Nobody gets investing right all the time. Even successful investors and experienced traders have to shake off common mistakes every now and then.
Because it’s next to impossible to avoid mistakes completely, successful practitioners learn from their missteps in order to minimize them in the future. Consider these tips to avoid common pitfalls and achieve better results with your investment options.
Last updated: May 20, 2021
Problem: Loving a Company or Stock
Even experienced investors have companies they’re passionate about for personal reasons. Their reasons can include admiration for the company’s management, products or philosophy. The problem with falling in love with a certain stock is that selling it becomes much more difficult. Just because you love your smartphone, for example, doesn’t mean the company’s stock is a good investment.
Similarly, investors might hold on to a stock longer than appropriate. Although this problem is less likely to impact professional asset managers, experienced investors with well-managed portfolios are susceptible under the right circumstances. Some research indicates that selling stock is typically harder for all investors than buying.
Solution: Practice Portfolio Discipline
To avoid the pitfall of investing in a company or stock for emotional reasons, consider putting some portfolio management rules in place. If a stock has lagged the market or dragged down your portfolio, it likely should be replaced. In general, every stock should be evaluated with the same criteria. Use discipline in this approach.
Problem: Holding on to Losers
Selling is one of the most difficult parts of successful investing largely because stockholders believe an underperforming investment will suddenly turn around. Rather than ditching a stock after it has lost value, they continue to wait it out hoping to at least break even.
Two problems arise with this approach. First, there is typically no evidence that the stock will rebound. An investment that has tanked has demonstrated to investors only that it can go down — not the opposite. The second problem is that while investors wait for the stock to rebound, they’re not invested in something more promising.
Solution: Look For New Investing Opportunities
Although some investments might reverse course, and some require a longer-term view, holding onto a stock based on hope usually leads to more losses.
If you wait for a stock to rebound without exploring other options, you’re losing out on what’s called “opportunity cost” — but it’s more like opportunity lost. Investors must consider what opportunities they’re missing while they stubbornly stay in a losing investment. An investing misstep like this can be avoided by doing a regular and objective portfolio review.
Problem: Missing a Plan
A common investment maxim is “plan your trade, trade your plan.” In other words, before investing a single dollar in a particular security, investors should have a plan about why they’re buying it, what their profit objective is and how much they’re willing to lose before declaring it a loss. Sticking to that plan after buying the stock is equally important.
Solution: Make and Stick to an Investment Plan
The underlying message is that even experienced investors can become emotionally involved with their own trading. Setting up a trading plan gives investors rules to follow from the beginning of a trade to the end.
Problem: Lacking Diversity
Several situations can impede proper diversification. For example, employees holding company stock often run the risk of being too heavily exposed to that single investment. Alternatively, investors’ best performing stocks could become their largest holdings if they don’t sell shares as they climb. Investors build diversified portfolios so that no single investment will cripple them. This is hugely important, though even experienced traders can overlook the need to rebalance their portfolios.
Solution: Rebalance and Diversify
Investors can avoid this common mistake by creating a schedule for rebalancing and sticking to it. Proper diversification can significantly lower a portfolio’s risk factor.
Problem: Timing the Market
A big mistake made by experienced investors involves fleeing underperforming managers and chasing performance. But even great managers will underperform at times. Similarly, although timing the market is not always possible, investors must still decide which assets and asset classes to put their money in. Asset allocation is considered to be the single most important determinant of performance.
Solution: Don’t Time the Market
Economist and Nobel Prize winner Paul Samuelson said in the Journal of Portfolio Management in 1994 that timing the market doesn’t work. He said there were confident investors who moved from investing almost exclusively in stocks to the reverse based on their views of market performance.
Samuelson also determined that they don’t do better over time than those who keep about 60% of their money in stocks and the remaining amount in bonds. There were no big moves — these investors changed their equity exposure up or down only marginally. A portfolio that’s relatively independent of the overall market, and that doesn’t attempt to beat a particular index, is recommended.
Just as hubris drove Icarus to fly too close to the sun, overconfidence can make even a sophisticated investor think he knows better than the market. Overconfidence can blind even the most experienced investors to the signs that they are making a mistake.
Solution: Practice Caution
Instead of letting unfounded confidence dictate your investing moves, look to the market for data to back you up. An oft-quoted Wall Street axiom is that “the market is always right.” In layman’s terms, this means that even if you are 100% sure you are “right” in your convictions about the market going up, if the market is going down, it is telling you that you are wrong.
