While euphoria is far off today, it's not too early to consider three key mistakes investors all-too-often make when it arrives. Source: Bloomberg/Getty Images.
If history is any guide, this bull market likely ends with investors becoming too euphoric about stocks' prospects-not seeing that expectations of a shimmering financial future outpace a dimming economic reality. This doesn't appear to be all that close today, but the time to prepare yourself to shun over-optimism isn't when it actually arrives, it's beforehand. Now, this doesn't mean you should squirrel away investible cash waiting for the drop. It just means you shouldn't chuck your disciplined investing strategy due to emotion-on the upside or down. Here are a few principles to help guide you as this bull market matures.
1. Don't chase heat. As euphoria sets in, investors often seek the hottest-returning stocks or sectors, assuming momentum will carry them sky-high. And they might stay hot! But they might not, and a selection process that weights past returns heavily breaks a cardinal investing rule: It assumes past performance predicts future return.
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How a stock performs today has zero ... ZERO ... bearing on how it does tomorrow, in six months or a decade from now. Remember when energy stocks were hot in the late 70s? In 1979 and 1980, the S&P 500 Energy sector rose 68% and 83%, respectively. Folks got giddy! Then the oil bubble went poof, and Energy stocks fell three straight years. Then there is Tech in 2000, a story you're probably all too familiar with-hot dot.coms turned into dot.bombs. Nothing lasts forever. Don't let the feeling of missing out make you think differently-if your pals are boasting, they might well be in for a roasting.
2. Don't be under-diversified. Another late-bull market mistake? Piling into one or a few stocks-or one country or sector. For some, the goal is to maximize returns. For others, it's the comfort factor-invest in what you know, whether that's the industry you worked in, the company you worked for, or a field you're most interested in. Regardless of the motivation, these are all forms of under-diversification-a risky tactic.
The fewer stocks or sectors you own, the more your returns are tied to a very narrow set of drivers. This might seem great if your picks are flying high. But what if they aren't? What if you're in the one industry that goes down while the rest of the market goes up? What if you miss out on far better opportunities?
Thankfully, you can avoid this trap with a couple simple guidelines. First, keep some exposure to most (if not all) major sectors and geographic areas-that way, you aren't tied to the fortunes of any one area. Second, don't put more than 5% of your portfolio in any one company-it might work out great if it's the next Apple, but what if it's the next Enron?[i] Enron's employees thought they were very familiar with that firm. Alas, that turned out to be a very painful lesson about diversification-learn from others' pain to avoid it becoming your own.
3. Don't use margin to amp up your returns. When stocks are flying high, the "get it while it's hot" mentality can tempt folks to invest more than their spare cash. How? Margin! Investing with their brokerage house's money as well as their own.
History is rife with proof über-bullish investors shouldn't use margin to attempt to maximize returns. Sure, your gains are magnified when things go well, but the downside is magnified, too-you get whacked twice as hard in a bear market. Plus, when you use margin, the equity in your account is collateral-if stocks fall, your collateral falls far enough, you have to post more. And if you don't have spare cash to add, either you sell while down or your custodian will sell stocks at their discretion to bring you back to required levels-effectively reducing your ability to participate in the eventual recovery. In short, you can lose more than your initial investment. There can be valid uses for margin-some tactics require it. But if you need your money to last your lifetime, the potential upside of margin probably isn't worth this risk.
Perhaps you're reading this and saying, not me! I'd never! Yet even the most steely investor can unwittingly fall prey to the emotional highs of a late-stage bull. Start prepping today, before "it can't go down!" becomes the theme du jour, and you'll be better equipped to guard against these temptations.
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[i] But there is a happy medium here-being over-diversified isn't a winning tactic, either. If you own hundreds of stocks, you likely rack up transaction costs without a tangible benefit. More diversified doesn't always mean better diversified. It can just mean owning basically everything, a costly practice devoid of a meaningful strategy.
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