Hargreaves Lansdown

7 investment traps that could harm your wealth

Joel Lewis | Jul 2013

7 investment traps that could harm your wealth

Over the last 30 years we've helped thousands of investors make better investment decisions. We've also witnessed common traps investors can fall into, and seen how they can harm returns. Below we highlight seven of the most common traps, and explain how to avoid them.

1. Too many eggs in one basket

When putting together your investment portfolio it's important to ensure you don't end up with concentrated exposure to a particular type of risk. One obvious area is industry sectors: consider the banking crisis in 2008, and the technology crash in 2000. Any investor whose portfolio was over exposed to these areas would have seen a dramatic fall.

Investors who took a more diversified approach would have seen a far smaller impact on their portfolio. Having a well-diversified portfolio is a key way to reduce risk.

See our Master Portfolios for ideas of ready-made, well-diversified portfolios

2. Over-diversifying

Just as damaging as putting all your eggs in one basket is over-diversifying a portfolio – sometimes dubbed 'di-worse-ification'. This can happen quite easily when building up an investment portfolio over a number of years. You can end up with dozens of quite similar investments, collectively delivering average returns.

A more effective approach may be to focus on a handful of favourite fund managers investing in different areas of the market. Our Wealth 150 list, which contains our favourite funds in the major sectors, could help you with this choice.

Free Guide to the Wealth 150 funds

3. Paying too much in charges

Aside from investment performance, a crucial factor affecting your total returns is the charges you pay.

Consider two funds, each delivering a return of 6% a year, but one with an annual charge of 1.5%, and the other with an annual charge of 1%. If you invested £10,000 in each:

  • The fund with the lower annual charge would be worth £26,533 after 20 years
  • The fund with the 1.5% annual charge would be worth £24,114 – or £2,419 less.

Keeping costs to an absolute minimum could mean thousands of pounds more added to the value of your investments over the long term. We can help you keep costs to a minimum by rebating part of the annual charges you pay on funds through our loyalty bonus service.

Find out how our Vantage Service can save you money on your investments

4. Not taking enough risk

Like many investors, you may be understandably nervous about taking risks with your hard earned capital. However, not taking enough risk can be just as damaging as taking too much risk.

One of the main dangers from not taking enough risk is that the spending power of your capital could fail to keep pace with inflation. While money saved in the bank might seem 'safe', in real terms its value is gradually falling every year because of inflation. Inflation of just 3% per year will nearly halve the spending power of capital over 20 years.

We believe taking more risk, in order to try and achieve an inflation-beating return, is therefore vital for any saver or investor taking a long-term view. However it is still important to have an emergency cash fund of say 3 to 6 months salary.

Try our FREE inflation calculator to see how inflation affects the spending power of capital

5. Poor administration

If you have investments dotted around between providers and you ever need to make any changes, you will often need to fill out a myriad of forms, which makes it a far more laborious process, and may prevent you from acting.

Good administration is key to managing your investments effectively. A good administration system means you can make changes quickly, conveniently and cost effectively. If it's easy to make changes you are also more likely to act, improving portfolio performance.

Good administration also helps you to gain a good overview of your portfolio. How much do you have in each area? Is it time to take profits? Making these decisions is far easier when you can view all your investments together, at a glance.

Find out how our Vantage Service makes it easy to manage all your investments in one account

6. Paying too much tax

Quite simply, the less tax you pay on your investments, the higher your returns will be. Fortunately the government offers a number of tax breaks to encourage investment. Two of the most popular are ISAs and pensions.

ISAs - if you hold your funds or shares within an ISA there is no tax to pay on any capital gains, and no further tax to pay on any income. Each tax year you have an ISA allowance, this tax year the allowance is £11,520, and used every year the ISA allowance allows you to build a significant portfolio of tax sheltered assets. What's more on the majority of funds the ISA comes with no extra charge, so many investors receive these benefits free. The icing on the cake is that with ISAs you can withdraw your capital at any time, so they are suitable for investors who want maximum flexibility.

Free Guide to ISAs

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Pensions offer similar tax benefits to ISAs, with a few important extras. Firstly when you add money to a pension you receive income tax relief, at a rate that depends on how much income tax you pay. So, for example, if you are a higher rate tax payer you could receive up to 40% tax relief on any contributions you make. It's also worth remembering that with pensions you can't access your capital until you retire. When you do, up to 25% can be taken as a tax free lump sum, with the remainder used to provide you with a taxable income in retirement.

Please note the value of tax shelters will depend on your own circumstances, and tax rules can change over time. The value of stock market investments can fall in value as well as rise, so you could get back less than you invest.

7. Focusing on the short-term

Legendary investor Warren Buffett famously once said "You can't buy what's popular and do well". There is a lesson here for all investors. Many are tempted to over-expose themselves to the latest 'hot' investment trend. Often these will be companies or sectors that just seem to rise relentlessly, giving the impression that you "can't lose". In the past sectors such as technology stocks have experienced such a rise, followed by a sharp fall in value, affecting the portfolios of thousands of investors.

Before you choose an investment, ask yourself: what is your attitude to risk? Would you be happy to hold it for the long-term? Do you think the shares represent fair value? Are there other overlooked areas which may offer better long term opportunity?

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