It has happened to most of us at some time or another: You're at a cocktail party enjoying your drink and hors d'oeuvres and "the blowhard" happens your way. You know he's going to brag about his latest "giant accomplishment." This time, he's taken a long position in Widgets Plus.com, the latest, greatest online marketer of household gadgets. You come to find he knows nothing about the company, is still completely enamored with it and has invested 25% of his portfolio in it hoping he can double his money quickly.
Despite your resistance to hearing him drone on, you start to feel comfortable and smug in knowing that he has committed at least four common investing mistakes and that, hopefully, this time he'll learn his lesson. In addition to the four mistakes the resident blowhard has made, this article will address four other common mistakes.
(See also: Major Blunders in Portfolio Construction.)
#1 Not Understanding the Investment
One of the world's most successful investors, Warren Buffett, cautions against investing in businesses you don't understand. This means that you should not be buying stock in companies if you don't understand the business models. 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. (See also: What Are a Stock's "Fundamentals"?)
#3 Lack of Patience
How many times has the power of slow-and-steady progress become imminently clear? Slow and steady usually comes out on top - be it at the gym, in school or in your career. Why, then, do we expect it to be different from investing? A slow, steady and disciplined approach will go a lot further over the long haul than going for the last-minute "Hail Mary" plays. Expecting our portfolios to do something other than what they're designed to do is a recipe for disaster. This means you need to keep your expectations realistic in regard to the length, time and growth that each stock will encounter.
#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 alive - not to mention the short-term tax rates and the opportunity cost of missing out on the long-term gains of good investments.
#5 Attempting Market Timing
Market timing, turnover's evil cousin, also kills returns. Successfully timing the market is extremely difficult to do. 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 Beerbower 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. In layman's terms, this indicates that, normally, 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 made. This means 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 the opportunity cost of what may be a better use for those investment dollars. (See also: Master Your Trading Mindtraps.)
#7 Failing to Diversify
While professional investors may be able to generate alpha, (or excess return over a benchmark) by investing in a few concentrated positions, common investors should not try to do this. Stick to the principle of diversification. In building an ETF or mutual fund portfolio, remember to allocate an exposure to all major spaces. In building an individual stock portfolio, allocate to 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 No.1 killer of investment return is your emotions. The axiom that fear and greed rule the market is true. Do not let fear or greed overtake you. Focus on the bigger picture. Stock market returns may deviate wildly over a shorter time frame, but over the long term, historical returns for large-cap stocks can average 10%. Realize that, over a long time horizon, your portfolio's returns should not deviate much from those averages. In fact, you may benefit from the irrational decisions of other investors. (See also: The Financial Markets: When Fear and Greed Take Over.)
How to Avoid These Mistakes
Below are some other ways you can avoid these common mistakes and keep your portfolio on track.
Develop a Plan of Action
Proactively determine where you are in the investment life cycle, what your goals are and how much you need to invest to get there. If you don't feel qualified to do this, seek a reputable financial planner. Remember why you are investing your money, and you will be inspired to save more and may find it easier to determine the right allocation for your portfolio. Temper your expectations to historical market returns. Do not expect your portfolio to make you rich overnight. A consistent, long-term investment strategy over time is what will build wealth.
Put Your Plan on Automatic
As your income grows, you may want to add more. Monitor your investments. At the end of every year, review your investments and their performance. Determine whether your equity-to-fixed-income ratio should stay the same or change based on where you are in life.
Have Some Fun Money
We all get tempted by the need to spend money at times. It's the nature of the human condition. So, instead of trying to fight it, go with it. Set aside your "fun investment money." You should limit this amount to no more than 5% of your investment portfolio. Do not use retirement money. Always seek investments from a reputable financial firm. Because some may compare this particular process to gambling, follow the same rules you would in that endeavor.
- Limit your losses to your principal (do not sell calls on stocks you don't own, for instance).
- Be prepared to lose 100% of your investment.
- Choose and stick to a pre-determined limit to determine when you will walk away.
The Bottom Line
Mistakes are part of the investing process. Knowing what they are, when you're committing them and how to avoid them will help you succeed as an investor. To avoid committing the mistakes above, develop a thoughtful, systematic plan and stick with it. If you must do something wild, set aside some fun money that you are fully prepared to lose. Follow these guidelines, and you will be well on your way to building a portfolio that will provide many happy returns over the long term.