Editor’s note: This article was first published in January 2013; the figures on mutual fund performance in 2011 and the Apple share price examples it cites are from that time.
Understanding investing isn’t complicated. We can learn all the theory we need and get familiar with every kind of term, and even be genuine maths geniuses. The problem with investing is money, because when we invest our own money, investing stops being a mathematical matter and becomes an emotional one, and it is the decisions we make based on our emotions that can end up playing tricks on us, along with the other points we explain below.
After the crisis, the SEC commissioned a study on investors’ behaviour patterns, which basically shows the most common mistakes made by retail, private or individual investors.
1. Selling the winners and holding on to the losers.
It seems like common sense: we take our profits on the stocks that have performed very well and keep the ones that have lost money in our portfolio, waiting for them to recover. Common sense that is probably wrong (though not always, depending on our investment horizon). The problem is that most of the time the private investor goes against the trend: a stock that is in an upward channel and shows no signs of weakness in its trend doesn’t need to be sold as long as it doesn’t break out of that channel to the downside. On the other hand, it is advisable to cut losses as soon as possible, unless we are very clear about the investment and use the fall to buy more shares. This would be a real dilemma, because at this point different strategies can be devised and we won’t always know which one is right.
2. Investment funds, or not taking fees into account when you buy into a fund.
According to a report covered by Business Insider, 84% of mutual funds did much worse than the market in 2011. If picking a (relatively) winning investment can be hard enough in itself, picking a fund whose basket holds winning stocks would be twice as hard. Assuming the fund managers are good, we need to be very clear about the fees we will pay for the fund, since the average cost is estimated at 3% a year, so to begin with the fund has to deliver a return above that 3%. We have always said that the best fund you can buy is your own diversification in the stocks you pick. At least we decide when to sell and what we consider a fair return before getting out of the market.
3. Trading too much.
An article published in The Journal of Finance shows what we all already know: the more trades you make on the stock market, the more likely you are to lose money. The market is not a gaming room; if you treat it like a casino, the house will always win. People often say that in this kind of trading you have to follow the market, and that isn’t true, because where we can follow the market is in short-term trends (and by short term we don’t mean a couple of hours, but days, or at least one full day). Trading is effective at very specific moments, when a sharp move up or down is expected. If you trade every day, you will lose, with total certainty. If you do well in the short term, the losses will be much bigger in the medium and long term. Most traders who say they have made a lot of money from trading are now either playing poker or teaching trading, whether through courses, books and so on. Some of them do still trade, mind you, but only now and then, which is how it should be done if you don’t want to end up in financial trouble.
4. Following the herd.
Here again is this habitual and common mistake in stock market investing. Private investors tend to buy at the highs. If you want to put Apple in your portfolio, buy now, while people are recommending selling it and it is falling towards the 450-dollar area. Don’t wait until it is recommended to you, because that would be a sign it has already passed 550 or 600 dollars. It’s just an example; as I’ve said before, I wouldn’t buy Apple, much less above 500 dollars. Read: The advice of the best investors through some of their sayings.
5. Too much ego.
Self-confidence is one of the best traits a person can have, but overconfidence when investing in the stock market can ruin you, because you are not the market, and what an index, a company or the global economy does doesn’t depend on you. Too much ego tends to be more common in men than in women, and according to one study that would explain why women may make smaller gains on the stock market but, by the same token, also have smaller “scandalous losses”. In other words, they don’t do anything crazy on the stock market and they try to control risk more than men do. And it has to be said, they tend to be much more rational at managing capital.
6. Stop losses
Using a stop loss (an order set in advance to cut your losses) incorrectly can actually cause you many more losses. You will have heard that big investors don’t use stop losses. There’s an explanation for that: they have no intention of selling, whatever happens. If their shares, which they have studied carefully, fall, they take the opportunity to buy more.
Why not use stop losses?
Very simple: where do we place the stop loss? If we set it very tight, someone could sell their block of shares during a session and trigger it. Two minutes later the stock could start rising, and that’s when we could say that we haven’t cut a loss, we’ve just made fools of ourselves.
At the other extreme, we could place it very far away. Suppose we set a stop loss at 15%. First, you wouldn’t want to swallow a 15% loss, and second, once you are 15% down, wouldn’t it be better to buy rather than sell? The issue of stop losses is also very delicate when it comes to long-term investing, since depending on the state of the market they can be highly advisable.
Further reading
- More mistakes to avoid when investing
- Chart patterns: a minimum of technical analysis
- What to invest in in 2013
Featured image: Miguel Virkkunen Carvalho, CC BY 2.0, via Flickr.
