KEY TAKEAWAYS
Mistakes are common when investing, but some can be easily avoided if you can recognize them.
The worst mistakes are failing to set up a long-term plan, allowing emotion and fear to influence your decisions, and not diversifying a portfolio.
Other mistakes include falling in love with a stock for the wrong reasons and trying to time the market
1: Not Understanding the Investment๐
One of the world's most successful investors, Warren Buffett, cautions against investing in companies whose business models you don't understand. The best way to avoid this is to build a diversified portfolio of exchange traded funds (ETFs) or mutual funds. If you do invest in individual stocks, make sure you thoroughly understand each company those stocks represent before you invest.
2. Falling in Love With a Company
Too often, when we see a company we've invested in do well, it's easy to fall in love with it and forget that we bought the stock as an investment. Always remember, you bought this stock to make money. If any of the fundamentals that prompted you to buy into the company change, consider selling the stock.
3. Lack of Patience
A slow and steady approach to portfolio growthwill yield greater returns in the long run. Expecting a portfolio to do something other than what it is designed to do is a recipe for disaster. This means you need to keep your expectations realistic with regard to the timeline for portfolio growth and returns.
4. Too Much Investment Turnover
Turnover, or jumping in and out of positions, is another return killer. Unless you're an institutional investor with the benefit of low commission rates, the transaction costs can eat you aliveโnot to mention the short-term tax rates and the opportunity cost of missing out on the long-term gains of other sensible investments.
5. Attempting to Time the Market
Trying to time the market also kills returns. Successfully timing the market is extremely difficult. Even institutional investors often fail to do it successfully. A well-known study, "Determinants Of Portfolio Performance" (Financial Analysts Journal, 1986), conducted by Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower covered American pension fund returns. This study showed that, on average, nearly 94% of the variation of returns over time was explained by the investment policy decision.1 In layperson's terms, this means that most of a portfolio's return can be explained by the asset allocation decisions you make, not by timing or even security selection.
6. Waiting to Get Even
Getting even is just another way to ensure you lose any profit you might have accumulated. It means that you are waiting to sell a loser until it gets back to its original cost basis. Behavioral finance calls this a "cognitive error." By failing to realize a loss, investors are actually losing in two ways. First, they avoid selling a loser, which may continue to slide until it's worthless. Second, there's theopportunity cost of the better use of those investment dollars.
7. Failing to Diversify
While professional investors may be able to generate alpha (orย excess return over a benchmark) by investing in a few concentrated positions, common investors should not try this. It is wiser to stick to the principle of diversification. In building an exchange traded fund (ETF) or mutual fund portfolio, it's important to allocate exposure to all major spaces. In building an individual stock portfolio, include all major sectors. As a general rule of thumb, do not allocate more than 5% to 10% to any one investment.
8. Letting Your Emotions Rule
Perhaps the number one killer of investment return is emotion. The axiom that fear and greed rule the market is true. Investors should not let fear or greed control their decisions. Instead, they should focus on the bigger picture. Stock market returns may deviate wildly over a shorter time frame, but, over the long term, historical returns tend to favor patient investors. In fact, over a 10 year time period the S&P 500 has delivered a 11.51% return as of May 13, 2022. Meanwhile the return year to date is -15.57%.2
An investor ruled by emotion may see this type of negative return and panic sell, when in fact they probably would have been better off holding the investment for the long term. In fact, patient investors may benefit from the irrational decisions of other investors.
How to Avoid These Mistakes
Develop a plan
Learn Emotion management
Learn to Take out profit
Have a Trading rule
