Top mistakes investors make - Part 2

Last month I highlighted two of the top mistakes I've seen investors make. This month we continue with two more common missteps.

Trying to know the unknowable.
In investing, as in other aspects of life, there are things we know, and there are things that are essentially unknown. In my opinion, many investors, both professional and do-it-yourselfers, waste entirely too much attention on what is unknown.

What is unknowable in investing? Tomorrow's market direction. Who will win the next election. When interest rates will go up or down. Where the market will end up at the end of the year. How fast the economy will grow this year.

These are questions that would be very interesting to know the answers to in advance. But we can't. They are unknowable. Yet this is where most investment commentary and energy are directed. This unknowable nature of future events is a big hang-up for many investors. It is difficult to let go of what is unknowable and instead focus on what is known.

What is known? In a word, data. Fortunately, for investors there is a lot of data to explore. A good place to start is the leading economic indicators. For one such series, go to www.conference-board.org. Other interesting indicators include data focused on employment conditions, new orders being placed for manufactured goods, new construction starts and corporate earnings. All of this, and more, is available free thanks to the internet.

Besides the data, there is another known quantity that is less reliable. Opinions. Every day in the media and on the internet you will find well-known personalities telling viewers that this or that will happen. There are enough opinions being projected that it is easy to find one that fits your own biases (we are all biased to some degree in our financial thinking). These opinions are "known" but, from my perspective, are not important. They will change as quickly as the wind changes direction. You cannot frame your investment decisions around others’ opinions.

Having too much or too little cash on hand.
It is often difficult for investors to determine how much cash they ought to keep in reserve of their investment accounts. In general, during optimistic periods when market conditions have been favorable for some time, investors keep very little cash reserves, preferring to have their funds invested. Conversely, when the market environment is challenging and investors have recently suffered losses, cash reserves are generally higher.

Of course, this is another example of market timing. In my experience, investors often get this timing exactly wrong. They are raising cash when prices are low, and putting that cash to work at a later point - when prices are higher!

In the aftermath of the Great Recession of 2007-09, it was common for me to see extraordinarily high levels of cash reserves among investors. Much of this cash was raised in the midst of the sell-off in the stock market as investors feared that prices would continue to fall and they would be left with little or nothing if they didn't "go to cash" even if that meant selling investments at a significant loss.

In 2017, now that the market has spent eight years recovering and is again at all-time highs, I see cash levels coming down. The cash that was raised, at tremendous opportunity cost in 2008-09, is finally being put back in the market at significantly higher prices.

I believe a mathematical approach is better than an emotional approach in determining an adequate and logical level of cash reserves. There are many methods used to solve the issue, and most of them are common-sense based. My own guideline for clients who are retired, for example, is to have an amount equal to two to three years of income that they draw from investment accounts.

I base this guideline on my research of historical bear markets and their impact on balanced portfolios. A bear market is one where the overall stock market is down by over 20 percent, and there have been four such bear markets in the modern era. These bear markets saw a balanced portfolio (equal parts U.S. stocks and U.S. Treasuries) lose an average of 18.45 percent, and it took on average of 30 months for the portfolio to recover to its previous high-water mark.

Drawing from a portfolio during one of these bear market episodes can vastly change its potential longevity. In other words, it increases the possibility of running out of principal. A better strategy would be to draw from cash reserves until markets can stabilize and recover.

Jonathan Lokken, CIMA, is managing principal of Lokken Investment Group LLC in Lewes. He has been professionally managing client investments since 1997. For more information, go to www.lokkeninvest.com or call 302-645-6650.

Disclaimer: The foregoing content reflects the opinions of Lokken Investment Group LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Past performance is not a guarantee of future results. All investing involves risk. Asset allocation and diversification does not ensure a profit or protect against a loss.