The five most common investing mistakes and how to avoid them
Be it at a cocktail party or at lunch: there is always someone chattering about the best stocks, Bitcoins, commodities and other fancy investments. Admittedly, it is fun to get involved in the discussion, but you must never forget about the common sense of investing.
There is nothing wrong about making mistakes though. Quite the contrary, making mistakes is crucial to help you learn and grow. Of course, this is also true in investing. However, you must learn from your mistakes and try not to repeat them. In the following, I will outline the most common investing mistakes I haven seen during my years working within the financial services industry. Unfortunately, contrary to what you might expect, they are made not only by inexperienced investors but also by subject matter experts (including myself, of course).
First: Not knowing who you are in the context of financial markets
Simply put, there are two types of players it the financial markets: speculators and investors. Speculator, in this definition, refers to someone who just hopes that some event occurs without knowing the odds. Investing, on the other hand, means to know what you are doing. Hence, you can only be an investor if you know the risk you are bearing and the reason why you invest in a certain security. An investor always invest in an asset with the best risk-return-ratio, i.e., Sharpe Ratio.
I always hear people talking about an individual company they would like to "invest" in. Asking for their reason they start arguing about the bright future of the company and that the stock price has no other option than to keep rising. The same is true not only for stocks, but also for other fancy things such as Bitcoins. However, you can only call it a true investment once you fully understand its underlying fundamentals. For instance, in the case of Bitcoin, has a long-term value investor you would quickly realize that everything you do as a private person can only be pure speculation due to the missing value creation.
Second: Thinking that you can beat the market by actively picking superior securities
As an investor you basically must select one out of two approaches: active investing or passive investing. As a passive investor you will just hold a portfolio that consists of a broadly diversified low-cost index fund plus some treasury bills - depending on your individual level of risk aversion. On the other hand, active investing means you would pick very few individual stocks and bonds based on their underlying fundamentals and their intrinsic value.
As an active investor you must be very experienced in subjects such as valuation, accounting, strategic management etc. It is very time consuming and hard to find promising investments with superior returns than those the passive investor can expect. It is very hard to except that the active approach is only for a very limited number of people. Even if you are a billionaire the passive approach is very likely to be better choice. For instance, you often see professional athletes starting their own venture capital fund, restaurants, fashion labels etc. From a pure mathematical point of view, they are better of to just follow the passive approach, too. See here what Warren Buffett recommends to LeBron James on how he should best invest his money:
Unfortunately, I still see many people trying to follow the active approach, albeit lacking both the time and the skills needed to be successful. Hence, you should not act against your odds. I think the main reason why many people still cannot just stick to the passive approach is that you basically must admit to yourself that you will not get rich fast, but after a long time when the power of compounding starts working for you. If you decide to pick individual securities you want to keep the possibility of becoming very reach very fast, but poorer even faster and more likely. Just admit to yourself: from a mathematical, i.e., finance theory, perspective there is no way to get rich fast. If you want to go to the casino, of course, there is a chance you buy your Ferrari by tomorrow, but this does not mean it is the best way to go.
Third: Having the illusion that the odds are shared equally between all market participants
That being said, people often claim they know something better than others, e.g., that a stock price will keep rising in the future. If you argue in that way you claim to be smarter than the entire market. Explaining them about the financial market theory they stress that the underlying assumptions of the theory are wrong and that markets are not efficient. It is not that I don't agree with them. Indeed, some of were already proven to be unrealistic.
However, the financial market is also full of big players with an incredible amount of resources. Simply put, wall street traders are able to gain an edge over private traders, because they act fast and with an amount that shifts the whole demand curve and, hence, the entire market price. Even if you are a millionaire with a high-speed internet connection at home you can be sure wall street is acting faster upon new information. You should just stay out of the short-term trading game and rather focusing on long-term investing which is based on true value creation of the underlying businesses.
Hence, even though some of the theory's underlying assumption are might not be fully realistic, you should still accept the fact that financial markets are indeed very efficient most of the time. And if some inefficiency like arbitrage or excessive volatility arises you can be sure that Wall Street will act way faster than you ever can as a private investor. Private traders cannot beat the market - not even millionaires. Wall Street makes money because they are acting fast, you make money because you acting very very slow, i.e., you invest for a very long-term.
Fourth: Ignoring liquidity management
As mentioned, investing for the average joe - even the wealthy - must be long-term. That being said, along your investment cycle you will see a lot of ups and downs in market prices. You must not only have the patience and courage to ignore those movements, but also hold sufficient cash at hand to cover all your private expenditures.
To put simply, only invest the money in the stock market which you don't need for a minimum of 10-15 years - or even longer. To make it clear, if you want to save for your children's education in five years, don't do it by investing in stocks. If you want to buy a house in eight years, don't do it by investing in stocks. Instead, put your money into something that is more liquid like treasury bills. If you need cash within a very short period and as a risk buffer for hard times you should put it to a regular savings account.
Fifth: Ignoring the cost of investing
I already stressed that as a passive investor you will not get rich over night. However, you will become incredibly wealthy over the long-run if you let the magic of compounding work for you. Compounding is pure math, i.e., exponential growth. As humans, we often lack imagination about what exponential growth means. To emphasize this let us just assume you would invest 50.000€ today into a portfolio that would provide an annualized return of 8%. After 5 years you would have only 73.466€, but after 40 years already 1.086.226€, after 100 years 109.988.062€ and after 200 years you would be one of the wealthiest people on the planet with 241.947.479.245€. Sure, most of you would argue now that 200 years is more than a lifetime. That is true, but think about your children, too. However, a lifetime is indeed sufficient to enjoy a lot of the power of compounding.
Speaking about returns compounding works in our favor, but costs can easily grow on an exponential basis, too. At first sight, the costs that come along with investing seem to be small, but over the long-term the costs can easily eat up your returns. Hence, you should always focus on the cost of investing. Try to reduce your portfolio turnover to a minimum and stop trading.