Common Investing Mistakes
By John Owens CFP®, EA, ECA, CPWA® + The BKFi Planning Team
There are two really amazing parts of my role here at Brooklyn Fi - one being that I get to work alongside some incredibly talented folks who have some amazing perspective to share, and the other that we all get to interact routinely with amazing clients and prospective clients.
We’ve all, over the course of our careers, interacted with hundreds, if not thousands of folks to learn more about their financial planning and investing goals; dissected their current strategies, and helped them optimize their strategy going forward.
So I decided to gather up the BKFi planning brain trust and pose this question: what are the most common investing mistakes you’ve run into during your professional career?
My Precious Portfolio: Why Letting Go Is Harder Than You Think
Imagine your investment portfolio as a dragon's hoard of gold, with you as the fiery beast perched atop, basking in the glow of your amassed wealth. But there’s a twist: among your glittering treasure lies a collection of beanie babies from the '90s, their once-promised value now akin to the worth of the soggy cardboard box they lie in. Yet, here you are, claws sunk deep, refusing to part with them. This, dear readers, is the endowment effect in its most flamboyant display. We humans, much like dragons or someone who insists their garage full of outdated gadgets will be worth a fortune someday, tend to overvalue what we own simply because it's ours. "But this stock was my first buy!" you protest as it plummets faster than your resolve to exercise in the New Year. Or perhaps, "This bond and I have been through so much together," ignoring the fact that, unlike your dog, it doesn't love you back. Our portfolios become less a tool for financial growth and more a bizarre museum of sentimental investments, showcasing our reluctance to let go and optimize.
Navigating the Bermuda Triangle of Reporting Errors
Then, there's the thrilling adventure of investment-related tax reporting; a journey that could rival the Bermuda Triangle for its ability to make your sense of confidence and direction vanish without a trace. Picture yourself assembling a piece of IKEA furniture, but the instructions are in hieroglyphics, and your "helpful" friend keeps handing you the wrong pieces. That's what delving into the world of cost basis calculations, capital loss carryforwards, the mystical realm of Backdoor Roth IRAs, and so many other topics feel like for the uninitiated. It's akin to baking your first soufflé with salt instead of sugar because, well, both are white powders, right? The key to avoiding these fiscal faux pas lies in attention to detail and not being too proud to ask for directions before you're hopelessly lost (hello, that’s where we come in!). Think of it as a treasure map where X marks the spot to tax efficiency and the avoidance of an audit.
Eduard Zolotarev, CPA, MST, CFP®
Being a new-ish parent, most of my prose now occurs in the form of storytelling, so here is a finance story.
There once was a princess who lived in a tall tower and loved to read Reddit and trade stocks on Robinhood. She was lucky enough to participate in some of the MEME STOCK mania and make a few thousand dollars in the process. Encouraged by this stroke of luck/genius, the princess proceeded to follow more Reddit advice on “buying the dip.” She bought and sold the same stock on a daily basis to take advantage of the price volatility, to the point where, for the calendar year, she traded over $1M back and forth while having a steady full-time remote job.
Unfortunately for her Reddit gurus did not provide great advice on the IRS ”Wash Sale” rules, which prevent the deduction of a loss on an investment if that same or substantially similar investment is repurchased within a 30-day window.
Consequently, her “buying the dip” and daily trading strategies resulted in a significant cash loss for that year, of which NONE was deductible on her personal Income tax return. The princess became apoplectic when her Tax prep software showed a LARGE RED AMOUNT DUE. She begged and pleaded with the Tax software’s customer support to fix the issue with the software.
She called Robinhood’s customer service line to report an issue with the Consolidated 1099 tax form, but it was useless. Neither the Consolidated 1099 Tax form nor the tax prep software was wrong! The princess vehemently scoured the internet for answers, but the loopholes available to resolve this issue were unavailable since day trading was not her full-time profession. It was a brutal way to learn about the wash sale rules, but she does live in a castle, so she was able to take a loan from her trust fund to pay the tax bill.
