Editor’s note: This article was first published in August 2013. Its reference to the speculative prices of today’s market refers to the market in August 2013.
We’ve published dozens of articles about investing mistakes, and all of them deserve to be taken very seriously. Even so, it’s no coincidence when I say that sometimes knowing too much leads us into one of the biggest mistakes of all, which is basically the mistake of trying too hard to avoid supposed mistakes.
I know, it sounds convoluted. After asking more than 5 good investors (and by good investors I mean people I know personally and who I know get very good annual returns), they all agreed on the first big mistake.
1. Following the herd, market noise and so on
We all know that investing in the stock market is about “buying low and selling high”, but as we’ve seen many times, for some reason investors do exactly the opposite. Why is that? Very simple: popular stocks get a lot of media coverage, and since most analysts say you should buy stocks with a clear upward trend, investors end up buying at the top for fear of missing out on the high returns the stock has been showing.
Over time, you come to see that the best returns aren’t found in stocks with a clear upward trend, but in stocks coming out of a severe downtrend (there are exceptions, of course). (Read: Why individual investors buy and sell at the worst possible moment.)
2. I don’t know what to call this mistake
Clearly, the most profitable way to invest in the stock market is with a long-term mindset and, as far as possible, by spotting an undervalued company (although with today’s speculative market prices, that’s very hard). But what many investors forget (and this is much easier) is to spot an overvalued company.
(Read: 10 investing mistakes)
Suppose we buy into a stock and it starts to rebound strongly, reaching a 150% return within a matter of months. As a rule, we tend to think, or rather we like to imagine, that it will keep rising and gain another 20, 30 or 70 percent. Often the best thing may be to take those profits before the stock loses its shine, but…
Remember that the usual advice is not to sell a rising stock. Let the market itself sell that stock for you. Set a “trailing stop loss” (dynamic, rising, or whatever your platform calls it), so that while the stock keeps climbing you don’t need to sell it, and as soon as it shows signs of a correction it’s sold automatically.
3. Holding on when you shouldn’t
Just as we find it hard to take profits in case the stock goes even higher, there’s another very common mistake: not selling losing stocks. I know we always recommend long-term investing, but it’s a mistake to stick with a moment or a company where, as soon as we buy in, we see nothing but red candles and plunging prices.
If you buy in and the stock doesn’t behave as you expected, don’t think twice: cut the loss. Otherwise you risk putting your stomach to the test with a -50% return. I know Warren Buffett says we should have the stomach to watch our stocks fall 50%, but your stomach will also be happier if you cut a -5% loss, buy back in once it has dropped the other 45%, and so, instead of watching a -50% loss, you end up seeing a +100% gain over the same stretch.
In the stock market, we’re in it to make money in the first place, trying as far as possible to pick a good entry point, so if you get the moment of buying wrong… that’s bad news. (There are exceptions.) (Read: 5 enemies of investing.)
4. To diversify or not to diversify? Both can be mistakes
On this point, every investor has their own opinion. While excessive diversification is a way of protecting yourself against ignorance (as Warren Buffett put it), not diversifying and putting all your eggs in one basket is very dangerous (also Warren Buffett, according to the usual attribution).
It’s said that it’s a mistake to have any one stock make up more than 10% of our portfolio. Personally, I don’t agree with that. For me, the ideal investment portfolio is 4 stocks plus a little cash to take advantage of trends in particular stocks. I also split my diversification into stocks I buy for the short or medium term and stocks I buy, in principle, for the long term.
At a meeting I met an investor who said he had put his entire first big pot of capital (about €300,000) into shares of a single company. The investment was very profitable. Someone told him he might simply have been lucky, and that if it hadn’t worked out he could have suffered huge losses. The investor replied: “Do you think I could have earned that first €300,000 without taking risks?”
In stock market investing, just as in business, everything comes down to the risk/return equation. Is it worth it or not?
5. The investment horizon
Ultimately, the most profitable investing is long-term. Forgetting that, and combining it with any of the previous mistakes, can be utterly disastrous. Many people invest money they’ll need within a year. Suppose you make the mistake of not selling during a fall, and when you need the money you only have half of it.
Others go in looking for a quick windfall and, as in poker, go “all in” just when they’re holding their worst cards (a bad moment in the market, bad news about the company, or other factors).
The perfect investment would be to choose a solid company with recurring profits, cheap, within a cheap market that’s about to begin a recovery, and to hold it for the long term. It’s very hard to find that kind of investment, but at least let’s try not to invest in the opposite of that description.
Further reading
