Everyone’s guilty of investment mistakes, and avoiding as many as possible can help you beat the market. It’s called winning by not losing.
That’s easier said than done, especially when there are two parties involved—the client and the advisor. But if you review this list of common investment mistakes on a regular basis, it can pay off.
1. Falling in love with the story
If you fall for the story behind a company, its product or even the charisma of management, you may not see fundamental flaws, poor market conditions or overpricing of the stock. Instead, recognize that executives talk to advisors to sell their company as an investment. Also, know that marketing experts agree the best sales job is achieved through telling a story and not by talking numbers and facts. Stories get you emotionally invested, far beyond what plain facts could ever do. It’s easier for management to address changes or setbacks in the story than it is to talk about missed numbers.
2. Believing things are different this time
Believing you stumbled on something new or different in the investment world can get you in trouble. Simply put, it’s never different. The odds of successful investing never change. No matter the decade, only a certain percentage of investments will outperform the rest. Monumental shifts occur over a lifetime, not overnight, as investment bankers would have you believe. So stick to the tried and true. Nobody ever went broke by steering clear of new kinds of investments, especially anything that reeks of financial engineering.
3. Confusing good ideas with good investments
Sometimes clients will overuse a product or service—think social media or online gaming—and immediately classify it as a can’t-miss investment. The first mistake is usually the client’s assumption that they are early to the game and have caught something the rest of the investing public has missed. The next mistake is extrapolating personal usage into expectations for more widespread popularity. The third error is expecting wider product adoption to naturally translate into financial statement profitability. Lastly, even profitability does not guarantee an attractive investment because the shares may have been overpriced from the early stages. How many clients held onto BlackBerry for too long because they loved the product, and missed the fact that they were in the shrinking minority? This works in reverse, too. Don’t shy away from a stock just because you don’t like the product or company. Hate Wal-Mart? Too bad, because it’s gone up 50% over the past three years.
4. Falling for the investment banking trap
In our meetings with advisors, we often refer to investment banking traps. That’s when all the analysts on the street support the share price of a stock for investment banking purposes. This tends to occur with larger IPOs or serial equity issuers because it requires a host of underwriting firms to spread out risk and disperse the shares as widely as possible in the market. With so many analysts restricted in their opinions, the street consensus can blind advisors to potential risks and overpriced shares.
PrairieSky Royalty is a company that recently benefited from the team mentality among analysts on the street, despite trading well above industry averages on all relevant valuation metrics. The IPO was priced at $28 at the end of May, and closed at $37 on its first day. A month later, the banks that underwrote the stock started issuing their reports with an average target price of $44.
The analysts tried to justify the near 60% premium that materialized in just 30 days—we counted seven different valuation approaches, alongside commentary that dismissed traditional measures as superficial and irrelevant. At the end of August, it traded at $40.
5. Reaching for yield
Don’t delve into riskier investments simply to pick up a few extra points of yield. A yield over 7% in this market tends to be a warning sign. A few extra points of yield earned over a year can disappear in minutes when negated by a capital loss. There is usually something much safer available at a slightly lower yield.
6. Doubling down
Doubling down is when advisors are determined to break even on a particular investment. When a stock takes a hit because of bad news, advisors are faced with two choices: sell the name because more bad news may be coming, or double up on the number of shares owned so that even a halfway rebound will bring the investment back to par.
This is pure psychology at work. There is almost always a better investment alternative (with better upside) than the wounded stock in hand. The hard part is having to admit you lost before moving on and making it back on a different stock with better potential. So learn to let go.
7. Focusing on the near term
There are major forces that drive advisors to focus on short-term investment horizons. The vast majority of investment research is based on a 12-month outlook, and portfolio performance is measured on a quarterly, if not monthly, basis. Because of this, getting the timing right is half the challenge when it comes to investing. Nevertheless, there are times when quality stocks get beaten down by the market for various reasons. All you need is a patient hand. For instance, shares of SNC-Lavalin Group increased 70% in the 24 months after hitting its low following the revelation of corporate governance issues.
8. Riding winners too long
Holding winning stocks for too long can be just as costly as sticking with losers. The best way to avoid losing a huge paper gain is to sell gradually on the way up. It’s hard to argue against booking gains, but the psychological hold can be strong. A set approach to selling a proportion of winning holdings at certain levels can help to avoid this investing mistake. Remember, following rules is investing. Following emotions is gambling.