Four Dangers of Investing Like Your Grandfather

July 25, 2013— -- Your life is a lot different than your grandfather's, right? Well, in one respect, it may not be: Your basic portfolio structure may be the same as your grandfather's because you may have bought into the same investing strategy.

Because Wall Street firms have been highly successful signing up clients by selling the same investing strategies for decades, they have no reason to change. Here are four examples of such misguided strategies and why you should avoid them:

• Strictly age-based asset allocation, suggesting that you only need to change it as you age – not because of changing market conditions. If you have typical retirement goals and an average risk tolerance, many of the grandfather formulas that recommend today call for investors in their late 50s to have 40 to 60 percent of their portfolio in bonds.

The underlying rationale is that because stocks carry more risk, you want to reduce your holdings of them in favor of bonds so that as you approach retirement, you have more protection if the stock market is down when you attempt to recreate your paycheck to pay retirement expenses.

Bonds tend to rise in price as interest rates decrease, so investors buying bonds back in the 1980s, when peaking interest rates would soon begin to decline, were positioned for nice capital appreciation. Back then, a heavy allocation to bonds worked out well.

The problem is that interest rates have long been so historically low that there's almost nowhere for them to go but up. Despite this, year-in, year-out, many investing formulas on Wall Street continue to recommend the same heavy allocation to bonds for those approaching retirement – regardless of market conditions. This could be a recipe for disaster as interest rates rise.

• Diversification inoculates portfolios against all ills. The logic goes like this: By using a widely varied asset allocation — a mix that includes investments in foreign markets in addition to U.S. stocks and bonds — you can ensure substantial protection from risk because vastly different types of assets won't tank simultaneously.

Well, never say never. The big one, of course, was in 2008, when real estate in the U.S. – along with U.S. stocks and bonds – tanked. Increasingly, as the U.S. economy is yoked to the global economy, the performance of U.S. and foreign stocks is becoming more similar. The diversification fixation has many investors convinced that they must take a Noah's ark approach to stocks, owning some of every species. But owning a lot of small value stocks, for example, when that sector is trending down doesn't make sense. Why buy a sector that has more sellers than buyers? The increasing supply of shares created by having more sellers than buyers will usually lead to decreasing prices.

It makes more sense to focus on sectors and industries that are trending up. These can be pinpointed by watching to see when money is starting to flow into them; increasing demand for a sector. There's no point in blindly holding stocks in any one category just to make sure you have all the bases covered; you can't cover them all.

If you are sufficiently diversified and have the right asset allocation, all you have to do is buy stocks and hold them long-term. Though you don't want to incur costs by trading too much, it's better to be more tactical, dumping the losers using a strict sell discipline and taking profits on your winners as they appear to be peaking.

Stock prices are a function of human emotions – fear and greed. Greed causes investors to buy more and more shares, which pushes the stock's price higher and higher. Eventually, the stock becomes overbought. It may still move higher, but on lower and lower volume – a classic signal that it might be peaking. As an old investing saying goes, bulls make money, bears make money and hogs get slaughtered.

• You can't beat the market, so just buy index funds Though index funds, which own stocks reflecting those of certain market indexes (such as the S&P 500), can be an inexpensive way to gain exposure to an entire index, does it really make sense to faithfully hold them during a bear market as they continue to fall in price? There are many studies that show you this works over a 20- or 30-year time period if you just stay invested. Like so many investment theories – they are just that – theories, not reality.

These studies refer to investment returns, not investor returns. For investors to get all of the benefits, they have to be in these funds for the entire period studied. If only we should live so long — or have the forbearance to take pain with no gain for long periods. Many investors eventually sell out at some point – and it's usually near the bottom. Why not put a limit on how much you are willing to lose – say, 10 percent? You'll sleep better knowing that you've protected your capital and will live to fight another day. Besides, is your goal to outperform the market by half a percent, or is it to earn returns without losing sleep?

Big financial services companies like to communicate these notions because they are simple (I say simplistic). They are presented as indisputable, time-honored investing maxims. Well, they may be time-honored, but they are easily disputed by anyone who tried buy and hold through the tech crash of 2000 or the financial crisis of 2008-09.

This column is the opinion of the author and in no way reflects the opinion of ABC News.

Byron L. Studdard, a CERTIFIED FINANCIAL PLANNER™ practitioner, is founder and president of Studdard Financial, LLC, a financial advisory firm in Sarasota, Fla., dedicated to helping clients build wealth, protect it and pass it on to future generations. Studdard is listed in the Guide to America's Best Financial Planners (published by the Consumers' Research Council of America, an independent research organization). He can be reached at Byron@studdardfinancial.com. If you have a question for him, send him an email and he will try to answer it in an upcoming column.