Avoid making these costly investing mistakes
Have you found yourself wondering why your investment returns often lag behind those of your friends? Instead of making huge gains over the last couple of years while the stock market has traded to multiple new all-time highs, have your returns disappointed? If so perhaps you are guilty of making some common mistakes that frequently plague investors.
Investing is not a solved game. There is no crystal ball to help you always make the right decisions. Investing is a game of patience, work, and a good bit of luck. Hitting a homerun on your next trade is not easy to do, but it is far from impossible once you identify the leaks in your system and fix them.
Some of the mistakes we look at this week will be obvious ones, but also ones that nearly every investor has made from time to time. Sometimes you do not realize how obvious something is until you see it right in front of you.
There is no shame in making mistakes. It's only a shame to keep repeating the same mistakes over and over again. Investing is like everything else in the world, we can learn from our mistakes.
Failure to diversify
Perhaps the most common mistake investors make, especially when first starting out is failing to properly diversify their portfolio. In an ideal world, you would never have more than 5% of your portfolio invested in any one stock. The advantage of diversity is fairly obvious… you protect yourself against downturns in any one stock. Even the best of us pick losing trades from time to time, and if you have all your eggs in one basket, one bad stock can destroy a portfolio and quickly erase gains from several previous winning trades.
The reason so many investors fail to diversify is that it is not always easy to spread your money out over 20 or 30 stocks, especially when starting out with a small amount of money. If you have limited capital, you are limited in your options, but that does not mean you cannot quickly and easily diversify on a limited budget. There is a wide range of mutual funds, or exchange traded funds you can look at, which allow you to make one single trade and effectively spread your money over a large basket of stocks. If you have limited working capital, you could invest in an exchange-traded-fund like the SPDR S&P 500 (SPY). SPY is designed to track the overall S&P 500, so you are basically investing a little piece of your money into each stock in the S&P 500. It is a quick and easy way to diversify your portfolio and protect yourself.
Focusing too much on the short-term
Successful investors realize that there are rarely any free lunches. By that I mean that it takes time to build a winning portfolio. That is not to say you will never find an opportunity to make a quick score, but making big money fast should not be the goal. Of course, you have to be willing to take shots now and then, but the vast majority of your investments should be solid, long-term holdings, with a small portion of your working capital being held in reserve to take shots at big speculative moves from time to time.
Too much focus on short-term gains is easily understandable. We all know someone who bought the right stock at the perfect time and enjoyed a massive windfall when the security shot higher on strong earnings, or news of a buyout, or upbeat guidance. These things do happen, but your primary goal should not be to double your money in a month. While there are highly aggressive traders out there who do have a similar goal, they are outliers in the investing community. Your goal should be to find solid, reputable companies, whose futures you believe in. If you find good companies, and are willing to buy shares and patiently wait for the market to do its thing, then over time you can build a solid portfolio that will reward you for years to come.
Following your heart
By following your heart, I mean allowing your emotions to control your decision making. It is human nature to become emotionally attached to anything we own, and those emotions are amplified when we start talking about money. Have you ever noticed that after you buy a stock, you form an almost instant emotional bond with that company? Don't worry, it is common, and unfortunately one of the biggest pitfalls an investor can make. When we buy stocks, we feel as if that stock is part of us, and this emotional attachment can prove devastating for our overall portfolio performance.
There are several ways that emotions can cost us. When we pick a stock that enjoys a quick move to the upside, our emotions can convince us that the stock is the best investment ever, and we will ignore early warning signs that things are starting to turn. We can get so attached to the winning trade, that instead of selling the stock and locking in our gains, we decide to hang on for the ride, and slowly watch the stock correct lower and give back a lot of our previous gains. The same thing happens when a stock trades lower. Our emotions tell us that there is no way the stock can continue losing ground, and instead of cutting our losses, we decided that things have to get better, so we hold the security and watch our loss get bigger and bigger before finally dumping the trade for a much larger loss than we would have realized otherwise.
The point is that investments are just that… investments. Use your brain to decide when to buy and sell securities, and keep your emotions on the sidelines. Emotions tend to convince us to make irrational decisions, and the less you allow you emotions into your investment decisions, the better.
We already discussed is putting too much focus on short-term performance. I suggested that a better approach to investing for short-term success is to buy stocks that you can comfortably hold for the long-term, but even so, you have to keep an eye on all of your investments. Just because you buy a stock like Procter & Gamble (PG), that you plan to hold forever, you still have to stay on top of what PG is doing. Too many investors simply fill up their portfolio with a basket of stocks and then just forget about them. They have been taught (accurately), that over time the stock market always moves higher, so they believe that they can simply buy high quality stocks and let them sit for years and years.
There is some truth to this. You do need to accept that the market is going to fluctuate over time, so you don't want dump all of your holdings at the first sign of trouble, but you have to stay informed and educated on each investment in your portfolio. There is no worse feeling in the world than checking your portfolio and discovering that a position which was up 40% a month ago is all of a sudden just up 10%. Trust me, I have been guilty of neglecting my positions from time to time as well, and I have left a lot of profits on the table in the process. I am not suggesting that you spend hours each day checking up on each and every one of your stocks. I am suggesting that you try to establish some sort of schedule to check up on your positions. Figure out a specific time each week that you can commit to using for a quick check up, just to make sure you notice anything major happening in the markets. Buy for the long-term, but definitely don't just buy forget about your portfolio.
Not understanding risk
When we think about risk, we tend to think negatively about the subject. This is normal, because no one wants to put his or her money at risk… but without risk there would be no reward. If you want to find long-term success in investing you should not try to avoid risk, but instead you should aim to take appropriate risks. To begin with, you need to understand your risk tolerance. There are generally three different risk profiles; conservative, moderate, or aggressive. Before you can determine how risky you should be with your money, you need to determine which risk category you fall into.
Conservative investors are very risk averse. You should fall into this category if you are near or at retirement age because you have such low income potential in the future to replenish any losses you take. You should also fall into this category if you are working with a very low amount of working capital where any losses could devastate your overall portfolio.
Moderate investors are similar to conservative investors in that they really cannot afford big losses either. They are also risk averse, but they are willing to endure short-term losses in order to put themselves in a position for bigger long-term gains. Typically speaking, you should find yourself in this category if you are in your 30s or 40s since you have decades of future income to help cushion the blow of any short-term losses. You can take higher risks, but still want to keep a good balance of low risk securities as to avoid wiping out your total nest egg.
The final category is the aggressive investor. Aggressive investors tend to have the biggest swings in their portfolio. The wins are big, but so are the losses. Younger investors need to be more aggressive because it is the best time in life to take losses because you have plenty of time to make up for it later. Investors playing with disposable income should also be a bit more aggressive since they are not playing with money that will make or break their lifestyle.
Take a few minutes to determine which category you fall into, and then you can build your portfolio around that classification. Conservative investors probably do not want to be buying and selling naked calls or puts on Apple (AAPL) ahead of an earnings report, likewise the aggressive investor probably would not want to assume a large position in a slow and steady stock such as General Mills (GIS).
Michael Fowlkes is a financial writer who has been with the Fresh Brewed Media family since 2004. Over the course of his tenure with Fresh Brewed Media, he has worn many hats, including portfolio manager, options analyst, and writer. Michael received his undergraduate degree from Virginia Tech in Accounting and got his start in finance working as a stock trader for six years at Chase Investment Counsel in Charlottesville, Va.