Avoiding Common Investment Mistakes

Tuesday, 6 May 2014

US regulators study flags some common investment pitfalls that tend to cloud our judgments

For many of us, the hardest part about making the right investment decisions is not to let ourselves get in the way.

While turning a profit on our investments can be an exhilarating experience, it is much tougher to cope with the excruciating pain when we lose our hard-earned money on a bad call.

Sad to say, a recent study on investor behaviour commissioned by the United States Securities and Exchange Commission shows that investors tend to repeat the same mistakes all the time.

The problems it highlights sound drearily familiar.

Specifically, many investors damage their portfolios by under-diversifying, trading frequently, following the herd, as well as selling winning positions and holding on to losing positions, it said.

Dont we recognise in ourselves some of this?

The study also flags some common investment mistakes that tend to cloud our judgments. In doing so, it hopes that if we know the potential pitfalls, we may try to avoid them and turn ourselves into better investors. Some of the common pitfalls include:

Chief among our shortcomings is the enemy that lies within us our emotions.

The study said: Over-confidence, an emotion common among investors, triggers a wide range of investment errors. In the worst-case outcome, an overconfident investor becomes a victim of some form of investment fraud such as a Ponzi scheme.

The study notes that active traders underperform the market, as the over-confidence they display causes them to over-trade.

It cited another research report which noted that investors, who use traditional brokers and remain in touch with them by telephone, achieve better results than online traders, who damage their performance by trading more actively and speculatively.

What is also noticeable is the horde of investors who tend to chase after hot stocks as market conditions turn bubbly.

Because a bubble inflates rapidly and is not durable, it is a common metaphor for financial mania. When the bubble bursts, the price of the asset plunges, setting off a panic, the study said.

It cited two well-known examples of financial mania in the past 12 years — the bursting of the dot.com bubble in 2000 and the US sub-prime housing crisis in 2008.

This refers to a strategy practised by many day-traders which involves chasing after penny stocks when they suddenly burst back into life.

While most investors would focus on the newsflow before making an investment, momentum traders seek to take advantage of a price trend, especially in small-cap stocks with low analyst coverage, the study noted.

But the short-run momentum can lead to long-run reversals as stock prices overshoot their intrinsic values, it added.

Another pitfall, and one related to momentum trading, is noise trading — a mistake frequently made by traders as they get confused between the false signals sent out by a stocks trading pattern and the overall market trend.

These investors generally have poor timing, follow trends, over-react to good and bad news. They make decisions regarding buy and sell trades without the use of fundamental data, the study noted.

In value-style investing, an investor buys out-of- favour stocks with low price-to-earnings and price-to-book ratios, believing them to be trading below their intrinsic value.

But the study notes that investors tend to under-estimate the ability of value stocks to rebound and over-estimate the ability of glamour stocks to maintain above-average growth.

It said: Whether investor psychology is the cause or not, excessive investment in these stocks may drive up their prices well beyond their intrinsic value. Over time, growth stocks fail to meet optimistic expectations, while value stocks exceed pessimistic expectations.

Selling The Winners And Keeping The Losers

And finally, the one trait which dogs most of us who are loss-averse investors the tendency to sell our high-performing shares in order to try to recoup our losses on the loss-making ones.

But in the months following the sale of winning investments, these investments continue to outperform the losing ones still held in the investment portfolios, an outcome exactly the opposite of that intended, it added.

In other words, try to keep the winners and cut the losers. While it may be very painful taking the loss, in the long run, you will find yourself enjoying better returns on your investments.