10 investment mistakes to avoid: common errors and what drives people to make them.

Common errors and what drives people to make them

Are you often enticed by intriguing "no money down, get rich quick" investment offers? Or, have you been the victim of a tricky investment scam? If you answered "yes" to either question, you're not alone. These days "investors frequently are swayed by impossible promises of great income at almost no money market risk," says Eileen Sanders, an analyst for Morningstar Inc. That's why the investment pros often say in a mantra-like tone: "There is no such thing as a free lunch."

A few years ago, such promises enticed many people to invest in short-term world income funds. But many investors didn't understand that these attractive yields depended on relatively stable European currencies. When the system regulating European exchange rates fell apart in late 1992, "those funds took a pummeling and many of them are still losing assets," says Sanders.

The key to successful investing is not to avoid risk altogether but to recognize the risks you are taking. To avoid unpleasant surprises, do your homework. Nothing beats reading the prospectuses and checking the longterm performances of your investments. "People rush into purchases even when they don't understand what they're buying," says Ronald W. Roge', a fee-only financial planner and president of R.W. Roge' & Co. in Centereach, N.Y. "People do more research when they buy a refrigerator or a VCR than when they invest thousands in stock."

The sad fact is that individual investors make the same errors over and over. But don't be dismayed. Even as a novice investor you can improve your odds dramatically just by avoiding the following common mistakes.

1 Chasing numbers. Don't be so dazzled by a stock's statistical data that you don't properly analyze the numbers. If you buy a stock with a low price-earning ratio, make sure you understand what forces have pushed it down. In this bull market, there are few if any unrecognized bargains. "It could be a good deal, but it's probably not," Roge' says. Check it out before you buy it.

Similarly, if a stock boasts a lofty dividend, there's a reason. "Higher yields indicate that Wall Street feels the stock is high risk, particularly in being able to sustain yield," says Charles Carlson, editor of Dow Theory Forecasts.

2 Joining the new issue frenzy. The most promising new issues are reserved for large, preferred customers such as mutual funds or other large institutional investors. If you're offered a brand new stock for your portfolio, be wary. The brutal truth, says Carlson, is that "if a broker calls you, pitching a new issue, it's pretty safe to say it's merchandise that has been picked over already."

3 Coming late to the party. Generally you should avoid buying a stock that's already had a big run-up in value, unless you have a solid reason for expecting it to keep rising. Particularly vulnerable are stocks that have received a great deal of recent media exposure. Prices of highly publicized stocks may have reached their peak and be poised for a correction. Roge' advises waiting at least a month after such exposure before making any buys. "It's difficult, but you have to rein yourself in," he says.

4 Keeping a portfolio of individual stocks when you lack the time and expertise to monitor them. If you own just a handful of individual stocks, you're taking on two kinds of risk. One is the overall market risk (systemic risk) and the other is the risk associated with a particular stock and the underlying company (unsystemic risk).

Regardless of the dollar amount in your portfolio, making good stock picks requires keeping track of individual companies, their industries and overall economic trends. Before investing, ask yourself whether you have the time and expertise to do that on your own. If not, check out alternatives. An investment club allows a group of individuals to share their research. Or, you can invest based on the recommendations of a trusted financial adviser. (But make sure you've checked out his or her track record, references and possible conflicts of interest!) The easiest way is to follow the lead of most small investors: Confine your equity ownership to mutual funds, leaving the headache of individual stock picking to their managers.

But don't get lazy. All investors should devote some time to researching and monitoring their funds. Avoid surprises by reading your funds' prospectuses and other documentation. For example, many high-yield junk bond funds boosted returns in 1993 by investing in debt from developing countries like Argentina and Mexico. An investor who tracks only a fund's returns wouldn't necessarily know about the change in the portfolio's holdings or the increased risk it entails.

Beware of funds where top management has changed recently. A new manager may signal a change in investment philosophy. If the departing manager was responsible for the fund's stellar performance in the past, the trend won't necessarily continue.

Many investors fall into the trap of judging a fund by its name, rather than by what it actually owns, says Sanders. While the Kidder Peabody Equity Income Fund may sound like a conservative equity income fund, it's really a growth fund that lost money in 1992 and barely gained 2% in 1993. Sanders' advice: "Look at the performance. Look at the actual portfolio."

5 Failure to diversify. Back when IBM was one of the most successful and stable companies in the U.S., many investors, particularly IBM employees, didn't think twice about loading their portfolios with shares of Big Blue. They learned a painful and expensive lesson: Even the best company can hit hard times. When IBM's corporate performance faltered, the stock price fell sharply and the dividend was cut in half. Many employees and retirees saw both their equity and income plummet.

If your portfolio leans heavily toward a single stock or industry, you definitely should discuss diversification with your financial advisers. If you own a handful of mutual funds, don't assume that you're diversified. Review the funds' holdings. For example, if your portfolio is heavily weighted toward the health industry, then a health industry downturn could cripple you.

6 Investing without a plan. Sit down with your financial advisers and formulate a savings and investment plan, taking into consideration your long-term financial goals and your level of risk tolerance. Without a financial blueprint, it's difficult to recognize the investments that match up with your goals in terms of risk, diversification and income.

