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Wednesday, February 28, 2024

The four perils of self-managing your investments

The four perils of self-managing your investments

03.29.2022

There’s an adage that an overwhelming percentage of drivers consider themselves above average (a mathematical impossibility). Known as “illusory superiority” in social psychology, this phenomenon has been taught to high school and college students for decades, and to this day remains an amusing example of human overconfidence.

Unfortunately for us humans, that overconfidence extends to a wide range of activities, not least of which are investment decisions. Many investors choose to manage their own investments, and a small minority do just fine.

Sadly, the universe of self-managers is much, much larger than that small minority, and most don’t do very well on their own. They fall prey to any number of mistakes, and with significant costs: poor long-term returns, unnecessary risk, diminished spending ability in retirement, and even reduced quality of life from stress.

If you’re currently self-managing your investments, consider the following.

1. You’re part of a group that dramatically underperforms the market

The average active amateur investor’s portfolio was down about 30% in 2022, according to data compiled by Vanda Research, which studies self-directed retail traders globally. By contrast, the S&P 500 Index lost 17%.1

Investor behavior is not simply buying and selling at the wrong time; it is the psychological traps, triggers and misconceptions that cause humans to act irrationally. That irrationality leads to buying and selling at the wrong time, which leads to underperformance.

If you self-manage in an attempt to outperform the market, be aware that the odds are stacked heavily against you.

2. Your financial well-being is more than just your investments

Setting aside the above and assuming you’re part of the small minority that can keep up with the market, don’t forget there’s more to your financial life than just your investments. Even with strong portfolio performance and a good asset allocation, there are plenty of chances to go wrong.

Consider taxes. By failing to place assets into the optimal account types, you could end up giving more back to Uncle Sam or your state than you need to. Dividends, interest income, and capital gains are all treated differently depending on where they’re placed, so a sound strategy is key. Likewise, your tax bill can vary greatly based on your annual net realized gains – the difference between your realized gains and losses. Poor timing of sales can cause you to miss out on significant tax-saving opportunities, once again leaving you with less of your hard-earned profits.

The same is true of many other financial planning considerations. Take insurance. Buy too little and an unexpected catastrophe could wipe you out. Buy too much, and you steadily bleed precious premiums that could be working towards your retirement. Proper estate planning also entails a veritable rat’s nest of hazards. By assigning a bad trustee or executor, forgetting to assign appropriate beneficiaries, or failing to understand estate taxation, you could leave your heirs in a position starkly different from what you intended or expected.

And what about your retirement accounts? Do you have a tax-optimized withdrawal strategy for your IRA or 401(k)? Taking wealth management into your own hands extends far beyond pure investment strategy.

3. You can’t be on the clock 24/7

Overseeing a comprehensive financial strategy takes time. That’s a big drawback if you enjoy family, friends, or hobbies – not to mention interruptions like vacations or the occasional flu. Most people simply don’t have the time, inclination or training to properly manage a complex investment portfolio. And, the later you are in life, the larger the portfolio, which translates to more risk in managing on your own.

It’s possible you immensely enjoy investing and it doesn’t interfere with your other priorities. Fair enough. But what happens if you suddenly become incapacitated or lose access to your account, even if only for a short time? Illness, accidents, family emergencies and frozen computers happen. Often! In business there is a concept known as key person risk, and a common countermeasure is to create purposeful redundancy in subject matter expertise. As a self-manager, it’s unlikely you have trusted surrogates who could step in and manage your portfolio if you were unable to. That’s a big risk, and also a common element in the fourth and final consideration.

4. At some point, you will need a contingency plan

Too often, self-managers spend a lifetime painstakingly tending to their investments, only to eventually turn it over to a spouse or children who have no idea what to do. Without a solid plan for the inevitable handoff, it doesn’t take long for poor decisions, inactivity or unscrupulous financial salespeople to eviscerate what took so long to build.

That’s a real tragedy, and it happens every day. The good news is that it is easily prevented – just start early. Even if you’re great at investing (which very few are), have a thorough understanding of estate and tax planning (true for even fewer people), and have the time and interest to manage your investments (fewer still), you can and should still plan for a transition. Find an investment professional whose philosophy matches your own, and test them out with part of your portfolio. If they end up not being a fit, you have plenty of time to switch. If you like what they do, you can work with them to build a financial plan that both honors the hard work you’ve contributed and leaves the portfolio in good hands when you’re gone.

Our take

With the rise of robo-advisors and online investment tools, people are feeling more empowered to take investment management into their own hands. While there is a small minority of people who are relatively successful as self-managers, the majority negatively impact their overall financial portfolio and underperform the market. The right financial professional can support your investment objectives and work with you on every facet of your financial life.

1 Bloomberg, “Retail Traders Lose $350 Billion in Brutal Year for Taking Risks,” December 2022.

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