Investing requires a level head and firm decisions. A disciplined investor is much more likely to succeed than someone who puts money into the market without a plan. But even the best investors make big mistakes. These mistakes can ruin even a good plan and leave the investor frustrated and disillusioned.
The best way to prevent blunders is to anticipate them. Understanding the most common investing errors can help you make sound decisions and stick with them. By reviewing this guide, you can recognize situations that may throw off your investing plans.
Let's look closely at seven investment mistakes that you should avoid.
- Changing Strategies Often
Your investment strategy is a set of rules you follow. These rules help you reach your investment goals. For example, a person investing for retirement would use a much different strategy than someone who wants immediate income. A person with a low risk tolerance would certainly choose investments that are different than those using a high-risk strategy.
The problem arises when an investor continually switches strategies. This results in poor decisions because learning a strategy takes time and dedication. Suddenly shifting into different strategies means an investor is always an amateur trying to learn the nuances of another strategy.
Here are some sound strategies that can get derailed by frequent switching.
A passive investor buys shares in an ETF or mutual fund that tracks an index. Costs are low, and the investor can count on the fund to behave similarly to the underlying index.
But what happens if the passive investor gets excited about a stock that is rising quickly? Pulling money out of an index fund to buy a breakout stock means abandoning the safer investment for a riskier one. Knowing when to sell a high-flying stock is much trickier than deciding when to take profits from an index fund. The result of such rapid changes is confusion, and often, loss of money.
Growth vs. Value Investing
A growth investor seeks companies that have strong balance sheets and the potential for earnings growth. Such an investor does not try to time purchases with the rise and fall of prices.
A value investor looks for companies that are undervalued. The idea is to buy a good company when share prices have dropped, and profit from the ensuing recovery. They time their investment decisions.
When a growth investor hears about an undervalued stock and changes strategies, there's a chance he will lose money. Determining when a stock is undervalued vs. headed for bankruptcy is an advanced skill, and is much different than choosing growth companies that are on a steady upward path. Both strategies work, but switching between them doesn't make the investor an instant expert in the new strategy.
One strategy is to buy shares of companies that pay steady dividends. The investor receives quarterly cash payments.
When a dividend investor decides that income can be had just as easily from buying stocks and selling them when the share price goes up, she has switched to a kind of momentum trading. Momentum traders try to time purchases and make a quick profit off of short trends. This is a major skill that even many momentum traders fail at. If a dividend investor tries to jump into the game, chances are good that the lack of skill will result in lost money.
These are just a few of the strategy changes that can cause losses. Investors put themselves at a disadvantage when they try to learn a new strategy every few weeks or months.
- Buying When Everyone Is Buying
This blunder happens routinely in the stock market. People get excited about a stock and start buying shares, driving the price up. Those who don't want to miss out start buying in as well, and soon share prices soar.
At some point, someone will take profits. If a lot of investors start doing this, people that just bought in may panic and try to sell so they won't lose money on their recent purchase. Others see this and start selling too, and a cascade effect drives share prices down. Soon there are no buyers and only sellers. That can make it nearly impossible for you to sell your shares as the price plummets.
To counter this blunder, be wary of high-flying stocks that almost everyone says can't fail. This is one of the surest signs that a reversal is imminent.
- Trying to Catch a Falling Knife
This common phrase on Wall Street refers to trying to buy shares when a stock price plummets. Yes, buying low is a good practice, but not during a selling frenzy. You buy in too early and lose money. (The "knife" reference means you will get injured.)
A wise investor waits until the price settles down and emotions are not running so high. The stock will reach a point where everyone who wants out has sold, and then a buyer can step in and quietly pick up shares. This often works because the fear-based selling usually results in a stock being oversold, meaning its price is lower than the company's strength would suggest.
- Mistaking Revenues for Profits
When a company has a hot product or is experiencing increased revenues due to a competitive edge, it is easy to assume the company is doing well. This classic blunder leads many investors to buy stock in companies that grow revenues.
However, a business can have strong revenues but still have expenses that eat away at those revenues. In fact, a company with high revenues can be operating at a loss.
Always make sure you understand the company's complete financial condition before buying its stock.
- Flip-Flopping from Technical Trader to Fundamental Investor
There are two basic types of stock analysis.
A technical trader examines charts and looks for indications that typically mean a stock is about rise or fall. This type of trader will watch trend lines in the chart, examine the volume of trades, and watch for patterns that have statistically preceded breakouts or selloffs.
A fundamental investor examines a company's fundamentals, meaning how much profit the company is making, the amount of debt the firm has, and how much sales and revenues are growing.
Both approaches can produce strong results, and each one requires a level of expertise that can only be learned through months and years of practice.
When an investor who has chosen a fundamental approach starts buying or selling because of how the chart looks, she has switched to technical trading. Blunders are sure to follow.
The same goes for a technical trader who gets enamored of a company because of its fundamentals.
A blended approach is possible, but this requires mastering both techniques, not switching randomly between them.
- Believing You Have Lost Money When a Stock Declines
Many investors keep score too often. If your stock goes down in price, especially right after you buy it, you may start counting the dollars you are losing. For example, the day you put $10,000 into a stock, it drops and your investment is now worth $9950. Have you lost 50 dollars?
No. You only lose the money if you sell the stock at that price. Selling would mean you "locked in" your loss.
The same principle applies to taking profits. If your stock rises in price, you only have a profit if you sell it. In other words, get in the habit of locking in profits when a stock does well.
The best way to counter excessive scorekeeping is to make a firm exit strategy. Decide (before you buy) at what price you would absolutely sell if it drops, and at what price you would sell to take profits. Then stick to your decision.
- Failing to Diversify
Investors who look at their cash as one pile of money that should be placed in a single stock are setting themselves up for failure. It's like putting your life savings on one number on a roulette wheel.
Spread your money among different market sectors, such as energy, consumer staples, financial stocks, and health care, for example. The particular mix you choose should be based on your understanding of the economy.
And be prepared to be wrong. One or two sectors may underperform the others. If you are diversified, your winning stocks may make up for any losses in lagging sectors.
By the way, purchasing several stocks in the same sector is not diversification.
The Bottom Line
Some blunders come from not having enough information or misreading the information you do have. But the vast majority come from emotional investing. Any time you find yourself flushed with emotion, you are on the verge of a rash decision. Cool off. Reconsider. You have time.