Do you feel like you need to have "extra" money before saving for retirement? Or that you'd rather invest in specific companies instead of broad index funds? Those are just two common mistakes that young people make when they start thinking about putting money into the stock market. Here are six common errors, and how to avoid them:
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Getting excited about single stocks. When J.D. Roth, the Portland-based blogger behind popular personal finance site getrichslowly.org, started investing, he put a year's worth of Roth IRA contributions—about $3,500—in Sharper Image stock. A friend who worked at electronics and gadgets store The Sharper Image had recently mentioned that he invested in the company himself, which made Roth think the shares were undervalued. Unfortunately, that was in 2007, shortly before The Sharper Image filed for bankruptcy.
Investing in your favorite company may seem more glamorous than putting money into an index fund that reflects a broad segment of the market, but it's a far riskier choice, since single companies can suddenly go under or plunge in value. Aside from being diversified, index funds carry the added benefit of having low fees since they're passively managed, which means they don't rely on a person to research and select stocks. Today, Roth puts his money in index funds, including bond, stock, and real estate funds.
Thinking investing is for rich people. Waiting until you have "extra" money to invest probably means you'll be waiting forever. Instead, consider starting by contributing small amounts to your retirement account and slowly raising the percentage over time. The benefit of starting early is big: If you put $1,000 into an account that earns a 5 percent annual return when you're 20, you'll have about $26,500 by your 40th birthday. If you wait until age 30 to begin contributing, you'll have just $16,289.
Forgetting to check up on expenses. Expenses can take a big chunk out of your investment return. But fees vary widely, typically from 0.1 to 2 percent of your total investment on an annual basis. Think tank RAND calculates that even just 1 percentage point difference in annual fees adds up to $3,380 after 10 years on a $20,000 account balance. But most of us pay up without even realizing it, perhaps because the fee details are often hard to find. (They should be in each fund's prospectus; ask the fund company directly if it's not clear.) RAND found that when people were presented with various fund options, including one that clearly came with the lowest fees, only half selected that lowest-fee fund. One in 3 people inexplicably selected the fund with the highest fees. (All of the funds exhibited equivalent returns.)
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And that's another reason to invest in index funds instead of more tailored mutual funds: Because fees automatically reduce investor returns, they are a primary reason research suggests that passively managed index funds perform better for investors than do actively managed mutual funds.
Keeping close track of the market's highs and lows. If your investment portfolio is well diversified and you check in on it once every few months to see if it needs to be rebalanced, there's no need to follow daily fluctuations. Instead of keeping an eye on the cable news channels, which can make every dip feel like a crash, focus on your hobbies, relationships, and other sources of stability. If you still feel anxious about the market's movements, maybe your investments are too risky and you'd be better off putting a greater percentage of your portfolio into relatively safe (and lower yielding) money market funds.
Forgetting to diversify. Diversification—in market sectors, industries, and specific companies—reduces your chances of losing everything. One of the easiest ways to do that while investing in the stock market is through index funds, which mirror a specific market index such as the S&P 500. Most of the victims of the Bernie Madoff scam suffered particularly bad fates because they entrusted their entire nest eggs to a man who turned out to be orchestrating a Ponzi scheme (in which old investors are paid from new investors' money, not from any actual earnings).