Problem: Doubling Down
Every investor makes bad choices from time to time — it’s just a fact of stock market life. A common mistake that even experienced investors make is to take a problem and make it worse by sinking more money into it. If your analysis is wrong and a stock is going down instead of up, it means you made a mistake. Doubling down and hoping to recoup your money by having a stock reverse its course is throwing good money after bad.
Solution: Be More Conservative
Although doubling down might work once in a while, it’s not so much an investment strategy as it is playing the lottery. Be cautious — don’t let your losses get the better of your decision-making.
Problem: Not Seeing the Big Picture
No investment exists in a vacuum. Even the greatest stock in the world — the tree — won’t stand up if the market conditions around it — the forest — are collapsing. A perfect example is the market selloff of 2008 to 2009. Plenty of great companies got slaughtered in that bear market, trading to multi-decade or even all-time lows.
Solution: Take a Step Back
Many professional mutual fund managers follow investment mandates that only allow them to focus on individual stocks without adjusting for the market environment as a whole. But this usually translates to large losses when the market goes down.
If things are looking bleak for the market in general, it can be harder for your stock to succeed. On the other hand, in a booming market even stocks without solid fundamentals are more likely to rise — a phenomenon market pundits refer to when they say “a rising tide lifts all boats.”
Problem: Chasing Yield
One of the oldest investment mistakes in the world is to “chase yield.” Chasing yield refers to buying an investment because it pays an above-average yield rather than due to any fundamental analysis of the underlying investment itself. This method of investing amounts to playing with fire because in most cases above-average yields reflect an investment with greater risk.
Solution: Look For Consistent Yields
Managers who handle money for clients are particularly susceptible to chasing yield as they constantly strive to get higher returns for customers. But individuals are also prone to jumping at the highest number they see. Yield is computed by dividing a company’s payout by its stock price. If the stock price falls dramatically, the yield will skyrocket. Because a falling stock price typically represents poor business fundamentals, a company with a temporarily high yield is often a company that is about to cut its dividend.
Problem: Buying All at Once
Experienced investors can be prone to rushing to buying all at once. That’s because they often buy more frequently than novice investors and might want to get their trades done rapidly so they can move on to the next one.
Solution: Break Up Your Buys
A successful investor is a patient investor. If you plan to make a large investment in a stock, there’s no rush to buy every single share at the same time. Average your price by purchasing small quantities at different times during the day, or even during the week. Doing this can help you smooth out any short-term price fluctuations and ensure that you’re not getting the worst price of the day.
Check Out: 5 Best Value Stocks To Buy in 2021
Problem: Buying Early in the Day
The first half hour of the trading session every day is often referred to as “amateur hour.” It’s the time when investors either panic about overnight news or rush in to buy based on good news. Volatility is also heightened because orders piling up before the market opens are all executed at once. Experienced investors know better than to buy based on emotion — whether that emotion is fear or greed.
Solution: Take Your Time
It’s hard to overcome human nature, even for veteran investors. With the exception of the last half hour of the day, the first half hour of the day typically sees the highest volume of shares traded. If there’s a panic in the market, either upwards or downwards, give the market time to reach its equilibrium point before you rush in after the herd and make a mistake based on emotion.
Problem: Not Keeping Current
Some investors believe that once they understand the basics of investing, all they have to do is construct a portfolio and let it do its work. Although it’s true that trading less frequently often produces better results than trading too frequently, no portfolio is static. Even the best companies hit rough patches, and the market itself is constantly evolving.
Solution: Stay Up To Date
In 1896, the Dow Jones Industrial Average had 12 stocks. Each was considered the leader in its industry — a true blue-chip stock. Guess how many of the original Dow stocks are still in the index? If you said one, you’re right. And that one, General Electric, could be on its way out as well.
Always keep current on trends in the market and in the economy, and keep your portfolio vibrant and current.
Problem: Failing To Understand Behavioral Finance
Human nature being what it is, even if you’re dedicated to taking emotion out of your investing, you’re likely still subject to inherent biases. Here are three of the most common behavioral tendencies affecting investors:
– Confirmation bias: Makes investors more likely to listen to information that reinforces preconceived notions
– Recency bias: Refers to the tendency to favor recent news over older news
– Loss aversion: Makes investors twice as sensitive to losses as to gains
Solution: Be Aware and Be Mindful
Although it’s hard to fight human nature, failing to at least be aware of those most common behavioral tendencies can cloud your judgment when it comes to making investment decisions.
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Douglas Ehrman contributed to the reporting for this article.