One of the most least understood truths of investing is this:
Success in the game of investing depends more on not making mistakes than it does on picking big winners. Period. In fact, Warren Buffett’s two rules of investing are: #1) Never lose money and #2) Never forget rule #1.
It’s all too easy for small investors to make bad choices: The securities industry creates a “latest and greatest” way to make a quick buck almost every day. But almost all of these ideas are structured to benefit people other than the small investor. Small investors wind up getting relegated to their usual status… as victims.
The way most investors miss out on success is not because they are not smart enough to succeed in the markets, rather because there are fundamental flaws in the ways that they approach investing. With that in mind, let’s look at seven of the most common mistakes the small investor makes:
1. They don’t have a plan. One of the most common and deadly mistakes that small investors make is not having a plan for investing. While it is impossible to predict markets — being prepared and able to take advantage of market conditions, separates the pro from the amateur. If the market tanks like it did in 2008-2009, does one sell or buy? This is a question that an investor should be prepared to answer long before the situation occurs . With due diligence and careful consideration, it’s not hard to formulate an intelligent plan for how, and in what conditions, you will make your investments. When people deviate from a rational plan is when many of the most costly errors in investing are made. I can tell you from personal experience, the key to beating the market is having an investment philosophy that’s based on sound logic, not what’s popular on Wall Street at the moment.
2. They invest in something they don’t understand. One of the world’s most successful investors, Warren Buffett, cautions against investing in businesses you don’t understand. This means that you should not be buying stock in companies if you don’t understand the business models of the underlying companies. The best way to avoid this is to invest slowly after you have researched a company thoroughly. What does the company do? What is the company’s earning and balance sheet history? How richly is the company’s stock valued? Who are the company’s competitors and does the company have a durable competitive advantage? Is the company run by honest, forthright executives? These are just some of the questions that need to be answered by the small investor to ensure they understand the business. A good place to start getting information? Study the 10-K and 10-Q annual reports required of every public company. But don’t stop there, research everything you can about the company. Remember to do your homework before you invest your hard-earned cash.
3. They let their emotions betray them into doing the wrong thing at the right time. Wall Street can be a scary place when the markets are gyrating wildly. This is not new. Three centuries ago, when scientist Isaac Newton lost a fortune in the “South Seas” stock collapse, he complained: “I can calculate the movement of the stars, but not the madness of men.” A more recent market meltdown was the 2008-2009 collapse. The Dow lost half its value in less than a year. Millions of investors saw billions of dollars in assets disappear. Letting their emotions rule their day, many investors pulled out and sold at the worst possible time—the bottom. Yet six years from that 2009 market bottom, the Dow is up over 10,000 points to a new record high. Keeping your emotions in check, will allow you to take advantage of the market’s follies, not be a participant in them. As Buffett always says, “be fearful when others are greedy and greedy when others are fearful.”
4. They buy momentum stocks. Just as a rising tide lifts all ships, a surge in the stock market will boost most stocks. Many small investors select stocks simply based on how they’ve performed recently. The feeling that “I’m missing out on a great stock” has probably led to more bad investment decisions than any other single factor. If a particular stock has done extremely well for several years, we know one thing with certainty: The time to invest in that stock was probably three or four years ago. As they say at the end of every cycle, the smart money is moving out of a stock and the dumb money is pouring in. It’s difficult to ignore a stock that appears to be taking a ride to the moon, but it’s best to stick with your investment plan and wait for the right opportunities. Although opportunities may not come every day, they do come and the key is to be ready for them.
5. They have a short time horizon. Perhaps one of the biggest killers of high investment returns is having a short time horizon. Patterns, predictions and stock-market gyrations all have one thing in common – they are a short-term distraction from an investor’s long-term goals. Stock market returns may deviate wildly over a shorter time frame, but over the long term, historical returns for large cap stocks can average 10 to 11%. In investing, one principle always rings true: Time is the single most important element of investing. And for that reason, mismanaging time can have the most devastating effect on your money. Before jumping on the bandwagon of a short-term market swing, weigh the decision carefully with what it could really cost you in the long run. It’s important to remember to keep your eye on long-term investing goals. Let the day-to-day gyrations take place while you focus on creating a consistent return over the long haul.
6. They take their investment cues from financial media. You would think that the financial media, even the reputable ones, have your best interest in mind when they publicize their stock recommendations. You would be excused for believing that they actually do a lot of research before they publish their analysis. If you do, you are giving them way too much credit. Their chief concern is getting eyeballs on the story so they can sell more ads. In fact, many of financial media’s “screaming buy” recommendations are followed by a “screaming sell” recommendation only 30 days later. My advice for when you hear the pundits tell you that a particular investment is a guaranteed winner? Close your ears and calculate the facts for yourself. They are no smarter than you and they certainly don’t have your best interests in mind. Think for yourself.
7. They speculate instead of invest. The word speculator comes from the Latin word specere, literally meaning a spy. In the heady days of the Internet bubble, speculation became rampant. Everything was going up. You couldn’t lose! You simply waited a few months, weeks, or hours and someone else would come along to buy the stock from you at a higher price. That all worked nicely…until it didn’t. As Ben Graham (Warrren Buffett’s mentor) said, “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative. Know this, an investment is something that you’ve analyzed carefully. You know exactly what you’re buying. You feel confident that it’s stable for the long haul. You also know that it will give you an adequate return, either through an increase in share value or through healthy dividends for the price you pay. Don’t invest without knowing what you’re buying. Study it very carefully before you buy. If you must speculate, then do so with money that you won’t need for the future. In other words, don’t speculate.
Making mistakes is a part of any learning process. Knowing what they are, when you’re committing them and how to avoid them will help you succeed as an investor. To avoid committing them, develop a thoughtful investment plan and stick with it. Do your own thinking and don’t be afraid to do the opposite of the herd. Follow these guidelines, and you will be well on your way to building wealth with investing over the long term.
Be free. Nothing else is worth it.
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