Harmonizing your Investments - The Benefits of Coordinated Investment Accounts
In many ways, your investment portfolio is similar to conducting an orchestra. Each individual instrument (investment) plays an important part, but the most beautiful music happens when they synchronize and work together. By coordinating the investments you hold, you can better assess your overall risk exposure to certain asset classes and improve diversification. Without a cohesive asset allocation strategy, you might unintentionally expose yourself to more risk than is necessary to achieve your financial goals. You are able to better balance your portfolio when you incorporate assets that have different risk/reward characteristics. When you are not considering your investment portfolio as a whole, it can be easy to accidentally overconcentrate in a specific asset class when choosing your investment holdings. This could lead to significant missed investment opportunities if an asset class that you do not hold in your accounts performs exceptionally well. Similarly, if the asset class that you are overconcentrated inexperiences losses, holding other asset classes in may help to offset overall portoflio losses. A coordinated approach can help you make sure your investment decisions are working together to achieve a beautiful symphony!
The Passive Income Myth - How Dividends and Interest can Hamper your Portfolio Choices
To be clear, I am not recommending you avoid investments that provide dividends or cut out bonds from your portfolio. Both of those things are an important piece of being appropriately diversified. This myth revolves around those who preach the vast benefits of ONLY holding bonds and dividend-producing investments is a safe and lucrative way to provide passive income.
One issue we see is taxation, and unless you have specific holdings, you will be paying either short or long-term capital gains on all of the income produced. This reduces the earned percentage by 20-50%. For example, a 5% bond pays out $50 each year, but you will owe between $10 and $25 in taxes, significantly reducing the net income you receive. This is the same situation with dividends; an added risk is that a company may stop paying them because they aren’t guaranteed. Another issue is overall portfolio growth. When a dividend is paid, it impacts the stock's price, which means a 3% dividend reduces the price by 3%, forcing the stock to appreciate 6% to return to the previous price.
Since a diversified portfolio is expected to have upper single-digit annual returns, on average, over the long run, a passive income portfolio grows much slower. When considering financial independence, we want to look at the big picture and consider the benefits of a more traditional diversified portfolio focused on total return (dividends plus capital appreciation) to allow us to reach our goals.
Caitlin Fastiggi, CFP®, CPWA®, ECA
Personal finances are commonly an emotional pain point for people. Which when mixed with investing, can cause us to make some poor decisions. We invest hoping that the money we put into the market will grow, but at times, market volatility causes us to see red, literally. This, in turn, can cause investing mistakes.
First, we kick ourselves and think about what we could have done better. While the media will make us believe that events that occurred were obvious. In reality, hindsight is 20/20, and market events are not predictable. This often causes people to anchor themselves to the price of the past, believing that the stock will recover to the prior price. While that may be true, it also may never recover or may recover at a slower rate than the rest of the market.
Anchoring ourselves to an event of the past can cause us to miss out on gains in the future. The impact of this is amplified by what is called the disposition effect. When an investment is up, we are more likely to want to sell it, but when it is down, we hesitate. It doesn’t feel good to see our investment decline so
we continue to hold. By doing this, we are missing out on the opportunity to harvest that loss and offset gains elsewhere or $3,000 of ordinary income each year. Many people also fear that selling that investment will later lead to regret if it does recover. We need to remind ourselves that we are investing for our future and can’t let the events of the past impede our decisions today. It's best if we learn from those decisions and move forward.
So, you’ve bought into the idea that diversification is paramount to financial independence. You’re saving a lot, you’re selling your concentrated positions of company stock, and you’re wondering what to do next. Naturally, you’ve stumbled upon a Brooklyn Fi blog post! I could drone on and on about how to build a balanced portfolio, but you already agree. Instead, let’s talk about two methods of diversification that don’t necessarily achieve the ends we’re looking for: simply buying an S&P 500 index fund, and investing in a rental property.
