The last issue's personal finance column began the task of looking at six big financial mistakes for investors. The number of mistakes investors can make is by no means limited to six, but the vast majority of them fit within one of these six areas. The first three, which we focused on in the last issue, are panic, euphoria, and under-diversification. Here are the last three:
As much as under-diversification can devastate a portfolio (think of Bear Stearns employees holding much of their nest egg in the stock of the now failed company), so too can over-diversification be a major problem. Under-diversification adds risk that is wholly unnecessary, but over-diversification jeopardizes investment performance in ways that are also undesirable. The goal is to construct a portfolio that is well-balanced, not one that owns too many things. This balance is key to properly gauging risk, and obtaining reward.
The last several months of headlines about the American economy provide all the support needed to argue that excessive leverage is a grave mistake. Homeowners with 100 percent financing on their mortgage and stockholders who utilize massive margin borrowing in buying stocks are but two examples of excessive leverage potentially devastating mom and pop investors. The headlines tend to focus on hedge funds using 30-to-1 leverage, but individuals often will extend their debt-to-asset ratio as well in a manner that is completely imprudent. The reality of this mistake for a Christian is this: There is simply no reason ever, ever to do it, if one is obeying the biblical dictum to avoid greed. Pay for the investments you own. Do not expose yourself to being hurt beyond what you can afford if the value of your investments goes the wrong way.
Allowing tax decisions to guide investment decisions
We are all familiar with Jesus' exhortation to "Render unto Caesar what is Caesar's." A Christian is obligated to pay the taxes that he or she owes. However, many investors will wisely seek to be as tax-efficient as they can in managing their income, their deductions, and their investments. This is a good and prudent thing. The mistake, which is much more common than many imagine, is seeking to be so aggressive in buffering tax consequences that they jeopardize the performance of their portfolios.
The expression is "putting the tax cart before the investment horse," and it is very dangerous. Unless tax rates are 100 percent, it is irrational to allow a tax decision solely to determine what you do with an investment holding. If the time has come to sell an investment, sell the investment. Paying a 15 percent capital gains tax on the profit is better than losing the profit. I reiterate: There are ways you and your advisors can implement tax-efficient strategies into the management of your investments, but obsessing over taxes to the detriment of your portfolio is the sixth big financial mistake-and one wholly contrary to Christ's aforementioned exhortation.