Investment Mistakes to Avoid
In life, mistakes happen. The same is true in investing. With all of the historical data and experience we possess there is still no computer program or individual that will get it right all of the time. This is because investing contains uncertainty. Moreover, investing is an emotional endeavor, especially when the money was the product of years and years of hard work and discipline. In this article, we’ll examine some common mistakes investors make.
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Mistake #1: Making Emotional Decisions
It’s true that investing is part science and part art. Because of this, generally speaking, successful investing should contain elements of each. Decisions made purely by emotion can bring disastrous results, just as decisions made only from a computer program can also pose a problem. Emotional decisions are often tainted with biases. For example, when an investor buys a particular investment and it subsequently rises, they may adopt the belief that they were sure that would happen. Conversely, if the investment declines, they may convince themselves that they had a hunch that could happen as well. This inconsistency is because human behavior has a tendency to arrange our thoughts to fit the thesis of the moment. This is where ‘behavioral finance’ enters the picture. Psychologists have identified a number of human biases which explain certain inconsistent patterns of behavior. The truth is, good investment decisions contain elements of number crunching as well as human reasoning. And, although it’s important to recognize this, it’s much easier said than done. Now, let’s move on to mistake #2, holding a losing investment too long.
Mistake #2: Hold A Loser Until It Breaks Even
I’ve seen this a number of times over the years. The storyline goes something like this. I bought an investment and it lost value. Now it is down 20%. But when I bought it, I believed it was a good investment. Therefore, I’m pretty sure it will rebound and when it breaks even I’ll sell it. The truth is they will probably not follow through. Why? Because, if and when it comes back, they’ll hold it, believing it will continue to rise, reinforcing their initial belief that it was a good investment decision. Here’s the problem. If the individual were to sell it at a loss they would be forced to admit that they made a bad decision. And admitting this is very difficult for some. In reality, sometimes it’s best to cut your losses and move on. Now let’s look at mistake #3, impatience.
Mistake #3: Impatience
Investing requires a great deal of patience. Conversely, making rash decisions, in any endeavor, can be problematic. Most of us have been trained by society to expect “instant gratification.” The truth is, life doesn’t work that way and neither does investing. Investing requires patience. For example, there are numerous instances where an investment severely lagged for several years before it turned around and became a top performer. This is not at all unusual. Therefore, assuming you have chosen a quality investment, to maximize its return you need to be prepared to hold it through a complete cycle to allow the manager’s strategy to play itself out. How long is a complete cycle? This can only be answered after the fact. It’s the same with indentifying the end of a recession. It’s normally several months after the fact before we realize a recession has actually ended.
Mistake #4: Placing Too Much Importance On Past Returns
When selecting an investment, don’t rely solely on past returns. For example, if you’re buying a mutual fund it’s important to evaluate how the manager performed during a bad period in the markets, such as 2008. My clients, on average, lost 16.25% that year. There were a number of reasons why it wasn’t worse, but here’s the point. When you look at a mutual fund’s performance during a bad year, if you find they lost markedly less than similar funds, it may be an indication that they have strong risk management controls in place. The importance of this cannot be overstated, especially when the next downturn occurs.
Mistake #5: Avoid Water Cooler Recommendations
Just because a friend recommends a particular investment it does not necessarily mean it’s a good choice. Moreover, there are some important issues to consider. Here’s how a typical conversation unfolds. A friend tells you about this great mutual fund they own (never mind the ones that didn’t work out). “In fact,” they say, “last year it returned X%!” “Wow,” you reply. “That’s more than I got!” Perhaps it really did do well. But here’s the relevant question. Will its performance be replicated? In other words, will the following year be as good as the previous year? Odds are not in your favor on that one. In fact, if you make your decision based solely on past returns, you stand a good chance of being disappointed. There are a number of important statistics to consider when investing, but past returns have very little to do with future returns. And, funds that were at the top of their peer group one year, often do not remain there the following year.
Mistake #6: Failure To Harvest Winnings
The saying “Nothing goes up forever and nothing goes down forever” is highly applicable to investments. With human nature as it is, most would tend to sell the losers and invest the proceeds in the winners. However, this would usually be the wrong decision. When you have a position which has risen and now has a substantial gain, it’s usually best to harvest some of its gains. I say “usually” because there are a few exceptions to this, but we don’t have the time to elaborate. Suffice it to say that emotion would dictate that we keep the winners and sell the losers. But try to resist this urge. Which brings us to the next mistake, getting in too late.
Mistake #7: Investing Near The Top
When investors suffer a major loss, as many did in 2008, fear spikes and they tend to sell their losers and wait on the sideline until they feel it’s safe to get back in. However, by the time they feel it’s safe to invest in stocks again, it’s usually after stocks have risen substantially. Even though we all recognize it’s best to invest when prices are low, because fear peaks after a major decline, most individuals are hesitant to reenter the market after a severe selloff. This is another mistake governed by emotion. To avoid this, it’s best to have rules in place that dictate when you will buy and when you will sell. In other words, to the extent you can remove emotion from the equation, your chances of investment success will rise, assuming your rules are sound of course.
Obviously, there are additional mistakes. To reduce your mistakes remember, be patient and even though it goes against how you may feel at a given moment, try to adopt a contrarian point of view. In other words, don’t follow the crowd. Because emotional investing can be so damaging, a very large percentage of wealthy and affluent individuals delegate this task to a qualified advisor.