First up, the S&P 500! You already know it’s a fool’s errand to pick out a handful of stocks, and you like the idea of buying and holding a large basket of them instead. The most common nomenclature that often gets confused for the whole “market” is the Standard and Poor’s 500, which is just a group of the 500 largest publicly traded companies in the United States. While you’re diversifying your investments across 500 companies by buying a fund that tracks this index, you’re only buying one asset class: US large cap stocks. However, there are THOUSANDS of stocks, both domestic and international. A well balanced portfolio taps into these other asset classes like small cap stocks, international and emerging market stocks, US bonds, etc.
While it’s true US large cap stocks have performed well over the last 10 years, it’s no guarantee they’ll lead the pack in the future. Let’s spread your chips out a little bit.
Second, let’s talk about rental properties. When you buy your forever (or long term) home, should you keep your starter home and rent it out? This is easily a top-5 most common question I hear from prospective and first-time home buyers starting to think about their long-term plan. First and foremost, everybody’s situation is different, yadda yadda. This is my first gripe when I see a TikTok clamoring on about the brilliance of passive income (unless they’re obviously committing fraud, in which case that’s gripe number one). The second or third thing we learned in Econ 101 was that there are no free lunches. On a more substantive level, owning a rental property is not a well-diversified investment. It’s a single parcel of real estate in a specific location within a specific city, and its value is very tied to things outside of your control: the neighborhood, the local economy, the quality of the structure built on it, the renters, and the future cash flows of rental income. Even if your rental income breaks into the black after paying the mortgage, property taxes, and insurance, an unexpectedly large piece of maintenance or a gap in rental income could drop it right back into the red. Real estate value and cash flow risks aside, do you really want to deal with being a landlord and fix shower curtain rods and leaky toilets at 9 pm on a Thursday night when your kids are going to bed? Our guess is probably not.
John Owens, CFP®, EA, ECA, CPWA®
I find that there are two common investing mistakes I’ve seen folks make in my experience, one being focused on cost rather than value; and the other being distracted by “sexy” investment opportunities that take your eyes off the ball.
In today’s investing world, especially in the fee-only planning space, cost is very clear. If you’re not sure what your advisor is getting paid - that’s a red flag. But the challenge is that that cost is more quantifiable and identifiable than value to folks. Our fee of 0.90% on the first $1M comes up often in my calls with prospective clients. And while that fee is tangible - you can see it on your account statement and in our portfolio reporting software; the value piece is less tangible. But investment management is an investment in and of itself. So unless you have a process in place to do due diligence on securities, build a diversified allocation of low cost index funds, build a bench of alternative securities for tax-loss harvesting, be able to tax-loss harvest any day the market is open in an efficient manner, understand asset location strategies to crank up after-tax returns, a refined tax-optimize rebalancing process that’s coordinated with your cash flows, and can stay the course on that strategy day-in and day-out during
market chaos and euphoria - then you’re probably missing out on optimization. That optimization, monitored consistently, as part of an overall financial plan can often provide value above and beyond 0.90% to the bottom line; it’s just that that value does not show up on the account statements as clearly as the fees do. So while cost is incredibly important, it’s important to assess it relative to the value.
I also think that it’s very easy to get distracted by what I’ll call “sexy” investments that may not fit into your portfolio. From oversold direct-indexing strategies for folks who have minimal capital gains exposure, to expensive, illiquid alternative investments, to the latest excitement around Bitcoin ETFs. The data shows that over the long run, a portfolio composed of stocks, bonds, and real estate, both domestic and foreign, in developed and emerging economies, can provide vast diversification, at an incredibly low cost, and significant value if coordinated with your financial plan and tax situation.
Conclusion
As you probably can tell, there’s no, one, single investing mistake we see - there’s a variety that we’ve seen folks make - often unintentionally - that hurt their bottom line and financial plan. Our team helps folks navigate these every day, and implement a portfolio strategy - with a process behind it - that can mitigate these mistakes and optimize your bottom line.