Investing can be simple if you buy a broad market index fund and never touch it for decades. But many people read about all the latest investing tips and make frequent tweaks to their portfolio. Doing this exposes you to the possibly of making investing mistakes that could have dire consequences. Here are a few common investment misunderstandings that could cost you money.
Bond funds versus bonds. Buying a bond fund is very different from buying individual bonds. Bond funds invest in a collection of bonds, buying and selling them and charging you a fee in the process. Unlike stocks, bond prices change in relation to yields in other types of safe investments like treasuries. This means that when a bond fund sells bonds it holds and rolls the money over to new bonds, the price of your bond fund will change with relation to yield changes. If you simply buy a bond, you are looking at getting the same yield for the whole duration of the bond plus the principle that you put in it at maturity. With the exception of default, individual bonds will always increase in nominal value while the value of your bond fund can decrease in times when yields rise.
Outperforming indexes is difficult. Some people believe beating index funds isn't possible, citing the fact that most mutual fund managers underperform, taxes eat away at your gains, and transaction costs. But beating the index is not impossible, it’s simply difficult. I recommend index funds because beating the index takes insight and research that is sure to take time and add stress to your life. When I was actively investing my own portfolio it was more than a part-time job. Is it really worth the time? I say no. Stick to an index fund, and instead focus your energy on trying to make more money. For most people, this is a much better and surer way to accumulate wealth.
Tax rates vary for different investments. Investments can have very different tax treatments. Long and short-term capital gains, dividends, and other investments are all taxed at different rates. You could be paying Uncle Sam much more than is necessary if you don't hold the investments with higher taxes in retirement accounts and low-tax investments in your taxable accounts. You could save yourself a significant amount of money without changing your overall asset allocation by keeping investments taxed at regular income tax rates in your 401(k) and investments taxed at lower rates in taxable accounts.
Taxes do matter. Many active investors will tell you that taxes don't matter, and for some frequent traders this can be true. But for most people, timing the market is just a recipe for disaster. Without the discipline to buy and sell that's backed by research, most people are just guessing at when they should make their investments. With that type of investing style, there really is no advantage to selling your investments now or a year from now, so why not sell your investments when they are taxed at a lower, long-term capital gains tax rate? For most people, trying to take advantage of long-term capital gains tax rates is a sure thing and timing the market amounts to a flip of a coin.
David Ning runs MoneyNing, a personal finance site aimed at helping others change their habits for a better financial future. He suggests that everyone to sign up for an online savings account to get more out of our hard earned money.