10 Investment mistakes and how to avoid them
People make mistakes all the time, but these errors rarely have as much consequences as those in the stock market. When you invest in stocks, you’re investing your hard earned money for your future financial health. Make sure you don’t fall prey to those common financial traps.
In this post we’ll look at 10 stock market mistakes that even the pros fall victim too.
Mistake #1 - Refusing to sell a losing stock
This is a mistake I used to make a lot. I would buy an average stock at (what I thought was) a great price but would end up making a loss. After a string of bad news on the company, and a significant deterioration of the stock’s fundamentals, I still found it difficult to accept this as a loss. Like many investors, I have grown attached to the stock, refused to accept that I was wrong, and I let my emotions get the better of me.
So I perpetuated a mistake akin to novice investors: I refused to sell the stock and told myself: “I will only sell once the stock returns to the price at which I bought it”. I thought to myself that, technically, I would only realize the loss once I sell the stock, so I’ll simply wait until I find my price again. I was effectively making a decision to keep some of my money tied up on bad stocks.
At this stage I wasn’t investing anymore, I was gambling.
I know from first-hand experience how difficult it can be to accept a loss and move on, but you must understand: this is part of the game. In general out of 10 stocks you buy, 2 would perform extraordinary well, 5 would perform as expected, and 3 will perform poorly.
Remember: Investing is a winner’s game. You’re going to win the league, but you won’t win every game, and that’s okay.
Mistake #2 - Buying a stock because it's cheap
We’ve all been there. You come across a huge household name such as IBM or Bayer and you notice that the stock price appears a little low for such a renowned company. The stock isn’t trading at its highest and its P/E ratio is a little low, clearly it’s a great value right?
Yes, the stock market is inefficient and will sometime temporarily misprice a stock, but the market isn’t blind. There’s probably a good reason why the stock price is low, and it’s probably because these giants have fallen.
Sure, the stock is not dead yet and it will continue to bring in average profits for its investors for years to come, but it won’t be returning to the double digit growth that made them giants in the first place.
Mistake #3 - Avoiding a great stock because its price is too high
Remember when your friend advised you to buy Microsoft stocks in 2015? You had a quick look at the chart and thought to yourself: Microsoft is trading at all-time highs and its share price has doubled in two years. I’m not going to buy the stock now, I missed out on all the gains!
Well guess what? Since then Microsoft has quadrupled in value and you once again missed out on the gains.
This is another reason why you should not concern yourself with the price of the stock, instead focus on the fundamentals.
If Microsoft is consecutively growing its revenue by 20% every year, assuming its P/E and profit margin remain stable, you will make 20% per year too. Don’t forget that this growth will compound every year too!
Even if Microsoft is trading at a high P/E ratio and a 10% correction happens the day after you buy the stock, if the 20% annual growth persists, you will make good returns over the long term.
Disclaimer: This isn’t an endorsement or recommendation of the Microsoft stock, this is simply an example of how a company which appeared expensive has continued to be a good investment.
PS: You can read up on Peter Lynch and his great book One Up on Wall Street here.
Mistake #4 - Selling a great stock because its price went up too high too quickly
I get it, you learned from the best traders and you now have trading plan. You feel great, this trading plan reminds you at which price you bought, how much you expect to make, and at which price you’re going to sell. Your emotions won’t get the best of you this time!
Suddenly, one of your stocks is up 15% in just a few weeks. You check the news and there is nothing convincing to justify this growth. You check your trading plan and found that you bought the stock expecting a 10% yearly profit. Great, your stock has over-performed, and you now think to yourself: time to take the profit.
And so you sell your stock at a nice 15% profit and forget it about for a few months. For one reason or another, this stock gets back on your watch-list a year later and surprise: The stock price has doubled!
This can happen when you don’t check the fundamentals.
Selling a wonderful company because the stock is temporarily overvalued is a losing strategy. Yes you’re probably right and the stock is overvalued today, but is this going to matter in 10 years?
Mistake #5 - Trying to time the market
I cannot stress the importance of this one.
Remember the pandemic induced stock market crash of March 2020? We lost 35% of our investments in just 32 days. I actually welcomed the crash with open arms, sold about 45k worth of bonds, and invested it in the stock market over the course of two months. Each time the market dropped by 5%, I would buy into the market with a huge smile on my face.
What were investment gurus suggesting at that time? They kept yelling: Don’t catch a falling knife!
The worst part? Some people actually believed them.
March 2020 was a crazy time. I kept telling my friends to start investing, insisting that this is the perfect time. Even educated investors did not follow this advice and they kept repeating to each other over and over and over again, almost in a cult-like fashion: Don’t catch a falling knife.
These people were afraid of investing in the stock market because, maybe, their investments might be worth less in a day, a week, or a month from now, all the while completely ignoring the fact that they would make huge gains over the next decades. Instead they kept telling themselves that they would buy when the market shows a strong reversal signal.
What happened? These people missed the bottom, and probably the opportunity of the decade.
I didn’t. I kept buying stocks at a discount, and sure each day the discounts were getting larger, but I certainly wasn’t going to risk my luck and wait an extra day, the discounts may disappear.
On 24 March 2020 the sell-off stopped and the S&P 500 gained 9.8% in a single day. Finally the strong reversal signal that people hoped for had arrived. What did the gurus claim then? They screamed “bull trap”. When that didn’t happen they yelled: “double dip”!
Not only did these people missed the bottom by not investing regularly when the market was crashing, but they did not benefit from the lower valuations either. Some people could not bring themselves to accept the fact that they missed the bottom and started fabricating stories in their head that the market could crash again. Hence, they continued to stay out of the market when stocks were recovering.
