The Investing Mistake Almost All of Us Make

I’ll bet I know where you think I’m going on the most common investing mistake: that individual investors at this state of the cycle are too heavily invested in bonds (which, by the way, could well be the case) or that they need to be more diversified.

But before we get there, many investors are making an even more fundamental mistake. They are measuring their assets incorrectly.

This is how we tend to enumerate our assets: Money in the bank? Check. Stocks and bonds? Check. Home? Check.

But this excludes what for many people is their largest single asset: their future earnings….or, more precisely, the net present value of their future earnings. This is the amount that you will earn in the future, and, like your other assets, its value can go up or down by quite a lot. Managed properly, one should think about this asset in the following ways:

This is an asset that has real value, and its value can be protected: Think insurance here, both life and disability. Otherwise, it is very large asset that can be wiped out in the blink of an eye.

This asset’s risk should be assessed: If you’re an entrepreneur, there is real risk to this earnings stream, whereas if you have a steady, stable job (if those exist any longer), its risk is lower.

Once assessed, the rest of your asset allocation should be adjusted around this one. For the entrepreneur above, she may want to invest in lower-risk securities, so that if she fails several times on the way to great success, she has the cushion of something to live on. And the composition of this asset should be considered: if your career is in real estate, you might want to think twice before investing heavily in REITs.

The asset should be continually monitored. The value of this asset can decline as one moves through life and monetizes it. But its value can also increase if you find a cure for cancer, for example; and it can decrease (rapidly) if you are a Wall Streeter and that business is contracting.

But, you may argue, quantifying this asset can range from tough-to-do to nearly impossible. It’s much more comfortable to ignore it.

Before you do, here’s a mistake I (and my Financial Advisor) made. We stress tested my portfolio before the 2007 downturn. We estimated that if the stock market went down x%, my investments would decline about y%. But what we didn’t consider was that if there was a significant decline in stocks, the chances of my losing my job went way up….which is indeed what happened. Thus that y% decline was orders of magnitude too small, and my entire “portfolio” had much more risk than I ever dreamed.

Assessing and managing your full set of assets is not nearly as much “fun” as picking stocks or investing in emerging markets. But it’s the boring things like this that can make all the difference, particularly when times get tough.

(Photo: 401(K) 2013, Flickr)