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6 investing mistakes novices make

Young adults with steady incomes should be setting some aside for retirement -- but that can be a whole lot harder than it sounds. Here's how to avoid the common missteps.

[Related content: 401k, bonds, investments, mutual funds, stocks]
By U.S. News & World Report

Do you think you need to have "extra" money before saving for retirement? Or that you'd rather invest in specific companies instead of broad index funds?

Those are just two common mistakes that young people make when they start thinking about putting money into the stock market.

Here are six common errors, and how to avoid them:

1. Getting excited about single stocks. When J.D. Roth, the blogger behind popular personal finance site Get Rich Slowly, started investing, he put a year's worth of Roth IRA (it is named after the late Sen. William Roth of Delaware) contributions -- about $3,500 -- in Sharper Image stock. A friend who worked at electronics and gadgets store The Sharper Image had recently mentioned that he invested in the company himself, which made Roth think the shares were undervalued. Unfortunately, that was in 2007, shortly before The Sharper Image filed for bankruptcy.

Investing in your favorite company may seem more glamorous than putting money into an index fund that reflects a broad segment of the market, but it's a far riskier choice, because single companies can suddenly go under or plunge in value.

Aside from being diversified, index funds carry the added benefit of having low fees because they're passively managed, which means they don't rely on a person to research and select stocks. Today, Roth puts his money in index funds, including bond, stock and real-estate funds.

2. Thinking investing is for rich people. Waiting until you have "extra" money to invest probably means you'll be waiting forever.

Instead, consider starting by contributing small amounts to your retirement account and slowly raising the percentage.

3. Forgetting to check up on expenses. Expenses can take a big chunk out of your investment return. But fees vary widely, typically from 0.1% to 2% of your total investment on an annual basis.

The Rand think tank found that when people were presented with various fund options, including one that clearly came with the lowest fees, only half selected that lowest-fee fund. One in three people inexplicably selected the fund with the highest fees. (All of the funds exhibited equivalent returns.)

And that's another reason to invest in index funds instead of more tailored mutual funds: Because fees automatically reduce investor returns, they are a primary reason research suggests that passively managed index funds perform better for investors than do actively managed mutual funds.

4. Keeping close track of the market's highs and lows. If your investment portfolio is well diversified and you check in on it once every few months to see if it needs to be rebalanced, there's no need to follow daily fluctuations.

Instead of keeping an eye on the cable news channels, which can make every dip feel like a crash, focus on your hobbies, relationships and other sources of stability. If you still feel anxious about the market's movements, maybe your investments are too risky and you'd be better off putting a greater percentage of your portfolio into relatively safe (and lower-yielding) money market funds.

5. Failing to diversify. Diversification -- in market sectors, industries and specific companies -- reduces your chances of losing everything. One of the easiest ways to do that while investing in the stock market is through index funds, which mirror a specific market index, such as the Standard & Poor's 500 Index ($INX).

Most of the victims of the Bernie Madoff scam suffered particularly bad fates because they entrusted their entire nest eggs to a man who turned out to be orchestrating a Ponzi scheme (in which early investors are paid from new investors' money, not from any actual earnings).

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6. Letting an adviser -- or your parents -- invest for you. There's only one way to learn, and it's by making mistakes, as Roth did. If you enjoy checking up on your accounts regularly and plugging numbers into spreadsheets, you can probably manage your own money.

Some people prefer to rely on professionals, and that's also fine, as long as you still play an active role. Most good advisers recommend understanding exactly where you're putting your money and not just trusting someone to make the right decisions for you.

This article was reported by Kimberly Palmer for U.S. News & World Report.

Published Nov. 10, 2010

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