Most Common Mistakes of the Amateur Investor….
Knute Rockne, the famous Hall of Fame Notre Dame football coach, used to say, “Build up your weaknesses until they become your strong points.” The reason most individual investors constantly loose money in the stock market is they simply make too many mistakes. It’s the same in your business, sports and your career. You never fail because of your strengths. It’s always the mistakes or weaknesses that you do not recognize and correct that bring you down. Most people just blame somebody else, such as your advisors. It is much easier to have excuses than it is to examine your own behavior realistically. Don’t feel bad. It’s human nature.
Spending over 15 years in the investment industry and over twenty as an active trader, I’ve learned the greatest mistake all investors make is never spending any real time trying to educate themselves and learn where they made their mistakes in buying and selling stock in an effort to identify what they must stop doing and start doing in order to become highly successful investor. In other words, you must unlearn many things you thought you knew, stop doing them, and start learning new and better rules and methods to use in the future.
From my years in the industry, managing the emotions of hundreds of investment clients and through endless research, the following are the twenty-one most common mistakes investors make:
#1: Living in denial and stubbornly holding onto your losses when they are very small and reasonable.
Most investors could get out quickly when they have made a mistake, but because they are human, their emotions take over. You don’t want to take a loss, so you wait and you hope, until your loss gets so large it becomes almost impossible to recover. From my experience managing client emotions, this is by far one of the greatest mistakes nearly all investors make. As the world famous investor William O’Neil say’s “All stocks are bad. There are no good stocks unless you make money when you sell”.
Without exception, you should cut every single loss short. The rule I have taught all of our investment clients is to always cut all your losses immediately when a stock falls 7% or 8% below your purchase price. Following this simple rule will ensure you will survive another day to invest and capitalize on the many excellent opportunities in the future.
#2: Buying on that is down in price rather than a stock making new highs.
I used to get this call all of the time from my clients. “Hey, XYZ is down over 10% today. Let’s buy some. It’s a bargain.” Buying a declining stock makes you feel like you are getting something on sale. This very rarely works. A stock is down typically for reasons you should avoid it. For example, in late 1999, a client bought Xerox when it dropped abruptly to a new low at $34 per share and seemed really cheap. A year later, it traded at $6 per share. Why try to catch a falling knife? Many people did the same thing in 2000, buying Cisco Systems at $50 on the way down after it had been at $82. It never saw $50 again, even in the 2003 to 2007 bull market. In fact in June of 2010 you could buy it for $21 per share.
#3: Averaging down in price rather than averaging up when buying.
If you buy a stock at $40, then buy more at $30 and average out your cost at $35, you are following up your losers and throwing good money after bad. This amateur strategy can produce serious losses and weigh down your portfolio with a few big losers. Again, this sounds like common sense, but most investors don’t recognize it. A stock that is moving down is moving down for a reason. Either the company is sound and the broad market is in a downtrend or the stock itself is not what you thought it was. Either way, you need to protect yourself and look to cut your losses, not buy more. Avoid the big disasters in your portfolio. That is how you make consistent results.
#4: Not learning to use charts and being afraid to buy stocks that are going into new high ground off sound bases.
The public generally thinks that a stock making a new high price is too high to buy, but personal feelings and opinions are emotional and far less accurate than the market itself. The best time to buy a stock during any bull market is when the stock initially emerges from a price consolidation or a sound basing pattern of at least seven or eight weeks. Get over wanting to buy something cheap on the way down. It’s going down for a reason.
#5: Being lazy and not establishing sound selection criteria and not knowing exactly what to look for in a successful company.
Do your homework. Arm yourself with education. You need to understand what fundamental factors are crucial and what are simply not that important! Many investors buy fourth-rate, “nothing to write home about” stocks that are not acting particularly well; have questionable earning, sales growth, and return on equity; and are not the true market leaders. Others overly concentrate in highly speculative or lower-quality, risky technology securities.
#6: Not understanding the true direction of the overall market and recognizing when a market decline is most likely or a new uptrend is confirmed.
It’s critical that you be able to recognize market tops and major market turnarounds coming off the bottom if you want to protect your account from excessive giveback of profits and significant losses. Likewise, you must know when the correction is over and the market tells you to buy. You can’t go by your opinions or feelings. You must have specific rules and follow them religiously.
#7: Letting your emotions drive your decisions rather than following your buy and sell rules.
Never become emotional about the stock market. The soundest rules you create are of no help if you don’t develop the discipline to make decisions and act according to you historically proven rules and game plan.
#8: Concentrating your effort on what to buy and, once the buy decision is made, forgetting to manage your position.
Most investors have no rules or plan for selling stocks, meaning that they are doing only half of the homework necessary to succeed.
#9: Failing to understand the importance of buying high-quality companies with good institutional sponsorship.
Always pay attention to what the pros are buying. They are the ones that buy enough shares to move a stock. Make sure you are on the right side of the institutional market.
#10: Buying more shares of low-priced stocks rather than fewer shares of higher-priced stocks.
Many of my clients are more concerned about buying more shares of a stock with a lower price than few shares of a stock that has a higher price. Remember, there is a reason the lower price stock is lower in price. It typically is not for good reasons. Some of the strongest companies in this market trade for over $200 per share. Think in terms of dollars when you invest, not the number of shares you can buy. Buy the best merchandise available, not the cheapest. If you buy $10,000 of a $5 stock and the stock moves 20% you make the exact same that you would if you buy $10,000 of a $100 stock. You don’t get more bang for your buck by buying more shares of a cheaper stock.
