Today, many folks are well aware of the slow erosion caused
by high fund expenses, hefty advisory fees and big investment-related tax
bills, as evidenced by the growing enthusiasm for exchange-traded funds, robo
advisers and tax-loss harvesting.
My fear: While
investors are focusing on these relatively modest drags on their annual
investment returns, they may be overlooking big gaps in their financial plan
that could quickly destroy the savings they have accumulated. We are talking
here about mistakes such as failing to buy life, health and disability
insurance; holding a badly diversified investment portfolio; wagering on one or
two heavily mortgaged rental properties; or betting big on stocks when you
don’t really have the stomach for it.
It is hard to know precisely how many families are
underinsured or making overly large investment bets. But the available
statistics suggest the problem is widespread. For instance, according to the
Social Security Administration, 68% of private-sector workers don’t have long-term
disability insurance, which would provide them with income if illness or injury
prevented them from working—and Social Security pays such benefits only in
relatively dire circumstances.
What about those large investment bets? The Employee Benefit
Research Institute found that 35.5% of individual-retirement-account owners had
more than 90% in stocks. More alarming, in 401(k) plans that include company
stock, 8% of participants had more than 80% of their money in their employer’s
shares—an extremely risky strategy—according to a report by EBRI and the
Investment Company Institute.
No doubt some families don’t buy enough insurance because
they can’t afford it or hold badly diversified portfolios because they don’t
know better. But in many cases, I suspect the blame lies with two mental
mistakes. First, folks misjudge the risk. For instance, if you are in your 20s
or 30s and you have young children, life insurance might seem unnecessary
because the chances you will die are slim. Similarly, long-term disability insurance
might seem unnecessary because you don’t have a dangerous job. But most
disabilities don’t result from on-the-job injuries.
This failure to grasp the risk involved is compounded by the
second mental mistake: overconfidence. We saw this during both the soaring
stock market of the late 1990s and the booming housing market of the early
2000s. As prices rose, and investors either made money themselves or heard
about others who were growing rich, they grew increasingly confident—prompting
them to make big bets on a handful of companies, a single stock-market sector
or a few rental properties.
Whether it is living without crucial insurance coverage or
making big investment bets, you can go years without suffering the
consequences. In fact, these strategies may, for a while, make you considerably
richer, further bolstering your confidence that you are doing the right thing.
But all it takes is a bad auto accident or a big market downturn, and your
financial progress might be set back 10 or 20 years.
My advice: Spend
some time thinking about life’s nightmare scenarios. What would it mean
financially for your family if you died tomorrow, lost your job, became gravely
ill, suffered a long-term disability, got sued or the stock and real-estate
markets tumbled 50%? There will almost certainly be some financial impact. If
not, it may be a sign that you are overinsured or taking too little investment
risk.
Click
here to access the full article on The Wall Street Journal.