Financial mistakes — and how to avoid them

20-12-2019

Financial mistakes — and how to avoid them

 

The year 2019 will not go down in history as a vintage one for private investors.

Hundreds of thousands of people have been left nursing substantial losses after the collapse of Neil Woodford’s flagship Equity Income fund. They must wait until next year to find out exactly how much they could get back from liquidators.

Liquidity problems have also trapped millions of pounds’ worth of investors’ cash in open-ended property funds, after M&G’s £2.5bn Property Portfolio fund was suspended last week.

As the search for income intensifies, retail investors have been tempted to move into untested investments such as mini-bonds and peer-to-peer lending — sectors subject to a belated clampdown by regulators following a series of scandals.

After the £236m collapse of mini-bond issuer London Capital & Finance earlier this year, nearly 12,000 investors are anxiously waiting to see if they can recoup any of their original investment.

They could be in for a long wait. Following the failure of Equitable Life in the 1990s, 160,000 with-profits policyholders are due to find out next month whether they will get compensation worth an average £9,250 — in most cases a fraction of the sums that were lost.

Bad investment decisions are not the only financial mistake that wealthy people are at risk of making. Advisers say that greater sums have been lost due to poor financial decision making — or the lack of it — in other areas of people’s personal finances.

Here, FT Money asks how you can recover your poise if you have made a blunder and the mistakes that financial advisers say everyone should be at pains to avoid.

Financial mistakes — and how to avoid them

An error compounded

“Making a mistake is one thing. It’s accepting and understanding that you’ve made one that people tend to struggle with,” says Michael Martin, private client manager at Seven Investment Management.

“Look at the reason for the mistake. Was it a failure of due diligence or getting too emotionally attached to something you had bought? Work out what you will do differently next time, which could include making some rules about diversification or how often you review your investments. The worst thing you can do is repeat the same mistake — so learn from it.”

However, being clear-headed about your investment choices is a difficult thing to manage when emotions come into play.

“Even when we believe we are making logical, rational decisions, emotions such as fear and greed can override and jeopardise our smart investment choices,” says a recent report from merchant bank Close Brothers about the lessons investors can learn from behavioral finance theory.

When asked, investors typically rate themselves as “above average” in investment ability. This can result in overconfidence.

David Hearne, a chartered financial planner with Satis Wealth Management, recently tweeted that one of the words he used the most frequently as an investment adviser was “no”.

“No — your global portfolio doesn’t care about Brexit . . . Bit-what? No. Remember what I told you about Woodford? No. And whisky is for drinking, not investing.”

Other experts say better understanding these cognitive biases can prevent costly knee-jerk reactions further down the line.

“Anticipating your own behaviour is part of what makes you a better investor,” says Dan Egan, managing director of behavioural finance and investing at Betterment, the wealth manager. “So plan for what you’ll do during a market downturn to help ensure you don’t make any irrational mistakes, and stick to it. If you get excited about gains and upset about losses . . . you are more likely to churn your portfolio [adding to your costs], to hold cash and performance chase.”

A major reason why investors are tempted by higher-risk products such as mini-bonds is because of the low yields on offer elsewhere — meaning that testing your risk tolerance is crucial, says Nicole Tanenbaum, chief investment strategist at Chequers Financial Management.

“Know what you own, and know why you own it,” she says. “Many retail investors in LCF minibonds were lured by the promises of high returns. However, the risky profiles of the businesses behind these lofty return expectations were poorly understood, if they were understood at all.”

Many of the investors nursing losses who have been featured in the press had invested their life savings into the bonds, compounding their misery when LCF collapsed. Concentration risk was also a factor for many investors in Neil Woodford’s funds, who had allocated large amounts of their overall portfolio to the former star manager.

“It is critical to understand what role each investment is expected to play,” Ms Tanenbaum adds. “For an asset with a riskier profile, size the investment accordingly. More speculative positions should receive a smaller allocation so that unexpected results will not derail the overall outcome of the broader portfolio.”

When investments don’t go to plan, it can be easy to fall into a cycle of self-blame or get stuck in feelings of injustice says Dr Elena Touroni, co-founder of the Chelsea Psychology Clinic.

However difficult, investors need to treat any setbacks as a learning experience and move on.

“It’s about harnessing the ability to reflect on what happened with a critical eye so that you can put a plan in place to action it differently next time,” she adds.

The need to diversify can cut both ways. An investment that performs very strongly could end up accounting for a bigger percentage of your portfolio than your parameters dictate, triggering the need to take profits. This can be painful if the shares continue to rise — but perhaps not as difficult to deal with as an investment that suddenly falls in value.

Sonya Thadhani Mughal, executive vice-president of Bailard, the wealth management firm, describes holding on to poorly performing investments as “get even-itus”.

“Clients think ‘I will sell when the price gets back to where I bought it’, which is a flawed investing theory,” she says. “Every day an investor decides to hold a stock, bond or other asset that has a paper loss, they are actually making a decision to buy it. This decision makes sense if the investment thesis is still strong — but if it’s somewhat neutral to negative, then realising the loss is actually beneficial.”

Another advantage of divesting yourself of poorly performing assets is the ability to reduce your tax bill by offsetting capital gains with capital losses. However, even Ms Mughal admits: “This knowledge does not help the emotional impact of a loss.”

