Sep 23, 2009

Top 5 Stock Investing Mistakes

Photo by Christopher Chan

Investing is a continuous learning process. No investor has ever become successful without making mistakes. There is nothing wrong in making mistakes. What matters is our ability to learn from our mistakes so as to avoid repeating them. But this is easier said than done.

This post talks about the oft-repeated and fatal investing mistakes made by majority of investors:

5 Top Stock Investing Mistakes / Pitfalls

1. Having no investment strategy
If you don’t know where you’re going, no road will take you there.

Investing in an ad-hoc manner is the biggest blunder committed by investors. Having a casual approach towards investments is a sure recipe for failure in the financial markets.

What are you investing for? Why are you investing? If you’re not clear about your objectives behind investing in the markets, if you don’t know whether you’re an investor or a trader, if you’ve no idea whether you want to invest for the short term or the long term, then you are doomed to fail from the start.

And, it becomes really dangerous when you start gambling or speculating in the name of stock investing.

But despite not understanding the basics of stock investing, why does every Tom, Dick and Harry fall prey to its deceptive charm? To know why, see this article by Jagoinvestor:
Why stock investing seems so easy?

The second important reason is that stock trading gives you a high feeling similar to the “high” experienced by drug addicts.


2. Too high expectations
Don’t you look at the pink papers daily to see how your stock is performing? Don’t you expect to double your money in a short period of time? It’s down right foolish to expect high returns year on year without any intervening bad periods.

Stock investing is all about patience. Growth is never linear. Also, over a long period of time, returns have a tendency to revert towards mean (mean reversion).

To meet our unrealistic expectations, we take unnecessary risk. There are no free lunches. Excess returns require excess risk which is not good for financial health.


3. Wrong buy/sell timings
The way we buy stocks is really amazing and defies all logic. When we go shopping for a TV or a cell phone, we go to great lengths to find a good bargain. But when it comes to investing, we invariably choose wrong time to enter and exit. We buy when the markets are at the peak (greed) and sell when the markets crash (fear) whereas it should be the other way round.

Most of the investors buy when the markets are overheated and sell when the markets are in panic. But why do the same investor who is not willing to buy a stock when it is quoting at a P/E (price-to-earnings) multiple of 2-5 suddenly changes his mind and ready to buy after the 10 times increase in the price? Why do we are ever ready to buy stocks at more than there intrinsic worth?

Stock markets are perhaps the only market where demand increases at higher prices because we believe that there will always be a greater fool (than us) sitting out there who will be ready to buy it from us .

For example, when the Sensex bottomed out at around 8,000 during November 2008 to mid March 2009, there were no buyers. Now when the stock valuations at current level look stretched and have become historically expensive (Sensex has more than doubled during last six months and is nearing 17000), retail investors are again back.
Note: Yesterday (22 September, 2009), Bombay Stock Exchange (BSE) Sensitive Index, Sensex closed at 16886.43 with a P/E of 21.86 and the National Stock Exchange (NSE) index, Nifty zoomed past the 5,000-mark for the first time in 16 months.


4. Hesitation in booking Losses
Suppose you buy two stocks A and B for Rs 1000/- each. A rises to 2000/- while B drops to Rs. 500/-. Which stock would you sell?

Don’t you prefer to sell those shares which make a profit while continuing to held on to loss making shares?

Put another way, investors tend to hold onto their losses too long while holding onto their gains too short. But why do investors generally retain their losing investments longer than they hold on to winning investments?

Behavioural Finance says that there are 4 basic reasons behind this irrational behavior:


i) Regret avoidance: Investors avoid selling stocks that have gone down in order to avoid the pain and regret of having made a bad investment decision. We are reluctant to acknowledge our losses to avoid the stress associated with admitting a mistake and because it hurts our ego.

People are afraid to admit an error in judgment and are thus more likely to sell winners in their portfolios than losers.

ii) Mental Accounting: Mental accounting predicts that people will hold onto losing stocks because closing an account at a loss is painful; realized loss is more painful than the paper loss.

iii) Anchoring: It means to wait for investments to break-even at a price at which it was purchased.

iv) Disposition effect / Loss aversion: Our tendency to avoid loss than to profit from gains because psychological losses are twice as powerful as gains.



