Common mistakes of the average investor

Author: Steven posted in Investing basics tagged with Investing 101, Stock market

If you see yourself in any of the traits described in this article, make sure you take corrective action in order to preserve your capital and maximize your long-­term rate of return. Before you start buying stocks make sure you first have a good understanding of investing basics and that you have a well­-defined investment objective and associated time frame. I must admit that when I first started investing in the stock market I didn’t have a good understanding of what was going on but I was attracted by the idea of making money quickly. I was lucky with my first investment where I made a significant profit on a single stock and as a result I thought I was a stock guru. Actually I was just lucky and could have just as easily have had a significant loss on my investment. Fortunately I eventually learned my lesson. I learned it the hard way, but I learned it and today I have a totally different approach to investing in the stock market. Don’t get me wrong, I’m a big fan of the stock market. The market provides an excellent opportunity for the individual investor to earn a nice rate of return which exceeds the rate of inflation. To accomplish this you must have a disciplined approach that will minimize the chances of putting you in a difficult financial situation. Your goal should be to achieve lifetime success when investing in stocks rather than chasing instant success.

Here are the most common “mistakes” that the average investor commits:

Tends to become grossly overconfident

Just because you made a good profit on a couple of stocks doesn’t mean you know more than others and that you can predict the future direction of stocks. Sooner or later you will make serious errors of judgment and potentially lose all your gains. A well diversified portfolio will help reduce the amount of risk compared to individual stock investments. You must decide how much risk you are willing to take and not exceed that level or you will panic when the going gets rough and sell at the worst possible time. Remember, the goal is to buy low and sell high. Many people do exactly the opposite, they buy stocks when everything is going well (prices are high) and they sell when things are looking bad (sell low). Isn’t that how you lose money? Warren Buffet famously said “I am certainly not going to predict what general business or the stock market are going to do in the next year or two, since I don’t have the faintest idea”, If this master investor felt this way what makes you feel you can do better? Always be humble and cautious.

Systematically pay too much for certain classes of stocks

Buying low and selling high is the dream of all investors but if it were that simple we would all be millionaires. When you are a short-­term investor you might end up paying too much for a given stock. But guess when you will realize this? When the share price plunges. There are some indicative methods to see if a stock share price is overvalued compared to other stocks, but in general it is impossible to foresee how a stock will perform in the future as such theories are based on indefinite factors. For example we know that the higher the growth rate and its duration, the higher price an investor is willing to pay and thus the stock will have a higher P/E multiple. If you have two stocks with the same growth rate and duration (which are based on predictions thus be cautious), the one with the higher P/E is more expensive.

Trade too much at great cost

Commissions add up quickly and have a large impact on the overall rate of return. When buying stocks try to minimize the number of transactions by sticking with your original investment plan. The key to wealth building is sticking with you savings plan and investment strategy (long­-term investment strategy). You only make a profit when you sell an investment for more than you paid for it. Your stock broker collects their commission every time you buy or sell a stock whether you make a profit or suffer a loss. The broker always wins! Although mutual funds can be an effective vehicle to diversify your portfolio, make sure you analyze the associated costs. In general, the actively managed funds involve greater costs than index funds which reduces your net returns.

Regularly make irrational buy and sell decisions

The key to success is going for long term return where you will benefit from compound interest and reduce the overall risk of your portfolio. The reason the rich get richer is because they make their money work for them. Don’t try to time the market and don’t overreact to the mood of the market. It is normal for the market to go up and down and throughout your investment career you will encounter at least one bear market which can even last for more than 10 years. The key is to keep control your emotions and don’t lose your head when everyone else around you is losing theirs.

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