5 Dumb Investments Smart People Make

Advertiser Disclosure ▾

This page contains affiliate links from which we receive a compensation. Like many publications Wise Bread is supported by affiliate commission from partner companies whose products appear on our site. This may influence which products we write about and the location and order in which products appear. We aren't able to cover every product in the marketplace.

Wise Bread Picks

• Travel Rewards Credit Cards
• Cash Back Credit Cards
• 0% Balance Transfer Credit Cards

Investing is complicated enough. Don't make it harder by making decisions that are just plain dumb. Here are five of the dumbest investing mistakes even smart people make. (See also: 5 Beginning Investor Mistakes I've Made)

1. Investments You Can't Afford

Wise money management is a step-by-step process. Two of the most important steps to take before investing are building an emergency fund stocked with three to six months' worth of essential living expenses and getting out of debt (all debt except a reasonable mortgage, which is one that requires no more than 25% of your monthly gross income for the combination of your mortgage, taxes, and insurance).

The only possible exception to the debt-free rule is when you work for a company that provides a match on money you contribute to a 401(k) plan. That's such a great deal; it would be a shame to miss out. So, if you can afford to make more than the minimum payments on your debts while at the same time contributing enough to your retirement plan to take advantage of the match, do that. If you can't do both, focus on your debts first.

2. Investments You Don't Understand

Peter Lynch was one of the most famous mutual fund managers ever. He ran Fidelity's Magellan Fund from 1977 to 1990, generating average annual returns of 29%. That's an astonishing achievement.

Lynch also had a talent for teaching others the essential to-dos and not-to-dos of investing. In one of his most famous bits of advice, he said if you can't explain an investment you're thinking about making to an 11-year-old, you don't understand it well enough to be putting your hard earned money into it.

If you're thinking about investing in an individual stock, you should be able to explain what the company does, who its main competitors are, and why you believe it's worthy of your investment. If you're investing in a mutual fund or exchange-traded fund, you should be able to explain its overarching strategy and underlying investments. And you should be able to do this in language that would make sense to a fifth-grader.

3. Investments That Don't Match Your Time Frame and Temperament

It's best to think of all of the money you have invested as a single portfolio. That means if you have $20,000 in a 401(k) and $10,000 in a Roth IRA, you have a $30,000 portfolio. The types of specific investments you hold across that portfolio should be based on an asset allocation that's appropriate for your investment time frame (typically, the amount of time you have until you plan to retire) and your investment temperament (more commonly known as your risk tolerance). There are a number of free asset allocation calculators or other tools available on the Internet for free, including Morningstar's Lifetime Allocation Indexes.

Making sure your investments adhere to an asset allocation that's appropriate for you has been proven to be more important to a person's long-term investing success than the specific investments he or she holds.

4. Investments That Sound Too Good to Be True

Mentioning the name Bernie Madoff should be enough to explain what is meant by this type of dumb investment. As well-publicized as Madoff's Ponzi scandal was, a new Ponzi scheme is nevertheless discovered almost every week. Apparently, there's a large audience of people who are easily suckered into too-good-to-be-true investments.

Anytime you hear about a "can't miss" investment or one "guaranteed" to go up by a certain percent, you shouldn't just think twice about making such an investment; you should decide right then and there it's not for you.

5. Investments You Think You Can Afford Not to Make

One of the most important ingredients for successful investing is time. While people just starting out in their career typically don't have much money to invest, that's the right time — at the latest — to start investing.

Time is what enables you to take full advantage of compound interest. In essence, compound interest refers to interest earning interest. For example, if you invest $200 and it generates an annual return of 10%, one year later you will have earned $20 of interest. The next year, if you earn another 10%, you won't just earn another $20; you'll earn $22. That's because the $20 you earned in the first year will also earn interest. No big deal, you say? Let's take a look at an example.

Now Ned didn't get his name by procrastinating. He's a go-getter, especially when it comes to investing. He started investing $200 per month at age 20, kept at it for 50 years, and generated an average annual return of 7%. After 10 years, Ned had invested $24,000 and earned $10,617 in interest. Nice, but nothing spectacular.

Let's skip ahead. After 50 years, Ned had invested $120,000 — impressive unto itself. But he earned nearly $970,000 in interest. Wow! His $120,000 turned into over $1 million.

That's what happens when compound interest is given time to work. However, if he had decided he couldn't afford to invest at such a young age and waited until he was 30 years old, he would have invested $96,000 — just $24,000 less — but his investment account would be worth about $565,000 less! The lesson? To take full advantage of the power of compound interest, start investing as soon as possible.

It's easy to think that successful investing is only about playing a great game of offense, capturing all the market up-ticks you can. In reality, it's just as important to play a great game of defense, avoiding major mistakes such as the five highlighted above.

What else would you add to the list of dumb investment mistakes?