Editor’s note: This article was first published in May 2013. Its examples are from that month: Bankia having risen 700% after its rescue, and the author’s Gamesa trade (bought around 1 euro, sold near 1.90, today above 3 euros). Gamesa has since merged into Siemens Gamesa, which was taken private by Siemens Energy in 2023.
The only way to protect yourself from the most common stock market investing mistakes is to recognise in advance the causes that can lead you to make a bad decision when buying or selling shares. Some time ago I published an article on the most frequent mistakes we can make when investing. In the same vein, we published a couple of videos in which some Spanish experts gave us a few tips we should bear in mind.
Today we are going to focus on the psychological side of stock market investing, which is probably the most important.
We often see people who are delighted with their latest investment because they put in a certain amount and the shares rose 300% in a few weeks. When we ask that person about the company, it often turns out they know practically nothing about it. They don’t know how much debt it has, they haven’t studied its annual results, and they probably don’t even know what the company does. They simply thought it looked cheap, bought it and got lucky. That was the case of one of our readers, who bought into a bankrupt company despite my advice against it and ended up with a 120% return because it received a generous delisting tender offer.
These people, unless they keep learning, will almost certainly risk more capital next time and will probably hit a big stumbling block. A few days ago someone commented to me: “And you were saying it wasn’t worth investing in Bankia, and look, it went up as much as 700%. That’s where you need to be and where the money is made.” Clearly, words like these give us an idea of what many people think the stock market is, and confirm why they lose their shirts. (Read: The risk-takers make money, the crazy make money, and the reckless go to the slaughterhouse)
Let’s look at the mistakes we should avoid when investing in the stock market.
1. Investing in a company you don’t understand
This is one of Warren Buffett’s principles, and I think beginner investors sometimes fail to interpret it correctly: understanding a company is not just knowing what it sells. We all know that Inditex sells clothes and we know its brands. That does not mean we understand the company. How is Inditex different from its rivals? Who are its current rivals? What are the dangers for this company? What is Inditex’s business model? Debt? Potential? We need to give the company a full X-ray if we plan to buy its shares for the long term. Above all, we need to understand the business models of the companies we invest in.
2. Falling in love with the company
The usual advice is to have a strategic plan of action for every possible scenario we might face with the shares we buy. In other words, before buying I need to know that the stock can go up or down and behave in a way I did not expect. If it falls 5%, do I sell or buy more? Am I prepared to see it fall as much as 50%? Love for a company whose shares we have bought is no different from falling in love with a partner. Did you know that the number of divorces has risen by 30% in recent years? So have bad investments. Never forget that you bought shares to make money, so if there is any factor that suggests selling, don’t hesitate: sell if you believe the likelihood of losing your money has increased. Love on the stock market can be blind too. Don’t fall in love with companies.
3. Lack of patience
Lack of patience is what leads us to improvise more than usual on the stock market. And in stock market investing, the less we improvise and the more we stick to a strategy, the better. I admit this is one virtue I lack as an investor, and it has cost me on more than one occasion. Here is an example: my romance with Gamesa was a long-term one. After several disappointments with this company, I finally managed to buy it around 1 euro and make a return of nearly 90%.
After several rises to around 1.90 euros, a level it rarely broke through, impatience finally led me to sell. The following week it kept climbing, and today it is already above 3 euros. In other words, I could have made 300% on a company I wanted to hold in my portfolio for the long term. Impatience made me miss out on that extra return, and on top of that, I no longer hold it today.
4. Managing your investments too actively
Making too many trades is not healthy for our money: commissions alone can eat us alive if we are not careful. What’s more, making lots of trades increases the risk of losses exponentially. We should keep an eye on our portfolio to avoid nasty surprises, but as a general rule, if we have chosen a stock well, we will make more money by doing nothing (with some exceptions). Overly active management is another thing Buffett warns us about.
5. Letting emotions drive our investing
Is it true that the stock market is driven by emotions? Absolutely, and we should try to set them aside. It is often said that a solid, low-volatility stock can deliver an annual return of between 8 and 12 percent. That is over the long term: over short periods there will be weeks when it could drop 10%, or it could fall 25% in three months. If we hold a solid stock, fear should not make us sell our shares, and we could probably take the opportunity to buy more. We can use other investors’ fear as a tool that works in our favour, giving us the chance to buy the company we own at lower prices. This lesson comes from Benjamin Graham.
There are other mistakes we have already mentioned in other articles, such as failing to diversify and diversifying too much. Diversification should be kept in proportion, because overdiversifying, according to the great investors, is a way of protecting yourself against ignorance.
Another mistake lies in how we manage our portfolio: we sometimes sell the winners (to lock in quick gains) and hold on to the losers (hoping they will recover). What often happens is that the stocks we sold keep rising and the ones we kept keep falling.
And finally, we need to avoid the curse of the retail investor: buying at the top and letting fear push us into selling at the bottom. Read why investors almost always buy and sell at the worst moment.
So how do you protect yourself from all these mistakes? Phew… bearing in mind that even those of us who warn about these mistakes, because we know them, tend to fall into them again (less and less often). Just remember them, write them down and keep them firmly in mind. At least we know what we are trying to avoid, and that is no small thing.
Further reading
- 5 questions to ask before making your first investment
- 5 steps to build a dividend investing strategy and earn over 10%
Featured image: Unknown author, Public domain, via Wikimedia Commons.
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