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The Three Most Common Mistakes Investors Make
Posted by: Matthew Indyke and Brian Zen (IP Logged)
Date: October 14, 2012 08:39AM
Buying and selling stocks has been heralded as one of life’s many fun activities by the most avid of investors. It is one of the best ways to ensure a financially sound future for you and your loved ones. However, we need to watch out for some of the common mistakes that will cost investors money, including the following:
Do You Really Think You Know Your Stocks?
Oftentimes, we barely know what we're investing in. We also may have no game plan when choosing a company to invest in. If you don’t know where you’re going, the road can take you anywhere. As investors, we tend to be quick to focus on a company’s past success, like what price it's achieved in the stock market, and forget about its future prospects. Past performance only indicates what has already happened but it tells you nothing about the nature of the company’s business prospects. Past performance only measures an investor’s reaction to a company’s reports but it doesn’t determine whether the price goes up or down in the future. We might look at Expedia (EXPE) and recognize it as a great company because of the way it transformed the nature of online travel booking. But more often than not, we will forget to check the finer details behind Expedia’s value, failing to refer to valuation statistics that give potential signals on the level of success it can achieve in the future. Past performance is irrelevant to how any company will prosper into the future.
Past stock prices work the same way as sunk costs in financial accounting. When you are the financial manager of a company, you are always told to ignore sunk costs and never refer to it to determine your next business transaction. Stocks work the same way. As investors, we need to avoid looking at the stock price when determining its value. Expedia’s closest competitor, Kayak (KYAK) is currently the cheaper company of the two. Kayak, therefore, is presumed to be the better investment. But we need to analyze the price further before jumping to conclusions. We need to ask questions like: Why is the price what it is? How do we know that the underlying value will push the price higher in the future?
Some of the most important things for us to understand about any company are its long-term goals, objectives, and risks. One starting point is to take the time to thoroughly look into the managerial history of the company you are interested in, its current state, and its future plans, if they are known.
Figuring out the business risks involves digging deeper into company resources. When trying to understand risks, we want to evaluate competitive factors such as the company’s leadership structure and recent trends in the relevant industry sector. Take online travel for example. Do its companies carry a sustainable business model? And most importantly, are they keeping up with society as technological changes take effect? Nowadays, industry trends are often determined by the nature of technology. Most major industries and niche sectors, including internet-based companies like online travel, find themselves continuously at the mercy of technological advancement. As investors, it is essential to be aware of these developments on a regular basis, as we can ill afford to ignore the ongoing technological advancements that can not only cost a company its business but also cost you money as an investor.
Riding the Wave
We tend to make our investment decisions based on the wave of actions and opinions from others. Many investors select stocks based on recent strong performance. Oftentimes, we buy shares in a stock just because other investors are buying shares. How do you explain this mindset? It comes down to being heavily influenced by what the media has to say. Investors tend to spend lots of time watching financial shows on TV like Jim Cramer’s Mad Money and reading newsletters like StockGuru. All these mediums do is create the notion that popular, cool stocks is signaling a strong trend or wave.
Buying into hot stocks like Facebook (FB) is a horrible mindset for investors. Most of us are too focused on the short-term. Not to mention that even short-term focused investors are not guaranteed to profit off of an investment in a hot company. By the time we invest in a stock, it may very well have reached its pinnacle and therefore will have nowhere to go but down.
It is apparent that those who invested in Facebook didn’t know that its price was possibly at its top already when first entering the market.
Investors, furthermore, often choose to participate in day trading because they think it is a good get-rich quick kind of scheme that can create instant profits, as day trading is rapid trading in and out of stocks as their value rises and falls in the course of minutes or even hours. Some day traders can sometimes make great profits but overall day trading is a losing game for most people. As investors, we need to avoid the temptation to follow a day trading style. What we need to do is spend more time creating our own investment plan and sticking to it. It is more important to trust our own market knowledge and instincts and react more to market conditions rather than the words of others.
Warren Buffett buys cheaply with an eye towards undervalued stocks that will prosper deep into the future. He never lets himself get influenced by another investor’s suggestion. He never follows the life of a day trader. He sticks to an investment plan and is rarely quick to let go of companies he has held for a short period of time. Buffett holds big positions in Coca-Cola (KO), American Express (AXP), and Kraft Foods (KRFT). What these stocks have in common are that they are all recession-proof, iconic brands in the business of serving necessities. Sticking with an investment plan is the polar opposite of chasing performance, a no-no in the world of successful investing.
Setting Targets and Goals for Your Investments
When you fail to plan, you plan to fail. No matter how well or poorly founded, every stock selection strategy produces both losers and winners. Before initiating a position, experienced investors always have an exit plan. The reason is simple: when you don’t have one, every decision you make will be emotional, not rational. And emotional decisions are almost always poor ones, leading to large losses and small gains. Once you own something, you tend to get either greedy or scared. We get greedy when we entertain delusional thoughts that a stock will continue to rise after its price goes up at a fast rate. At the same time, we are scared when the stock price dips below the original purchasing price, creating an urge to immediately sell and cut losses. It is vital to make all decisions up front, before you are scared (if the position happens to go down), or greedy (if it soars).
The reason for selling a stock is always the same: to preserve capital and allow you to redeploy it to more profitable investments. The question is how to determine the right time to sell. Since the potential gains from a stock are often higher than the potential losses, an even bigger source of under-performance is selling too soon when you find a great winner. Again, the motive for investors is to preserve profits. We may choose a target price at which we want to sell the stock in order to protect what we have earned. But in the event that the stock goes up further, we may later regret missing out on the additional lost earnings we could have had if we held on to the stock.
Companies like Apple (AAPL) and Chipotle Mexican Grill (CMG) were, at one time, stocks valued below $100 before their great innovations drove their value. Today, both companies are among the top fifteen most valuable companies on the stock market. Apple is now trading at $628 whereas Chipotle once traded at $442 before sinking to $286 in the last year. If you invested in Apple five years ago and kept your earnings in it for the next year, it was one of the best investing moves in history. You can say the same about Chipotle. But on the other hand, if you got out of Chiptole a year ago, you were smart, as the company had experienced a significant decrease in its price since reaching its all-time high. The smartest move for us to make in these types of situations is waiting until the price finally stops going up and starts decreasing. Even if the decrease takes away a part of the profit you earned, chances are that the stock price will fall well above or close to your target goal. Mainly, the goal is to have a set price for which we want to sell and earn profits, but to avoid the greedy feeling of wanting to hold on to the stock longer in the hopes it will reach that high price at which you hadn’t sold the stock.
Investors have been making these same mistakes since the dawn of modern markets and will likely continue repeating them for years to come. We can significantly boost our chances of investment success by becoming aware of these typical errors and do the opposite: know your investments. Avoid the urge to jump on the bandwagon. And always have set targets and goals.
Guru Discussed: Warren Buffet: Current Portfolio, Stock Picks
Stocks Discussed: EXPE, KYAK, FB, KO, AXP, KRFT, BP, AAPL, CMG,