To err is human. This applies to investing also. Equities as an asset class is the best long term investment option, but some investors do lose money and end up being shy of the asset class. Stock market is a place where fear and greed affect investors, whether an expert or a novice.
While even the best investors make some mistakes, one should endeavor to minimize investing mistakes. These mistakes not only have a financial impact but can have a psychological impact, which keeps them away from investing in equities, leading to missed opportunities. If investors know where they can go wrong, they can minimize the impact of these mistakes, if not avoid them. We list down five most common mistakes.
Timing the market: Many investors often try to time the market. However, this can be a frustrating exercise and the attempt to catch bottoms and tops in their zeal to squeeze the last possible penny from that trade can end in undesirable results. In the process, often an investor ends up incurring losses. John Bogle, founder of Vanguard, once remarked, “The idea that a bell rings to signal when to get into or out of the stock market is simply not credible”. Investors should recognize that it is not possible to time the market perfectly and should be prepared to forego some profits for making late entries or early exits. There is another aspect to market timing; it is easy to be fearful when markets are close to the bottom and investors may get greedy when markets are at a high, however, in Warren Buffet’s words, “One should be fearful when others are greedy and greedy when others are fearful.” Be ready to buy during times of adversity and sell when others are euphoric.
Buying on tips: Many times investors get lured into making a trade based on tips provided by a friend, family member or someone with a reputation of being a stock market rock star, some of this advise may be well intentioned, but may come from people who have little knowledge or feeble experience. People providing tips may boast of only their successes and not of their mistakes, also many a time, rumors are spread with mala-fide intentions. Buying on tips may result in investors incurring heavy losses. Whenever an investor receives an advice or a 'tip' they should take time out to research the proposed investment by focusing on the fundamentals including business prospects of the company, its earnings potential and valuation.
Lack of diversification: 'Don’t put all your eggs in one basket' may be a cliché, but extremely important for investors to follow. Many investors ignore the benefits of diversification. Returns in markets are often determined by asset allocation. It is advisable for investors to diversify their investments across asset classes like equities, bonds, commodities (including gold) and real estate. This approach of diversifying across asset classes helps minimize volatility of their portfolio. For instance, in a bear market in equities, bonds and other asset classes will cushion the portfolio. Also within the equities asset class, one should invest in about 25-30 stocks spread across sectors to diversify risks. Often, investors get wedded to their ideas such that they end up investing a substantial portion of their funds in few stocks and this exposes them to unnecessary risks.
Emotion overrules rationale: Often investors get emotionally attached to their stocks. They get wedded to their ideas, specifically if they have researched the stock. However, this can prevent them from taking rational decisions like selling a stock when there is little upside left. Also every investor will make some mistakes, investors should think rationally and accept their mistakes and take corrective action when required. Another place where emotions need to be kept in check is to get fearful near market bottoms and greedy near market tops. While one may not be able to catch the highs and lows exactly, one should buy when others are fearful and sell when others are greedy.
Not cutting losses and averaging down: Often, investors are late in accepting their mistakes. Many investors average down when the value of their investment declines. Averaging down involves buying more of the same stock as it falls more. By doing so, they may end up incurring greater losses. One should pause and re-evaluate their investments when there is a decline. This involves studying the fundamentals again. If they find that there is potential downside in a stock, they should cut losses and move on to other attractive opportunities in the market. Why deploy good money to chase bad stocks?
To sum it up investors should be aware of the fact that it is common to make mistakes. When they realize they made a mistake, they should accept it and focus on minimizing the damage. To achieve this, they should have a plan of action and implement it without any bias or emotion. While it is quite natural to have the itch for stock market action, one will make a few mistakes, however, I hope that with the pointers above, investors will be able to minimize mistakes and profit from the opportunities available in this asset class. (The author is CEO - Stock Broking, Karvy)