Bottom line: Trying to time the market is counterproductive. Short-term thinking will lead you to avoid investing in stocks when they’re at a discount while fear will keep you out of the market while it’s recovering.
Mistake #6 - Investing in value plays
So you’ve done your research and found a company that is trading below its fair value. The fundamentals are not spectacular but they’re stable and the company has a good track record. Congratulations, you found an average company selling at a great price! You estimate that the company is about 20% undervalued and think to yourself: Sweet! This is an easy 20% gain.
What happens next? Well if you’re lucky, the stock price will jump soon after you bought the stock and you will sell at an easy 20% profit. But let’s be real, this seldom happens.
Instead, you will likely sit on your investment for a few years waiting for its P/E ratio to catch up to its historical average. Make no mistake, you will still get your 20% gain but you might be waiting a few years for it. In that case, you would probably have gotten better results by investing in an index fund instead.
Mistake #7 - Focusing on dividends
This is a mistake most new investors made, myself included: we pay too much attention to the dividend yield.
We’re novice investors, and at that point, the only investing experience we had was our yearly interest payment on our savings account. We grew accustomed to this sort of remuneration, and so it seemed logical to focus on dividends, after all, dividends pay much better than a savings account!
And so we bought stocks for their dividend yield, without looking at the company’s share price, pay-out ratio, earnings, debt, or underlying business. There’s a multitude of reasons why focusing only on dividends is a bad idea, but here’s the top 3:
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High-yielding dividend stock are usually a trap set by failing companies to attract investors;
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Focusing on dividends may lead you to neglect great growth companies that have a low dividend only because they choose to reinvest their profits to grow their business (e.g. Amazon or Microsoft);
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Focusing on dividends leads you to neglect companies with other forms of shareholder remuneration, such as share buybacks (e.g. Apple).
Mistake #8 - Over diversification
Even the most amateurish of investor knows not to put all their eggs in one basket. Unfortunately too many investors over-diversify their portfolio without knowing any better.
Studies have demonstrated that diversification can reduce overall portfolio volatility, but only up to a limit. This limit is 25 stocks. If you have 25 stocks, buying a 26th stock will only decrease your portfolio risk by 1%. Each stock you buy after that will decrease your overall risk even less.
As such, it simply isn’t worth it to own more than 25 stocks. Doing so will simply over-burden you with additional research time (to find good stocks and monitor them) and unnecessary trading fees.
In fact, spreading your portfolio across additional stocks will only be counter-productive: It isn’t easy to find one good stock at a good price, so how are you going to find 40? Don’t invest in mediocre stocks just for the sake of diversification.
Furthermore, over-diversifying will reduce the impact of your best stocks’ outperformance on the rest or your portfolio. I’ve seen many people who were absolutely convinced of the future of Tesla and Amazon, yet they only invested 1% of their portfolio in each stock. Now that these two stocks have massively outperformed the rest of the market, the impact on their portfolio is tiny, because their portfolio allocation to these stocks was tiny. These people effectively “cancelled-out” fantastic gains just to decrease their overall risk by a few percentages.
Allocating more money towards “average” stocks in pursuit of diversification is a losing strategy.
Mistake #9 - Trading the chart
This is where the line is drawn between trading and investing.
An investor focuses on the company, its price, earnings, debt, business model, and future growth.
A trader looks at the chart and nothing else.
While the data is incomplete, experts estimate that only 10% of day traders are successful. That’s because their strategy isn’t based on facts, but on public perception. Here’s two examples:
1. Following a stock looking only at price. It can be tempting to buy a stock because it keeps going up. There is comfort in following the herd on a rising stock (e.g. Tesla or Bitcoin), and it does seem optimal to make use of the stock’s momentum, but remember the saying:
“Something that everyone knows isn’t worth knowing“.
In other words, if everybody thinks that Tesla will be successful, this success will already be reflected in its share price, thus little to no profit can be made. These people could benefit from a quote from Robert Kiyosaki’s book Rich Dad Poor Dad: “Profit is made at the time of purchase, not at the sale”
2. Buying a stock because its trading at a historical low. People have a tendency to tell themselves: If its fallen this low, it can’t go any lower. Unfortunately, the share price is just one part of the formula. There’s sometimes a good reason for the share price to drop, perhaps the company is going bankrupt, perhaps its sales are steadily declining, or perhaps its best days have passed. Always research the fundamentals before reaching any conclusion about a stock.
Mistake #10 - Neglecting index funds because they're too simple
Index funds are all the rage nowadays, and for good reason. Unfortunately, too many investors think that index funds are too simple. They seem to believe that something which is simple with low-fees cannot achieve superior returns. For them, superior returns must equate complex financial products and strategies. This couldn’t be further from the truth.
As such, many investors neglect index funds, either by investing very little in them, or avoiding them altogether. They seem to believe they will be able to beat market returns on their own. When this happens, investors fell into the trap of illusory superiority.
Illusory superiority, also known as the superiority bias, is a psychological condition where a person overestimates their own abilities. For example, a 1981 study found that 93% of US drivers considered themselves in the top 50% of drivers. In a similar study, 87% of MBA students at Stanford University rated their academic performance above the median.
The same is true for the stock market. Investors overestimate their own abilities but the numbers do not lie: Historically the average investor experienced annual returns around 4.8% while index funds flirt with 9-10% annualized returns.
If there is one thing you should remember from this post, it’s this one: Index funds outperformed the vast majority of investment managers, hedge funds, mutual funds, and individual investors over the long term. These simple products should make up the pillar of every investor’s portfolio, make sure you don’t neglect them.