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When times are good, it's easy to stop paying close attention to your investments. But the best investors know that you can't lower your defenses against potential blunders. Even in the midst of one of the strongest rallies on record, you still have to be careful not to fall into costly investing traps that can sap away a good portion of your gains.
Time after time, investors make the same kinds of mistakes. Although healthy gains in the overall market can mask the consequences of those mistakes, they can still have a big impact on your portfolio performance over the long haul. Here are four of the most common traps that investors fall into -- and what you can do to avoid them.
1. Buying the hot new investment just as it's cooling off.
The biggest blunder that you can make is to pay too much attention to past performance. Unfortunately, it's incredibly difficult not to chase performance, if only because everyone hypes successful investments a lot more than they discuss their losers.
With mutual funds, you can actually measure the impact of performance-chasing by looking at the impact of fund purchases and sales on overall returns. Take a look, for instance, at the red-hot emerging-markets sector. The Vanguard Emerging Markets Stock Fund (VEIEX) has had a return of 11.4% annually over the past five years -- even after taking the bear market into account -- thanks to strong performance from holdings like China Mobile (NYSE: CHL ) and Petroleo Brasileiro (NYSE: PBR ) .
But when you look at what the average investor in the fund actually earned, you get a much lower figure: 6.4% annually. In other words, most investors waited so long after the fund had already reaped large gains to add their own money that they cost themselves five full percentage points of annual return.
You can see the same issue in other hot sectors. Tocqueville Gold (TGLDX), for instance, has returned an average of 22.4% over the past 10 years from holding precious-metals stocks like Silver Wheaton (NYSE: SLW ) and Newmont Mining (NYSE: NEM ) . But fund shareholders have reaped only 16.5% annually over the same period. That's a nice gain, but you're still leaving a lot of money on the table, and it's hard for any investor to catch up from that big a deficit.
2. Having an itchy trigger finger.
When your stocks are doing well, it feels good to sell them and count your gains while searching for your next winner. But trading too much brings a host of problems:
- Even with low commissions from discount brokers, trading costs can add up.
- Taxes on gains outside a tax-sheltered account are also higher for frequent traders. Especially over the past year in which stocks like Fifth Third Bancorp (Nasdaq: FITB ) , Mechel (NYSE: MTL ) , and Dendreon (Nasdaq: DNDN ) have posted gains of 600% and more, paying high tax rates on short-term gains can really cost you.
You'll do a lot better finding stocks you can hold onto for a while. Not only will they save you in expenses, but you'll be more likely to hang on and reap the full potential of their gains.
3. Paying unnecessary fees.
Too many investments come with ridiculous charges. Whether it's a sales load on a mutual fund, a surrender charge on an insurance policy or annuity product, or an expensive commission from a full-service brokerage company, there are many cheaper choices out there.
4. Getting confused by what you own.
Before you invest, make sure you know what you're getting. For instance, investors in target date mutual funds were shocked when they lost substantial amounts of money in 2008. Many had thought that these funds were a lot less aggressively invested than they actually were. But all it would have taken to discover the truth was a look at the fund prospectus. The information's at your fingertips, but it's up to you to use it.
Make the right choices
Even though it takes effort to identify potential pitfalls, the rewards for doing so are huge. By taking the time to pinpoint and avoid these investing traps, you'll go a long way toward earning the returns you truly deserve.
Even in a great market, not every stock deserves your money. Fool contributor Adam Wiederman thinks you'd be stupid to buy these stocks.