A key part of your plan should be to set aside an amount of money for savings and investments each month.

Otherwise, "people tend to invest on an impulse," says Paul Richard, vice president and director of education for the National Center for Financial Education in San Diego. "They find $1,000, stick it in a mutual fund. Then the next month, someone talks them into buying a car or taking a trip and they wind up not investing anything."

With interest rates low, even the most conservative investors are reluctantly increasing their level of risk tolerance. If you can't bring yourself to follow suit, be aware that you'll need to either modify your goals or stash away significantly more current income.

Whatever your financial profile, it's key for you to understand the level of risk of any potential investment. One litmus test is to take a look at the investment's performance in the fourth quarter of 1987. Consider that a worst-case scenario and ask yourself if you could handle it. If not, maybe it isn't the right choice for you.

7 Basing decisions on tax concerns You need to consider the tax consequences of your investments, but don't let the tail wag the dog. Don't buy municipal bonds, for example, just because they're tax-free. Their return may not be better than the after-tax return of a higher-yielding option. Tax-free investments, like all others, must fit into your overall investment strategy.

Concentrating on tax issues can blind you to bigger problems. Roge' was worried when he discovered that a new client's $800,000 portfolio was 70% invested in the stock of her late husband's employer. "It was a decent stock and it was paying a dividend of about 4% a year," he recalls. "But as a financial adviser with fiduciary responsibility, I had to advise her to diversify." The client demurred. She didn't want to pay the capital gains tax that would be triggered by a stock sale. Only after seeing IBM's stock price fall did she change her mind. To lessen the tax hit, she is spreading the sale over three years with a goal of reducing the stock to 10% of her portfolio.

8 Using life insurance as a savings/investment vehicle. In the past, the rule of thumb was to avoid mixing life insurance and investments. Financial planners advised forgoing expensive whole life policies in favor of cheap term insurance and investing the price difference elsewhere. These days, however, it's not that simple. Whole life and other policies with a savings and investment component can make financial sense, mainly because of the tax benefits. But this is a complex subject that you should review carefully with your financial advisers and accountants.

9 Failure to understand the costs of your investments. When you're salivating over the prospect of substantial returns, it's easy to overlook the costs. But you shouldn't, because they vary widely and can be substantial. Sales commissions on annuities, for example, range as high as 7.5%. The commission on some life insurance products may be as much as a year's premiums. Watch out for mutual funds with back-end loads. These funds do not charge a commission when you buy, but you will be liable for a hefty fee if you sell the fund within a certain amount of time, usually four years.

10 Avoiding the stock market altogether. All this talk of risk may make you nervous. But resist the temptation to bury your head in the sand and stash your money in the bank. You may think you're playing it safe but you're not. You're letting inflation gnaw at your savings. Roge' explains: "People who have no tolerance for risk in the stock market are taking an alternative risk - a loss in purchasing power."

PATIENCE AND PRUDENCE PAY OFF

After the stock market crash of '87, Eric Robinson got a tip from a reliable broker. Shearson Lehman was planning to buy another power brokerage house, E.F. Hutton, and the price of shares in E.F. Hutton were way down.

The broker believed the merger would be a good deal for shareholders. So, Robinson bought 300 shares at $13. Indeed, the stock price rose steadily, reaching $27 a share in 14 weeks, a nice value play for the novice investor.

But then Robinson made a common financial blunder: Instead of sitting on the stock, he cashed out. He took the money and reinvested it in six different puts and calls, a risky deal for even the savviest investor.

Stock options give you the right to sell or buy securities at a predetermined price and date. An option to buy is a call, in which the investor anticipates the stock price will rise. The right to sell is a put, where the stock price is expected to drop. By the expiration dates on the options, the stocks had done the reverse of what Robinson hoped; he lost what he'd won, nearly $10,000.

Robinson, a 32-year-old partner at a New York executive search firm, Bruce Robinson Associates, realizes now he should have steered clear of puts and calls. A hard rule every new investor must learn is never act on a whim. "I really didn't know what I was getting into," he says. "Just as quickly as I earned the money, I lost all of it."

DIVERSIFY TO GROW YOUR PORTFOLIO

Like many folks, Juanita Copeland was forced to do crisis financial planning when a tragedy struck. Six years ago, the former registered nurse was seriously injured in an accident that left her partially paralyzed. At age 54, she was forced into early retirement because of her disability.

"I had a neophyte account with Merrill Lynch," she recalls, "but I never developed a financial plan or worked with an adviser." That meant Copeland had to do some serious work to catch up.

The problem: The bulk of her $80,000 portfolio was a unit investment trust (UIT). While the UIT (which consisted of municipal bonds) was a nice tax shelter, the bonds it held were being called (redeemed before maturity) because of declining interest rates. Plus, she had a fixed-income-oriented portfolio when she was already making a good living - more than the average household income of $30,000. What she really needed was some growth investments.

"My portfolio is much more diversified now," says Copeland, who reinvested her money in a host of investments: municipal bonds, international and domestic mutual funds and several individual stocks, including Vanguard Cellular Systems and Ford. Better yet, her annual return on investments overall has increased 20%.