Savvy investors know that a single mistake can wipe out months—even years—of solid returns. And beginning investors often make their share of the same four common blunders. In fact, tactics for identifying and avoiding these investing missteps are among the most important things a new investor can learn. Here they are:
Swinging for the Fences
The Mistake: Making big bets on small iffy stocks.
Why We Do It: We know that it’s wise to invest in companies with strong fundamentals. Unfortunately, we also recognize that there is less upside investing in companies with already-proven track records. They’re profitable. They’re safe. They’re boring.
Young growing companies, on the other hand, promise higher returns. We hear about investors who got in early with Microsoft or Wal-Mart and made a fortune. Trouble is, such successes are rare and “swinging for the fences” is not the best way to build a financial future.
Loading up on risky all-or-nothing stocks is a sure route to investment disaster. Small growth stocks typically just putz along, unless they go belly up (which they often do). Example: Between 1997 and 2002, Nasdaq delisted eight percent of its listed firms each year. That’s approximately 2,200 firms whose shareholders most likely suffered big losses before the stocks were knocked out from the exchange.
How to Avoid It: Strive for consistent growth backed by fundamentals instead of throwing darts at smaller companies hoping that one of them is the next overnight success.
Investing With Your Heart
The Mistake: Investing in a company solely based upon your connection to the company or its products.
Why We Do It: It’s an easy trap to fall into. We can develop emotional attachments to companies and their stocks just like anything else. (For example, we work for the company, our parents spent their entire careers there, or we’re avid users of their products). So we invest in the company on faith rather than fundamentals. Our emotional connections blind us to more important indicators of whether or not the company is a good investment.
How to Avoid It: When we invest, what matters are the quantity and price at which we buy, the quantity and price at which we sell, and any dividends we receive. Period. It’s great that you love Panasonic because you love their new 50” flat-screen HDTV, and their quality product may lead you to research their company as an investment. That’s fine; but don’t let your connection to your TV lead you to invest before doing your homework. Great products and innovative technologies matter when assessing companies, but sound valuations matter more.
The Mistake: Investing with the herd.
Why We Do It: We humans are social creatures. We want to fit in, and we all assume that when masses of people act in a certain way, it must be the right way to do things. It’s hard (and scary) to be different. When there is a massive sell-off on Wall Street, fear combines with our desire to go with the pack and we are likely to sell too when, in fact, prices are going down and we might want to do the exact opposite.
Investing is a psychological balancing act of fear and greed. Too much of either will spell catastrophe. Success comes with taking a calculated risk when the chips are down, and knowing when to get out before the storm hits. Stocks are at their cheapest when everyone else is avoiding them.
Morningstar conducted a study every year for the past several years, which show the performance of unpopular funds. After evaluating which fund categories had the highest money inflows and which categories experienced the biggest money outflows, the asset classes that everyone hated outperformed those that everyone loved in all but one rolling three-year period over the past dozen years.
How to Avoid It: Timing the market is nearly impossible, so don’t try to pinpoint the bottom and top. But do go against the grain once in a while and seek out bargains in overlooked areas of the market instead of buying into the latest “hot” sector.
The Mistake: Investing in a company without understanding why the stock price is what it is.
Why We Do It: Making great investments requires a lot of research and a solid understanding of how companies and their stock prices are valued. Instead of buying only companies that are undervalued in the market, we often make investments based upon hype. Trouble is, that hype usually means that the company’s stock price is inflated…just the opposite of what we want.
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How to Avoid It: Making an investment requires a lot of research. Do it. A great investment should not only have great fundamentals of the company you’re investing in, but the price at which it’s trading should be reasonable. It’s possible that a great company has already been over-hyped, leading to a high price tag.
Also, when you buy stock in a company, you become a part owner of that company. The only reason you should buy a stock is that you think the business is worth more than what the market is accounting for. Also, don’t rely solely on earnings. Companies can make accounting-based earnings-per-share say whatever they want them to. Instead, look into a company’s cash flows. You can spot trouble by watching the trend of operating cash flow relative to earnings. Operating cash flows declining relative to earnings may be a red flag worth looking into.
The Bottom Line
Don’t let a single costly mistake ruin your portfolio’s annual performance. Avoid these common blunders and you’ll be light years ahead of the average investor.