Avoid These Common Investing Traps

1. Investing in Something You 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 what they do. Why is this important?  Because during periods when the stock is down, knowing what they do will give you the confidence to resist falling into the trap of panic selling.

2. Falling in Love with a Company

Too often, when we see a company we’ve invested in do well, it’s easy to fall in love with it and forget that we bought the stock as an investment. Remember: you bought this stock to make money. If any of the fundamentals that prompted you to buy into the company change, consider selling the stock.

3. Lack of Patience

A slow, steady and disciplined approach will go a lot farther over the long haul than going for the “Hail Mary” last-minute plays. Expecting our portfolios to do something other than what they’re designed to do is a recipe for disappointment. This means you need to keep your expectations realistic in regard to the length, time and growth that each stock will encounter.

4. Too Much Trading

Turnover, or jumping in and out of positions, is another return killer. Unless you’re an institutional investor with the benefit of low commission rates, the transaction costs can eat you alive – not to mention short-term tax rates and the opportunity cost of missing out on the long-term gains of good investments.

5. Market Timing

Successfully timing the market is extremely difficult to do. Even institutional investors often fail to do it successfully. A well-known study, “Determinants of Portfolio Performance” (Financial Analysts Journal, 1986), conducted by Gary P. Brinson, L. Randolph Hood and Gilbert Beebower covered U.S. pension-fund returns. This study showed that, on average, nearly 94% of the variation of returns over time was explained by the investment policy decision. In laymen’s terms, this indicates that, normally, most of a portfolio’s return can be explained by the percentage you allocate to stocks, bonds, and cash –  not by jumping in and out of the market, or by picking the right stocks.

6. Waiting to Get Even

Getting even is a trap that we’ve all fallen into at one time or another. This means you are waiting to sell a loser until it gets back to its original cost basis. Behavioral finance calls this a “cognitive error”. By failing to realize a loss, investors are actually losing in two ways: First, they avoid selling a loser, which may continue to slide until it’s worthless. Also, there’s the opportunity cost of what may be a better use for those investment dollars.

7. Failing to Diversify

While professional investors may be able to generate alpha, (beat the market averages) by investing in a few concentrated positions, non-professional investors should not try to do this. Stick to the principal of diversification. In building an ETF or mutual fund portfolio, remember to allocate an exposure to all major areas like stocks, bonds, cash, gold, etc

8. Letting your Emotions Rule the Process

Perhaps the No.1 killer of investment return is your emotions. The axiom that fear and greed rule the market is true. Do not let fear or greed overtake you. Focus on the bigger picture. Stock market returns may deviate wildly over a shorter time frame, but over the long term, historical returns for large cap stocks can average 10-11%. Realize that, over a long time horizon, your portfolio’s returns should not deviate much from those averages. In fact, you may benefit from the irrational decisions of other investors.

What You Can Do to Avoid these Mistakes

1. Develop a plan of action. Proactively determine where you are in the investment life cycle, what your goals are and how much you need to invest to get there. If you don’t feel qualified to do this, seek a reputable financial planner. Try to find one who will work for a fee and one who does not receive incentives to sell you high-commission products. Remember why you are investing your money, and you will be inspired to save more and may find it easier to determine the right allocation for your portfolio. Temper your expectations to historical market returns. Do not expect your portfolio to make you rich overnight. A consistent, long-term investment strategy over time is what will build wealth.

2. Put your plan on automatic. As your income grows, you may want to add more. Monitor your investments. At the end of every year, review your investments and their performance. Determine whether your equity-to-fixed-income ratio should stay the same or change based on where you are in life.

Conclusion

Mistakes are part of the investing 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, systematic plan and stick with it. If you must do something wild, set aside some fun money that you are fully prepared to lose. Follow these guidelines, and you will be well on your way to building a portfolio that will provide many happy returns over the long term.