Not understanding your cash flow

Regularly reviewing your investment choices is just one part of managing your financial risks. For those approaching retirement, cash flow is a crucial issue — and particularly so for those in pensions drawdown, who are taking an income from their retirement pot while it remains invested in the markets.

Financial planners say they tend to see two problem groups: those who spend too much and those who spend too little through fear of running out of money.

“People are often so used to saving, investing and accumulating wealth throughout their working lives, it’s a big psychological shift to start spending it in later life,” says Ruth Starkey, client director at financial planning firm Paradigm Norton.

“On the other hand, plenty of people have a lack of clarity about how much they’re spending. Whether you’re spending £20,000 a year or £250,000, you probably won’t think you have an ‘extravagant’ lifestyle because this is the level of spending you’ve become accustomed to. But that figure is going to inform how much you need to be saving for the future.”

Whether saving or spending, the solution is cash flow modelling, which helps determine whether your sources of income can match your expected level of outgoings. “It helps clients feel confident about what they can spend each year . . . no matter what’s happened in the markets,” she says.

“Going through this process can also give people the confidence to give away quite substantial sums of money to their children, and enjoy seeing the benefits of that — as well as reducing their eventual inheritance tax liability,” she adds.

Being underinsured

You might have life insurance — but have you considered critical illness or income protection policies which would provide you with a lump sum or regular income in the event that you could not work? Many employers provide this cover as a staff benefit. Paying for it yourself is not cheap, but if you are the main breadwinner, it could prove invaluable if things don’t go to plan.

“For most people, there’s a higher risk of being ill for an extended period of time than of dying young,” says Ms Starkey.

Angela Murfitt, a financial planner with Fairstone Financial Management, has several clients who have received a payout from their critical illness cover after being diagnosed with cancer. “One client paid his mortgage off, had a more relaxed time in recovery as he wasn’t worrying about money — and survived,” she says.

“It’s helpful to review these policies to make sure they still suit your family circumstances,” she adds. Having children is an obvious example, but moving house and taking out a substantially bigger mortgage is another. “If you need to up your level of protection, many critical illness policies have extension options where you can increase the level of cover without the hassle of re-broking.”

Forgetting that you are mortal

You may be fully on top of your family finances — but how will the family manage in the event of your death?

Experts say succession planning is a particular problem in relationships where one partner usually makes all of the financial decisions — and then suddenly dies.

Making a will and putting lasting power of attorney agreements in place are classic items on the long-term financial to-do list that people keep putting off until tomorrow, says Ms Starkey.

“People have a lack of understanding about the laws of intestacy. This is especially important if they are living together and not married, which can prove financially catastrophic for the surviving partner,” she says.

However, the ongoing management of the day-to-day finances can also be problematic.

If couples have a wealth manager or financial planner who helps manage their affairs, it makes sense for both partners (and potentially their children) to have a relationship with them. If you manage things yourself, consider how your survivors would be able to take over — particularly if they are grieving.

Being well organised will help. A common tactic is having a folder to be opened in the event of your death, containing key documents, contact details of key people, a list of assets, account numbers and (crucially) passwords.

Property problems

The Bank of Mum and Dad may have more risk on its balance sheet than it realises. With Bomad effectively the UK’s tenth biggest mortgage lender, experts say parents are wise to do some due diligence before they part with a property deposit.

For a start, is it a loan or a gift? Either way, the money should be documented properly — either with a formal signed and witnessed loan agreement or official record of the transfer that can be used to mitigate any future inheritance tax liability.

Advisers say parents are more likely to encounter a problem if their child’s relationship hits the rocks and there is a tussle over the property. Some parents set up a trust which lends money to their child to buy the property, to offer some protection in the event of a future dispute.

“If you’ve helped them buy a property and a partner moves in, even if they’re not married, if that person is contributing towards the mortgage then there’s a potential dependency claim if the relationship ends,” says Ms Murfitt.

The conversation that Mr Martin says he always has with his clients goes slightly differently. “I might say — so you’re giving £200,000 to this young couple, but would you give your child’s partner £100,000? If the answer is no, then don’t do it. If the answer is yes, then you should mentally write off that money immediately. If there is a dispute further down the line, you will take a completely different view of losing that money, as you’ve already reconciled it to yourself.”

Saving for children — but not yourself

Starting a family can often have a negative effect on women’s finances, with several recent studies highlighting the damaging effects of the gender pensions gap.

Moira O’Neill, head of personal finance at Interactive Investor, says a trap she frequently sees mothers falling into is prioritising Junior Isas over their own pension and investments.

Spoiling your children

Giving children their inheritance early to avoid future inheritance tax bills is a mistake that many wealthy families tend to make, says Mr Martin.

“I’m aware of someone who gave both of his children £2m each when they were still in their 20s,” he says. “This was driven by the 40 per cent IHT saving, but they ended up losing 100 per cent as they gave up their jobs, spent it all and went off the rails.”

The flip side of this conundrum is not giving your children enough money. If they stand to inherit a substantial sum of money after you’ve gone, how will they gain the responsibility and understanding needed to manage the money well?

Mr Martin’s answer? Start giving early, but don’t give it all at once. “My advice would be to start them off by fully funding a stocks and shares Isa, and see how they fare with that,” he says. “If you give them £1m and they go and do something stupid, then maybe don’t give them the other £10m.”

Source: FT News