asset Management

Understanding the basics of asset management is a necessity to building personal wealth. Individual investors can make irrational and costly decisions that otherwise could have been avoided.  Too often, people are able to prudently save excess cash to invest, but having no experience or interest in making an educated decision, they end up making foolish mistakes.  Below is a list of the most common mistakes:

  1.  Holding too much cash.

The first mistake is remaining too risk averse and never building a portfolio at all.  While it is strongly recommended to create an emergency fund in addition to having liquidity available for expenditures, at some point you need to put your excess cash to work and begin asset management.  Prudent budgeting should help you determine how much to hold in reserve and when to look into assets with higher rates of return.

  1. Not having objectives.

It goes without saying that you need to have an objective with your targets, investment horizon, and risk profile.  There are many online tools to objectively evaluate what asset allocation is right for someone with a specific investment horizon.  Understand that the recommendations are just that and your own risk tolerance should alter your asset allocations too.  The output of all of these things should be an asset allocation plan throughout the investment horizon.  This simply means what types of investments (and how much) you should hold and at various times throughout the investment period.

Having an investment objective involves sticking to a plan that should help you reach your goals, so long as it is followed.  Set risk tolerances to levels that you are comfortable stomaching even during the toughest times.

The mind if not trained can fall victim to emotions.  It is natural to second guess decisions especially when the impacts of those decisions are so easily quantified.  Having a plan in place and making decisions to support the plan is the best way to avoid having doubts.  Always consider the overall objective and the investment plan and you can avoid making an irrational emotion-based counterproductive decision.  Just knowing the fact that you will succeed if you stick to your plan should eliminate any Monday-morning quarterbacking.

  1. Paying for free stuff.

You don’t buy bottle water when perfectly good tap water is available to you, right?  Well, maybe that’s another topic!  The same common sense advice to avoid paying for things you don’t need especially applies here.  Unfortunately, having no attention to detail and not familiarizing yourself with the alternatives can be costly.  Do your due diligence when considering your broker and individual investments.

With the commoditization of online brokerage, fees in general have really come down.  You should never have to pay any fees for opening or closing an account, market advice, account maintenance, tax forms, account summary mailings, etc.  Transaction fees should be small if not waived altogether.   For example, Vanguard does not charge transactions fees when you buy Vanguard funds.

  1. Paying exorbitant advisor or manager fees.

This advice could have fallen under the last point.  However in some circumstances it makes sense to follow professional guidance if some people cannot do so on their own.  Compare quotes for fee-only advisors and don’t let them charge over 1% of assets under management.  Asset management is a simple business with simple solutions.  Do the math to determine if really makes sense to invest in a service that has been so commoditized via technology.

When considering ETFs or mutual funds, look at the expense ratio for the fund and compare it to another fund with the same investment objective.  Make sure the fund has low asset turnover to avoid having to pay excess taxes.

  1. Investing with the wrong fund family.

As a general rule of thumb, instead of investing in a fund by any family, find and invest in the comparable Vanguard fund.  If Vanguard offers a specific type of fund, it usually is the best option among all fund families due to its dedication to being the low cost leader.  Further, with Vanguard being investor-owned, it does not have objectives to increase profits from its products and services like other fund families that are shareholder-owned.  Note that recently, Schwab has undercut Vanguard in multiple core ETF categories.

  1. Minimal portfolio diversification.

In asset management, make sure to diversify your portfolio with investments throughout the world, in developed and developing nations, with a mix of stocks, bonds, and other investment assets.  The purpose of diversification reduces the exposure to any single event.  Consider the example of the Enron employees who invested their entire retirement funds in Enron stock.  Not only did they lose their jobs, their retirement funds were wiped out.

The easiest and least costly way to do this is via ETFs and mutual funds that are indexed to broad categories such as Vanguard Total Stock Market Fund, or the Vanguard Emerging Market Fund

  1. Not rebalancing.

Assuming you made it this far, you have created a asset allocation plan that is diversified.  From year to year, some investments outperform others and left unchecked, the weights will drift away from the original asset allocation plan targets.  Periodically adjust your asset allocations to offset the deviations from your target weights. This is a way to surely sell high and buy low every time.  Recommendations for how frequently to rebalance vary, but you should probably due so once or twice a year.  Rebalancing more frequently than once quarterly would likely be burdensome and the costs could outweigh the benefits.

  1. Trading too much.

Following the disciplined approach of asset allocation and regular rebalancing is extremely boring.  In fact, investing is boring.  Having impatience with this process can give you the urge to want to trade to get to your goals quicker.  Maybe you are some kind of clairvoyant witch that knows what the market it going to do.  Quit fooling yourself.  If professional active managers cannot consistently outperform index funds, they why should you expect to do any better? Avoid the perils of market timing!

Trading can have unnecessary tax impacts too.  If you don’t hold a position for a full year, gains are taxed at your margin tax rate versus the lower long-term capital gains rate.

  1. Not considering tax implications. 

Take advantages of the tax code as much as you can.  Generally, it makes sense to maximize your 401-K contributions to lower your taxable income.  Think of it as a loan from the government that is not only interest-free; you can invest, earn income, and make capital gains from it.

Maximize your Roth IRA contributions.  These accounts have awesome tax advantages when you withdraw (no taxes).

  1. Picking individual stocks hastily. 

The rationale to pursue an individual stock requires a thorough evaluation of the hypothesis that the individual stock holds significant value at the current market price with a margin of safety. In addition, the investor knows at what price the margin of safety erodes and he or she should sell the stock (see Security Analysis by B. Graham and D. Dodd).

Investing in an individual company requires a lot of analysis and evaluation.  The typical investor may not have the patience or wherewithal to even do so.  If you cannot perform financial analysis and do your homework, you should stick with index funds.