5. Use of borrowed funds to invest (Leveraging)
Investors do leveraging (which is a two way sword) either by investing borrowed money or by investing in derivatives (futures and options).

But what is leveraging and how is it a dangerous weapon in the hands of investors?

Borrowing money (e.g., personal loans, loan against shares, IPO financing, margin trading) to make more money is really seems an attractive proposition. Investing with borrowed funds helps you make profit much more than otherwise, but it’s extremely dangerous. When the market is rallying, the return on your funds gets magnified (due to leveraging) even after meeting the interest cost. However, in case of a market fall, there can be complete wipe out of your money.Put simply, leveraged investing (use of borrowed funds to invest) magnifies both potential gains as well as potential losses relative to the performance of the investments. Let’s see how:

Suppose Rs 100 is invested (which includes borrowing of Rs 50 @ say, 12% rate of interest). If the return on investment is, say, 20%, then the net return earned on own funds become 28% after paying interest cost. However, if instead of 20%, overall return is say nil (market remains at the same levels) then the net return on own funds becomes -12%. Further suppose that market tumbles and overall return on the funds invested is -20% , then after meeting the fixed interest cost, the net return on own funds invested works out to be -52%.What? How come? What’s the reason behind such an amplification of loss? It is because regardless of investment performance (i.e., inspite of negative returns or the investment becoming worthless), the loan principal and the accrued interest thereon still needs to be repaid.

Put another way, use of borrowed funds to invest is a speculative and risky adventure similar to gambling.

Similarly, using the derivatives (Options and Futures) route to invest (instead of cash segment) can be very dangerous.

I hope you enjoyed reading this post. As always, you’re welcome to post your questions or comments.


Also see:

1. Mutual Funds vs. Direct Stock Investing

9 comments:

  1. its a nice list I would say ..

    My Favorite is "2. Too high expectations "

    This is what I personally consider the top most reason of failing . People who have high expectations from stock markets are not able to think logically in many situation and hence take unneccessary risk to generate returns which they can make easily .

    This is true in all areas of Life .. True with Relationships also .

    Manish

    ReplyDelete
  2. I agree with you, Jagoinvestor, even I feel "too high expectations" is one of the top mistakes one makes.
    And, thanks Fisher. Great article.

    ReplyDelete
  3. Neatly written article.
    Kudos to Fisher

    Couple of questions here...

    1)How do I know that my judgement of a stock is bad? I did get effected with the Trap-4 above and sold winners way to early!

    2)What are the traits and characteristics needed of a Trader Vs. an Investor?

    +Shashi

    ReplyDelete
  4. Shashi: If you can’t decide, then don’t invest.

    If you want to become rich, be an investor. On the other hand, if your intention is to make your broker rich then you should become a stock trader.

    ReplyDelete
  5. Good post..!!
    I specially liked point about loss booking. Why we should hesitate to accept our mistake..?? Why people feel hesitation in booking Losses..??

    One important thing never use borrowed funds to invest. You are not going to buy a house nor going to pay education fees, then why loan..??

    ReplyDelete
  6. Another blunder which people usually commit is believing in Market Rumours ...

    ReplyDelete
  7. Do not believe in tips blindly even if it is highly recommended by your investment advisor , do some groundwork before you invest based on tips. I have lost on stocks which I bought based on tips either from others or from my RM. Other stocks which I bought myself after going through company fundametals and news( TV, newspaper etc), I have gained.

    ReplyDelete
  8. That's really awesome.. I hope I can see more of this.. I am looking forward for your next post..

    ReplyDelete
  9. I thing Top 7 Stock Investing Mistakes
    1. No Plan
    2. Too Short of a Time Horizon
    3. Too Much Attention Given to Financial Media
    4. Not Rebalancing
    5. Overconfidence in the Ability of Managers
    6. Not Enough Indexing
    7. Chasing Performance
    Equity Trading Tips

    ReplyDelete

You’re welcome to post a comment if you’d like to air your views, or if you’ve any further question to ask, but please stick to the topic and don’t forget to write your name.