The 10 biggest investment pitfalls (and how to avoid them)

Jennifer Hill gets the inside track from the stock market experts
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The Independent Online

Any savvy investor knows the basic principle of investment: buy low, sell high. However, investors often ignore this rule, as they get swept up in prevailing market sentiment. When markets storm ahead, they invest as they don't want to miss out on further gains. Conversely, when markets falter, they head for the exit for fear of making further losses.

Waiting for markets to turn the corner could mean you'll miss the boat. Britain has experienced four recessions since the Second World War, and on each occasion markets rallied strongly the year after: up 142 per cent in 1975, 29 per cent in 1982, 20.7 per cent in 1991 and 45.9 per cent in 2009.

Here, we ask the experts to share 10 big investment mistakes. Avoid these, and your portfolio will thank you...

1. buying high, selling low

In 2000-01, the peak of the stock market, investors pumped £5.86bn into retail funds, according to the Investment Management Association. The FTSE 100 bottomed in March 2003, but there were still five years of negative sales to come. In 2004-05, investors took a net £1.19bn off the table. The picture was similar during the most recent crash. On 3 March 2009, the UK's blue-chip index fell to 3,512. During 2008-09, the market low, investors sold £305m of investment fund holdings. Those who gave in to their fear lost out on a sterling rally.

2. Trying to time markets

Investors' habit of mistiming markets costs them more than 1 percentage point a year in returns, according to an academic paper from Cass Business School. The research, compiled using performance and sales data figures from 1992 to 2009 and commissioned by Barclays Wealth, shows that market timing decisions by retail investors in mutual funds have reduced their returns by an average of 20 percentage points over an 18-year period.

Andrew Clare, professor of asset management at Cass, says: "Over the 18 years covered by our study, a buy and hold strategy would have turned an initial investment of £100 into £311, but poor market timing meant that for the average UK retail investor it was only worth £255."

3. following the trend

The most obvious example of investors following the herd is the technology boom of the late 1990s.

"At that time, sensible investment strategies went out of the window and even pensioners relying on their investments for income were selling corporate bond funds and moving into technology, not wanting to miss out on the easy money," says Patrick Connolly, an independent financial adviser at AWD Chase de Vere.

"This trait has been repeated many times: property became very popular in 2006 following a return of 26 per cent, but soon there was a queue at the exit door after the sector lost 15 per cent in 2007 and 30 per cent in 2008."

The moral is: if an investment hits a record high, view it as a warning sign, not a reason to buy.

4. holding off

Many investors wait till the last minute before using their ISA allowance, but by using it earlier in the tax year, you could be £6,361 better off over the longer term, according to Fidelity International. This amount was calculated using the growth in the FTSE All-Share index over a 15-year period. Investors choosing a more actively managed fund could have made an extra £22,039.

5. ignoring costs

Investors ignore costs at their peril. Buying through a fund supermarket can save up to 5.5 per cent in initial charges. That equates to £587.40 for this year's £10,680 ISA subscription. Over 10 years, you could boost your investment returns by £1,051, assuming investment growth of 6 per cent, says Hargreaves Lansdown.

6. paying too much tax

Not holding investments in an ISA means you are subject to tax on income and gains. "Some banks, asset managers and stockbrokers would have you believe that an ISA is more expensive than simply holding a share or unit trust," says Danny Cox at Hargreaves. "[But] most fund supermarkets charge the same for ISAs as for taxable investments, meaning the tax benefits are free."

Non- and basic-rate taxpayers should shelter their investments as much as higher-rate payers. Non-taxpayers are subject to capital gains tax at 18 per cent on the growth of their investments, once this exceeds £10,600, unless they are held in ISAs.

Basic-rate taxpayers save 20 per cent income tax on cash and fixed interest investments in ISAs. Furthermore, after age 65, those with taxable income between £24,000 and £28,930 start to lose their age-related allowance at the rate of £1 for every £2 of taxable income – an effective tax rate of 30 per cent, says Cox. However, ISA income is free from further tax and doesn't count towards this means-tested benefit.

7. having a home bias

Most investors have too high a proportion of their assets invested in their own country and too little in rapidly growing overseas markets. British investors have 3.5 per cent of their assets in emerging markets, 10 percentage points less than their weighting in the MSCI Global Equity index, says Tom Stevenson, investment director at Fidelity International. By contrast, they have 49.8 per cent in UK assets – about 40 percentage points more than the "correct" weighting.

8. not reinvesting dividends

The reinvestment of dividends is one of the most important determinants of total returns over time. Figures from Barclays Capital's Equity Gilt Study 2011 show that £100 invested in the UK stock market in 1899 would have grown to be worth £12,665 in capital terms, but to £1.7m with the benefit of reinvested dividends. "This is the power of compound interest at work," says Stevenson.

9. confusing tolerance with capacity

An investor's risk tolerance is a measure of their temperamental willingness to take on risk, while their risk capacity is their ability to recover losses if they incur them.

Stevenson told The Independent: "A 35-year-old has a higher risk capacity than a 55-year-old because if the market falls 20 per cent they would not need to increase their annual return by very much to get back on track.

"For the older investor, a fall of this magnitude close to retirement may be difficult to claw back. Unrelated to their risk capacity, either investor may or may not have a high risk tolerance."

If you're young, with plenty of time to recover from adverse market moves, focus on the assets with the best long-term performance record: equities. Nearer retirement, when you can't afford heavy losses, hedge your bets by spreading your money between different asset classes.

10.losing your balance

Maintaining the balance of lower- and higher-risk assets is important, so that the actual risk you're taking doesn't get out of kilter with your tolerance to risk. Rebalancing brings a dual benefit: it reduces volatility and is likely to produce a better return.

A balanced portfolio of funds chosen 10 years ago would have generated 15 per cent more profit, if it had been rebalanced to the original proportions each year, than one that had been left untouched, says Skandia. Rebalancing controlled the volatility of the portfolio, too, with the rebalanced investment experiencing volatility of 11.6 per cent – the lowest of four scenarios examined. Some fund supermarket platforms offer automatic rebalancing. Investors can do it manually by switching funds or asking their financial adviser to do so.