Avoid these mistakes in money management

Question: It can be an overwhelming task to sort through the abundance of information available on investing today. How do I know what I am doing is reasonable?

Answer: You are right. It is an onerous task filtering through the many pieces of information on investing that we receive through the Internet, news publications, colleagues, friends and advisers.

However, there are five common mistakes that investors make today that, if avoided, could potentially save a lot of time, effort and money.

The first mistake is trying to "time" the market -- meaning, trying to invest based on when you think the market is at a peak or nadir.

Knowing when to get in and out of the market is a difficult, if not impossible, skill to master. For example, from 1993 through 2002, there were 2,774 trading days. If you were invested for the entire time in an S&P 500-based fund, you would have earned an annualized return of 9.3%. However, if you missed the best 20 trading days, your return would have dropped to 0.5%. Further, if you missed the best 40 trading days, you would have been down -5.3% annualized for that same time frame. Trying to time the market and being wrong can have a significant negative impact on your portfolio's performance.

The second mistake is chasing returns. This is somewhat related to market timing, except that "chasing returns" means you're trying to jump on the bandwagon of a hot stock or sector, rather than the market as a whole.

Like market timing, return chasing can also have a negative impact on your portfolio's performance. For instance, in 1999 the average return of technology mutual funds tracked by Morningstar was 125%.

However, if you invested at the beginning of 2000, your investment would have been down 31% in 2000, 35% in 2001 and 42% in 2002.

This is evidence that the best-performing sector in one particular year will not necessarily be the best-performing sector in the subsequent year, and could in fact turn out to be one of the worst-performing sectors that year.

The third mistake is not rebalancing your portfolio, meaning taking a little money out of high-performing investments and moving them into low-performing ones -- the classic buy-low, sell-high mantra.

Empirical data suggest that by rebalancing, you can add 0.3% to 0.6% annually to your performance, which over time can add up to a lot. If your strategic asset allocation is 30% bonds and 70% stocks and you find yourself at the end of the year with an allocation of 20% bonds and 80% stocks due to market performance, this is now a more aggressive portfolio.

Rebalancing your portfolio back to your target allocation can help preserve your return and decrease overall risk or volatility.

The fourth mistake is not adequately diversifying your portfolio. My colleague mentioned a conversation he had with a potential client who said that he thought his portfolio was well diversified since he owned more than 20 stocks. When he mentioned the names of the stocks, they were all commonly known U.S. large company stocks.

This person was not well diversified because these stocks are highly correlated to each other, meaning that when one large company stock moves up or down, the other stocks tend to move in a similar pattern.

In order to take full advantage of the benefits of diversification, it is important to diversify among different asset classes. In other words, investments like small cap stocks, international stocks and bonds have lower correlations to large cap stocks. Therefore, by incorporating other asset classes into your portfolio, you can help reduce overall risk or volatility.

The fifth mistake is missing opportunities. The U.S. stock market is clearly the largest market in the world, representing approximately 44% of the world's market capitalization.

However, the United States accounts for only 21% of the world gross domestic product. Further, emerging markets account for 50% of the WGDP, yet only 14% of the world's market capitalization. Granted, there are other risks inherent in investing internationally such as currency risk and political risk. However, by investing exclusively domestically, you may be missing out on opportunities.

Avoiding some common mistakes doesn't necessarily make plowing through all the information significantly less time-consuming. But it at least gives you a framework to make your decisions and to ensure that in the long run you're getting positive returns from your portfolio.