Accumulating money is hard work. Don't let the value of those earnings erode by not investing in stocks, bonds and other choices.
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updated 1/12/2012 11:28:32 AM ET 2012-01-12T16:28:32

Are you wondering how your investment portfolio can start 2012 off on the right foot? We recently got a couple of questions on our Financial Helpline about how to pick mutual funds to invest in. Here are five common investing mistakes to avoid this year:

Relying on past performance
If you study past performance, you’ll discover that it actually has a pretty bad past performance itself of predicting winners. For example, growth stocks and tech stocks in particular were all the rage in the '90s. They had a great track record of double-digit returns over several years. This was supposed to be the “new economy” in which old-fashioned concepts like profits and earnings weren’t as important as clicks on a dot-com site. Unfortunately for many investors, those double digit returns turned into double digit losses in 2000-2002.

The same can be said for star mutual fund managers. Bill Miller, manager of the Legg Mason Value Trust, accomplished an impressive feat of beating the S&P 500 index for 15 years in a row from 1991-2005. Who wouldn’t want to invest in a fund with a track record like that? After 2005, Miller went on to underperform in five out of the next six years and eventually turned over management of the fund to his co-manager. Do you think more people were invested in his fund before the 15-year run or after?

This doesn’t just apply to the stock market. We all remember what happened to real estate prices over the last decade. More recently, investors have been pouring money into areas that have been performing well like bonds and gold. We’ll see how that story turns out too.

Trying to time the market
Instead of looking to the past, how about looking into the future? In theory, this would give us spectacular results and make us the richest people on the planet. In practice, it’s a lot easier said than done.

That’s not to say that a lot of people won’t try to make money selling us on the idea that they can predict what stocks will do from one year to the next. The problem is that they’re doing that because they’re likely to make more money by selling that idea than actually following it themselves. Otherwise we’d all know their name by now. (The person who’s name we all probably know, Warren Buffett, was quoted as saying “Stop trying to predict the direction of the stock market, the economy, interest rates or elections.”)

Putting all your eggs in one basket
Warren Buffett also said that diversification is a protection against ignorance but he neglected to mention that when it comes to investing, we’re all a little ignorant because none of us knows the future. Even Buffett makes mistakes from time to time. Diversification can prevent us from losing all our eggs when that proverbial basket breaks.

Diversification actually comes in two parts. The first is diversifying between asset classes, which means having a mix of stocks, bonds, cash and perhaps some alternative investments such as real estate and commodities that match your goals and tolerance for risk. Instead, we have a tendency to invest aggressively in stocks after stocks have been going up and move to cash after stock prices come back down. This can result in buying stocks while they’re relatively high and selling them when they’re relatively low.

While we don’t know what stocks or bonds will do from one year to another, we do know that stocks generally outperform bonds over long periods of time (meaning decades not just five years) but that they do that with more ups and downs along the way. Basically, the longer the time your money will be invested and the less likely you are to bail out when the market inevitably has one of its many downturns, the more you can afford to invest in stocks versus bonds. This allocation should only change as your time horizon, goals or risk tolerance changes.

The second but no less important part of diversification is diversifying within an asset classes. The biggest mistake people make here is having too much (more than 10-15 percent of their portfolio) in their company stock. Keep in mind that any individual stock can go down even if the stock market as a whole is going up. In fact, a stock can go to zero (remember a company called Enron?) while it would take a catastrophic event (think nuclear annihilation or an asteroid hitting the earth) for the same to happen to the stock market as a whole. That’s why it makes much more sense to buy a portfolio of at least 20 stocks or use mutual funds or ETFs for instant diversification.

Ignoring costs
Let’s say you’ve decided to invest 60 percent in stocks and 40 percent in bonds because you have a long time horizon and you’re a moderate investor. You’ve decided to invest in mutual funds to diversify. Which mutual funds should you pick?

One place we might look is a fund’s Morningstar rating. The problem is that the rating is essentially past performance and remember, you can’t buy past performance. One study looked at 248 stock funds with 5-star ratings from Morningstar in 1999 and how they performed over the next ten years. Just four of the funds still had that rating at the end of the period and most of them typically did worse than the average fund in their category.

Two factors that have a huge impact on future returns are fees and turnover. When comparing funds that invest in similar things, the lower these costs the better the returns tend to be. Even Morningstar admitted that low fund fees are a better indicator of future performance than their own star system. Turnover is another expense in the form of hidden transaction costs and less hidden taxes. The funds with the lowest of these costs tend to be index funds, since they simply track an index and don’t have all the costs involved with active management. As a result, they generally end up outperforming actively managed funds.

Expecting a smooth ride
You can have the right asset allocation and pick all the lowest cost funds and still lose money in a year like 2008. The important thing is to stick to your strategy and re-balance. If your target allocation is 60 percent stocks and 40 percent bonds but is now 40 percent stocks and 60 percent bonds, you’ll need to move some of that money out of bonds and into stocks to bring the proportions back in line. This will force you to buy stocks while they’re relatively low and thus “on sale.”

In 2009 and 2010, you would have done the opposite and moved money out of stocks and into bonds to bring them back into line after their gains. It’s like pocketing some gambling winnings after a lucky streak. After 2011, you’ll want to move some money back into stocks even though the stock market was essentially flat because bonds were up about 4 percent. To quote Warren Buffett again, “Be fearful when others are greedy. Be greedy when others are fearful.”

So what kind of year will 2012 be? Will a stronger economy cause stocks to surge higher? Will the crisis in Europe hurt the U.S. stock market? Will ancient Mayan predictions of a global spiritual transformation or end of the world be proven correct? Who knows? In any case, the fundamentals of investing remain the same.

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© 2012 Forbes.com

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