Most people have experienced this at one point or another: you’re at a cocktail party when “the blowhard” walks by, boasting about his most recent stock market move. This time, he invested heavily in Widgets Plus.com, the newest and best online retailer of home appliances. You learn that he has invested 25% of his portfolio in the company with the hope of quickly doubling his money while knowing nothing about it and being completely enamored with it.
On the other hand, you start to feel a little proud that he has made at least four typical investing errors. The blowhard in residence made the following four mistakes, plus four more just for good measure.
KEY TAKEAWAYS
- When investing, mistakes happen frequently, but some can be easily avoided if you know what they are.
- The worst errors include not creating a long-term plan, letting fear and emotion control your decisions, and not diversifying your portfolio.
- Other errors include trying to time the market and falling in love with a stock for the wrong reasons.
- Ignorance of the Investment
Warren Buffett, one of the most successful investors in the world, advises against making investments in businesses whose business models you are unfamiliar with. Building a diversified portfolio of Exchange traded funds (ETFs) or mutual funds is the best way to avoid this. If you decide to invest in individual stocks, be sure to fully comprehend the businesses those stocks represent before you make a purchase. - Getting Smitten With a Business
It’s all too easy to fall in love with a company we’ve invested in when we see it succeed and forget that we bought the stock as an investment. Never forget that you purchased this stock in order to profit. - A lack of endurance
Long-term returns will be higher when portfolio growth is gradual and steady. A portfolio should only be used for the purposes for which it was created. Any other use would be disastrous. This means that you must maintain reasonable expectations regarding the pace of portfolio growth and return. - Excessive Investment Turnover
Another return killer is turnover, or changing positions frequently. The transaction costs alone can kill you, not to mention the short-term tax rates and the opportunity cost of missing out on the long-term gains of other wise investments, unless you’re an institutional investor with access to low commission rates. - Making an effort to time the market
Returns are also ruined when you try to time the market. It is very difficult to time the market correctly. Even institutional investors frequently fall short in their attempts. The returns on American pension funds were the subject of a well-known study titled “Determinants Of Portfolio Performance” (Financial Analysts Journal, 1986) by Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower. According to this study, the choice of the investment policy accounted for nearly 94% of the variation in returns over time on average.
Simply put, this means that asset allocation decisions you make—rather than timing or even security selection—can account for the majority of a portfolio’s return. - Waiting to Punish
Another way to guarantee you lose any profit you may have made is to get even. It indicates that you are delaying the sale of a loser until its cost basis has returned. In behavioral finance, this is referred to as a “cognitive error.” Investors actually lose money in two ways by failing to recognize a loss. They don’t sell losers because they might continue to decline until they are worthless. The opportunity cost of making better use of those investment dollars comes in second. - A lack of diversification
Professional investors might be able to achieve alpha—or excess return over a benchmark—by holding a small number of concentrated positions, but average investors shouldn’t try it. It is better to adhere to the diversification principle. A portfolio of exchange traded funds (ETFs) or mutual funds should include exposure to all key industries. Include all significant sectors when creating a personal stock portfolio. Don’t devote more than 5% to 10% of your overall portfolio to any one investment, as a general rule. - Letting Emotions Take Control
Emotion is arguably the biggest detractor from investment return. It is true that fear and greed control the market. Investors shouldn’t let greed or fear influence their choices. They should instead concentrate on the bigger picture. Over a shorter time horizon, stock market returns may vary greatly, but over the long term, historical returns typically favor patient investors. In actuality, as of May 13, 2022, the S&P 500 has generated a return of 11.51% over a period of ten years. The year-to-date return is currently -15.57%.When faced with this kind of negative return, an investor who is driven by emotion may panic sell when, in reality, they would have been better off keeping the investment for the long run. In fact, patient investors may profit from other investors’ irrational choices.
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