How to Avoid Common Investor Mistakes

Goal Setting

Before you set off on your investment journey, first, you need to set some investment objectives. The problem with immediately trading the market is that you don't have any parameters for your investment. There should be defined guidelines for your investment strategy that relate to your risk profile, risk tolerance, and investment time horizon, to name a few basics. By first defining your investment objectives, you establish the rules of play. Setting goals also usually leads to the decision of a longer term investment time horizon. Having a long-term perspective mitigates many of the mistakes that an average investor makes. 

Long-term perspective

First and foremost, financial markets eventually deliver positive returns over the long term. Therefore, by constructing a portfolio that mimics the global financial markets ensures that your portfolio will generate positive returns given enough time. A common mistake that many investors make, is that they believe that their actions are generating returns when in reality the markets are delivering returns. Empirical evidence shows that most investors underperform the markets; therefore, a globally diversified portfolio held over the long-term will beat most investors who are trading the markets.

Stop-losses

A common tool for investors trading the markets and buying stocks is the "Stop-loss". This option automatically sells a stock when its price falls to a level set by the investor. It could be set at a 15% loss, 20% loss, or any other arbitrary amount. The problem is that when the whole market crashes, then all these positions could be automatically sold. This is no fault of the portfolio, but could be triggered by a Black Swan event, such as the global pandemic. What this means is that when the global markets recover, the investor is no longer invested to benefit from the market recovery. In simple terms, stop-losses often automatically lock in losses, creating devastating losses for investors. 

Tips

Markets are widely known to be very efficient. What this means is that any public information is priced in to some degree, and the stronger the consensus the bigger the price movement. Many investors seek out stock tips from friends, social media, and other information sources, in the hope that they may find the next big win. This does not work as markets already price in news, whether positive or negative. Many investors become "momentum investors"; jumping onto a hot stock that has been performing well, however, that means that the price is already high, and these investors are probably buying near its peak. What could happen next is a correction in the price after the hype has tempered, leading to losses for these momentum investors. In seeking to outperform the market, it could require going against the consensus, buying positions that are not under the spotlight, or betting against the consensus by buying when others are selling.

FOMO 

The Fear Of Missing Out is a major reason why momentum investors buy at the wrong time. But it is also why investors buy into schemes that sound too good to be true. Some of these schemes are outright scams like Ponzi schemes, but other times, investors have tunnel-vision on the return without carefully considering the risk. One example of this was when Evergrande, the once-largest real estate developer in mainland China, was paying a 12% coupon rate on its bond, and investors flocked to buy up its bonds, but ultimately the developer defaulted on its bonds, leading to massive losses for investors. Look forwards, not backwards, consider the risk relating to the potential returns, and determine if the investment complements the rest of your portfolio and your overall investment strategy.

Golden Eggs

It is tempting to go on a treasure hunt for the big wins, to seek out weird and unheard of companies that are worth very little today, in the hope that it will become the next unicorn. We hear of these stories all the time (they make for great reading); someone bought a company back when it was unheard of, and today it's a multi-billion dollar company (think of Zoom), and the glory that comes with the big win. What we don't hear about are the many big losses that naturally come with venture capital; companies that never amount to anything, and many that go bust. The win that we hear about carries the many losses made elsewhere. Furthermore, the investors who can afford to buy these small companies have the flexibility to not require liquidity on these investments, whereas most retail investors require far greater levels of liquidity. Financial headlines in isolation make for a distorted reality. Many massive and well-known companies make fantastic returns for investors. Be wary of hunting for golden eggs.

Happy Trading-Finger

Many investors believe that it is their trades that make the gains in the financial markets. They believe that their active trading led to many gains in their portfolio. Empirical evidence shows that investors' actions often lead to lower profits compared with a buy-and-hold strategy. Timing the market in a way that outperforms the market is incredibly difficult, even for professionals. It is also worth noting that when money is out of the market, it is not earning dividends at the same rate that buy-and-hold investors are earning. Furthermore, although fees have dramatically reduced these days, active trading also incurs fees. This means that active market traders have to overcome the fees and dividends, as well as buy low and sell high at exactly the right times. Instead, create a globally diversified portfolio holding long-term assets, enjoy the dividends and long-term capital gains, and simply monitor its progress whilst remaining steadfast in most situations.