5 Investing Mistakes You May Not Know You're Making

You're probably already aware of some common missteps that can lead an investor off track. Whether it's overreacting to market volatility, chasing investing trends, or delaying investing altogether, there are clear and avoidable traps that can erode your potential investment returns or generate painful losses.

But some less-obvious mistakes can also set you back from achieving your financial goals. "Some problems may be under the hood, making them tougher to diagnose," says Nitin Barve, CFA®, director of portfolio analysis and advice tools & policy at the Schwab Center for Financial Research. Other problems may stem from misalignment between your values and your actual holdings, and some from behavioral biases that we all have but are often not aware of. Or you could be overlooking opportunities to save on taxes.

Here are five investing mistakes you might not know you're making.

When it comes to investing, diversification works. Individual stocks tend to be more volatile than a diverse array of stocks. For eight of the past 10 years, the majority of stocks in the Russell 1000 Index have generated annual lower returns than the index, and an average of 29 percent of those companies have suffered negative returns each year. Spreading your savings across a mix of assets can help ensure your investments don't move in lock step, especially when the market heads south.

But, as time goes on, overconcentration can become a big issue even for portfolios that start off diversified. You might hold shares in a stock or sector that has grown appreciably, accounting for an increasingly large share of your portfolio. You might hold the same stock across different funds, particularly in "cap-weighted" funds that give extra weight to companies with the biggest market capitalizations. Overconcentration is also a risk among those who work for public companies and receive stock options (or restricted stock units) as part of their compensation, especially if they hold shares of the company through other funds.

According to work done by the Schwab Center for Financial Research, you should be concerned if any one stock (including your employer's) accounts for 10 percent or more of your total equity exposure.

Your portfolio might contain stocks that you would rather avoid. You might have a strong view about the impact of long-term trends such as mobile technology, artificial intelligence, or environmental sustainability on certain companies and sectors—and want to avoid stocks that could be squeezed by them. Or you might be guided by a personal set of values in terms of where you want to invest.

If you choose to diversify your portfolio through exposure to index funds and actively managed funds that hold scores of companies, the risk rises that a few stocks sneak in that don't align with your views or values. It's hard to find the perfect fund, even when you're expressly looking for one that, at least on the surface, purports to invest where you want. For instance, some ESG funds—those that allocate to companies with strong environmental, social, or governance scores—have exposure to businesses that might rate poorly on environmental factors but excel against their peers in social or governance considerations. Thus, your control here is at best limited because you do not have direct control or ownership of the underlying securities.

Investors tend to pay less attention to after-tax returns than to pre-tax returns, but at the end of the day, after-tax returns are what investors get to keep. Tax-saving strategies, such as tax-loss harvesting, potentially reduce the difference between the two by generating what is called "tax alpha"—that is, the amount of outperformance your portfolio may gain by using efficient tax strategies.

You can calculate tax alpha by using this formula: tax alpha = after-tax excess return minus pre-tax excess return. For example, let's say a traditional managed portfolio generates pre-tax return of 11%, matching the benchmark index. Because it matches the benchmark, there is no pre-tax excess return. Its after-tax return is 9.83%, versus the benchmark after-tax return of 8.8%. That's 1.03% of post-tax excess return. A 1.03% post-tax excess return minus 0% pre-tax excess return = 1.03% tax alpha.

Those differences might seem small, but they can add up over time due to the benefits of compounding, particularly in accounts with significant assets and those that are more likely to have short-term capital gains. Research indicates that an optimal tax-loss harvesting strategy can yield a tax alpha of as much as 1.1% per year, and that such gains can lead a tax-aware portfolio to outperform a similar buy-and-hold portfolio by a total of 27% over a 25-year period.

Another behavioral tendency that shows up in investing decisions is recency bias, in which investors focus too much on the latest market moves or other developments. When stock market volatility increases, for example, some investors might pull more money out of stocks or other assets than they should, even if they don't need it anytime soon. You may hear investors talk about reduced "risk appetite" as their reason for caution.

But what matters more to investing success is how your decisions align with your "risk capacity"—the amount of risk you can take given your investing time horizon and overall financial situation and resources. Investors with years or even decades left to reach their goals can take more market risk than those who need the funds sooner. That's because they have more time to potentially make up for significant market losses by leaving their investments alone. When they do the opposite, by cashing out or otherwise trying to "time" the market, they introduce the risk that they'll miss some or all of the market's recovery, as well as the compounded interest from those gains. In recent years, equity markets have typically recovered quickly and sharply from major downdrafts.

Conversely, savers who need the money soon (if they have low risk capacity, for example) can get into trouble when their exposure to risky assets is too large. In other words, not appropriately allocating for long- and short-term goals can exacerbate issues on both sides of the risk spectrum.

The proliferation of index funds and exchange-traded funds (ETFs) has significantly reduced investing costs, but there are limits to what you can do with them. In addition to missed opportunities from tax-loss harvesting with individual stocks, such passive funds don't grant investors the potential to perform better than the benchmark index.

Actively managed funds can serve a complementary role in investor portfolios by introducing a hands-on approach for generating potential excess returns while mitigating the tug of emotions by handing over investing decisions to a professional. But such funds may be more expensive—sometimes far more expensive—than index funds and ETFs. Also, active mutual funds cannot help an investor produce after-tax outperformance as they are not managing funds to a specific investor's tax situation.

"In this trade-off between cost and control, investors often pay for funds that don't necessarily deliver what they want, including outperformance or the ability to customize holdings to suit their views and values, and end up investing in funds that may be more expensive than what's necessary to meet their goals," Nitin says.

Thanks to increasingly sophisticated portfolio management technology available to professional money managers, investors can apply a combination of passive and active management approaches to help correct these five mistakes. For example, investing professionals can create customized indexes tailored to their clients' specific needs.