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These are the top mistakes the common investor makes. Some of them are more easily avoided than others, but knowing about them should give you a fighting chance.
I know I will alienate some readers by listing market timing and trading as mistakes. The two go hand in hand, and although widely accepted today, it’s my view that they are nonetheless mistakes.
Trying to time the market is something usually driven by the classic emotions greed and fear.
We want to sell when we feel bad and buy when we feel good.
We feel bad when our investments have dropped and feel good when they have risen, so if we were to follow our emotions we would sell at low prices and buy at high ones.
It is not difficult to see why this method would be agonizing to the investor and will probably cause less than satisfying results.
Trading. Trying to profit from short-term movements in price.
Many investors who engage in this were lured in by someone selling them a dream.
The number of books and services being sold for the purpose of making profits by timing and trading the market reminds me of something I read about the 1849 gold rush of California, in which very few prospectors struck it rich.
Most of those who made money during the gold rush were the ones who sold the shovels, pickaxes, and other equipment.
In the stock market, you can be busy all day without getting anything done. Do not confuse motion with progress, a rocking horse can keep moving without making any progress.
Emotions and investing, forks and power outlets, toasters and bathtubs. Just to name a few things that don’t mix very well.
Emotional investors let their feelings get the best of them.
They can’t differentiate between decisions based on rationality and those based on their fleeting feelings and are therefore inclined to make faulty decisions.
Like I said before, basing decisions on your emotions will lead you to buy and sell at the worst times.
Rational investors would never sell something just because the price has dropped.
They’re more likely to do the opposite, as long as nothing fundamental has changed.
Just because you think you bought a share worth a dollar for 50c there is nothing that says that those 50c won’t take a detour to 30c before reaching a dollar.
If you’re rational and know you’re right, that would an excellent opportunity to buy more. Oppositely, if you can’t keep your emotions in check they will force you out of your position.
This one is pretty self-explanatory. This is investing, not laser tag. If you’re looking for constant action and entertainment go elsewhere or you’re bound to make mistakes.
While the stock market is a place where gamblers masquerade as investors, it is patience and rationality that is most probable in bringing the best results.
Diversification is protection against risk. If you only own two businesses and one goes bust, you lost half your investment, if you own 10 you lost one-tenth. But does it make sense to own 20, 30, or 40 stocks?
Short answer: it depends. It depends on how well you know what you’re doing and how well you know the businesses.
If you have found 10 strong companies which you deem to be of unquestionable quality, why would it make sense to place money in number 20 or 30 instead of buying more of the 10 “best”?
To me, it simply doesn’t.
The more stocks you own the more average results you will get, which is fine if that’s what you’re entitled to. Owning too many businesses means spending a great deal of time learning and keeping track of them, time that may or may not be justified in relation to the results.
While over diversifying can be justified by wanting to play it safe, there is no justification for under diversifying. Unforeseeable things happen from time to time.
Just because you can’t see some unfortunate event happening doesn’t mean it won’t. No one foresaw COVID-19 and few saw the 2008 financial crisis coming.
In the end, how diversified you should be is up to you, your knowledge, and your investing style.
Today measuring risk as volatility is something that is widely accepted. Volatility measures an issue’s price swings, if the price swings are wide the volatility is high and, supposedly, the higher the volatility, the greater the risk.
There are two types of price swings, those that are expected to recover and those that are permanent, i.e., those that are unjustified and those that are justified by a change in fundamentals. The problem is that volatility doesn’t distinguish between the two.
This means that if a stock is trading at 100$ and then suddenly drops to 50$ it is now considered riskier simply because of the drop, not taking anything else into consideration, like if the drop was justified. Quite absurd. Wouldn’t paying less for something mean less, not greater risk?
Here are some real examples of risks:
By paying too high of a price for a stock you’re probably paying for some expected but not guaranteed future growth in earnings, if this growth doesn’t come to pass then the price will suffer accordingly.
By leveraging your portfolio, you’re introducing a great deal of risk to it, depending on how leveraged you are. When the market or a stock crashes, being patient is the most important thing but by being leveraged you can easily be forced out of your positions by a margin call wrecking your portfolio.
Business-related risks are risks specific to the business you invest in. It can be things like: operating in a highly competitive market, regulatory risks, being highly leveraged, etc.
We are not looking for the truth. We are looking for things that confirm what we already believe. Being impartial when it comes to digesting new information is crucial to investing otherwise we just pick the parts we already believed or want to believe and spit out the rest. The tendency to do this is called confirmation bias.
We often put way more emphasis on possibility than on probability, i.e., if there is a chance of something great happening, we don’t care about how likely it is.
This is why investors pile into businesses that might not even be profitable, pushing prices way over what is justified, see the dot-com bubble of the late nineties. Everyone was focusing on the seemingly endless possibilities of those new internet companies while ignoring the probability of them realizing the possibilities.
We perceive risk differently depending on the perceived benefits. The more beneficial something seems, the lower we perceive the risk to be. The same is true for our feelings, if we dislike something we perceive the risk to be greater than if we like something.
We tend to take mental shortcuts. These mental shortcuts are incredibly useful time-savers for many aspects of our lives.
Like when we’re driving a car, we screen out large amounts of unimportant information while making small decisions like braking, steering, looking in the mirrors, all while listening to the radio. Almost all of this happens automatically.
The problem comes when we take these mental shortcuts in more complex aspects of our lives that require active thinking, like investing.
Of all the shortcuts we take in investing, the main one is probably not calculating the odds properly when making investment decisions.
We tend to rely heavily on the first piece of information we receive about something. This is a cognitive bias known as anchoring.
In investing it might mean that the first price we see of a given stock is the one we perceive to be the “correct” one. So if we find a stock we’re interested in trading at 100$, we might think it’s cheap at 80$, not taking into consideration that it might be grossly overvalued at 100$ and a more fair price would be at 40$.