#11: Buying on tips, rumors, split announcements, and other news events; stories; advisory-service recommendations; or opinions you hear from other people or from supposed market experts on TV.
Do your research. There is no easy way out. Many people are too willing to risk their hard-earned money on the basis of what someone else says, rather than taking the time to study, learn, and know for sure what they’re doing. As a result, they risk losing a lot of money. Most rumors and tips you hear simply aren’t true. Even if they are true, in many cases it is already priced into the stock and when the event actually takes place, the stock concerned will ironically go down, not up as you assume.
#12: Selecting second-rate stocks because of dividends or low price/earnings ratios.
Dividends and P/E ratios aren’t anywhere near as important as earnings per share growth. In many cases, the more a company pays in dividends, the weaker it may be. It may have to pay high interest rates to replenish the funds it is paying out for the form of dividends. Better performing companies typically will not pay dividends. Instead, they reinvest their capital in research and development or other corporate improvements. Also, keep in mind that you can lose the amount of a dividend in one or two days’ fluctuation in price of the stock. As for P/E ratios, a low P/E is probably low because the company’s past record is inferior. Most stocks sell for what they’re worth at any particular time.
#13: Wanting to make a quick and easy buck.
Again, I saw this mistake made by almost every single client. Wanting too much, too fast without doing the necessary preparation, learning the soundest methods, or acquiring the essential skills and discipline to be a successful investor. Chances are, you’ll jump into a stock too fast and then be to slow to cut your losses when you are wrong.
#14: Buying old names you’re familiar with.
Just because you used to work for General Motors doesn’t necessarily make it a good stock to buy. As I was a broker in the Detroit area, I had a number of General Motors employees as clients. It was like pulling teeth to get them to part with that stock. Very few actually would. Well their emotions got in the way and most never saw GM was headed in the wrong direction. As a result they watched their life saving get destroyed as GM went into bankruptcy. Remember, many of the best investments will be newer names that you won’t know, but that, with a little research, you could discover and profit from before they become household names. Did you recognize the name Google ten years ago?
#15: Not being able to recognize (and follow) good information and advice.
Friends, relatives, certain stockbrokers, and advisory services can all be sources of bad advice. Only a small minority of people giving advice are successful enough themselves to merit your consideration. Outstanding stockbrokers or advisory services are no more plentiful than outstanding doctors, lawyers, or ballplayers. Only one out of nine baseball players who sign professional contracts ever make it to the big leagues. Most of the ballplayers coming out of college simply are not professional caliber. Many brokerage firms have gone out of business because they couldn’t mange their own money wisely. Look what happened to Merrill Lynch. They had to be bailed out by Bank of America due to poor investments and leverage. Better yet, look how many people blindly trusted Bernie Madoff and lost everything. You have to do your own homework. Trust no one blindly.
#16: Cashing in small, easy-to-take profits and holding the losers.
In other words, doing exactly the opposite of what you should be doing: cutting your losses short and giving your profits more time. So many of my clients would say, I have not lost money in this stock because I have not sold it. Trust me. When the stock is down, you have lost money…
#17: Worrying way too much about taxes and commissions.
The name of the game is to first make a net profit. Excessive worrying about taxes usually leads to unsound investment decisions in the hope of achieving a tax shelter. You can also fritter away a good profit by holding on too long in an attempt to get a long-term capital gain.
The commissions associated with buying and selling stocks, especially through an online broker, are minor compared with the money to be made by making the right decisions in the first place and taking action when needed. The fact that you pay relatively low commissions and you can get out of your investment much faster are two of the biggest advantages of owning stock over owning real estate. People can get over their head in real estate and lose money if they overstep themselves. With instant liquidity in equities, you can protect yourself quickly at low cost and take advantage of highly profitable new trends as they emerge.
#18: Speculating too heavily in options or futures because you see them as a way to get rich quick.
Some investors also focus mainly on shorter-term, lower-priced options that involve greater volatility and risk. The limited time period works against holders of short-term options. Some people also write “naked options” (selling options on stocks they do not even own), which amounts to taking greater risk for a potentially small reward. Make sure you completely understand how options or futures work prior to delving into this world. It’s very complex. I’ve seen too many investors loose it all because they don’t truly understand what they are getting into.
#19: Rarely transacting “at the market”, preferring instead to put price limits on buy and sell orders.
By doing so, investors are quibbling over eights and quarters of a point (or their decimal equivalents), rather than focusing on the stock’s larger and more important movement. With limit orders, you run the risk of missing the market completely and not getting out of stocks that should be sold to avoid substantial losses. The markets are much more efficient than they used to be. Don’t worry about getting a bad fill.
#20: Not being able to make up your mind when a decision needs to be made.
Many investors don’t know whether they should buy, sell, or hold, and the uncertainty shows that they have no guidelines or rules. Most people don’t follow a proven plan, a set of strict principles or buy and sell rules, to correctly guide them. Make sure you set up non-emotional guidelines. This will help you avoid the most common mistake, getting emotionally involved in the stock market.
How many of these describe your own past investment beliefs and practices? Poor principles and methods yield poor results; sound principles and methods yield sound results. As knute Rockne says, “Build up your weaknesses until they become your strong points.” It takes effort and time to properly arm yourself with knowledge. Trust no one. Take the time to become a great investor. Learn from your mistakes. That is the only way you will become a great investor.