Why do most investors fail?
It has happened to most of us at some time or another: You're at a cocktail party enjoying your drink and hors d 'oeuvres and "the blowhard" happens your way. You know he's going to brag about his latest "giant accomplishment." This time, he's taken a long position in Widgets Plus.com, the latest, greatest online marketer of household gadgets. You come to find he knows nothing about the company, is still completely enamoured with it and has invested 25% of his portfolio in it hoping he can double his money quickly.
Despite your resistance to hearing him drone on, you start to feel comfortable and smug in knowing that he has committed at least four common investing mistakes and that, hopefully, this time he'll learn his lesson. In addition to the four mistakes the resident blowhard has made, this article will address four other common mistakes.
The goal of investors and speculators alike is to buy cheap and sell dear, but few do this with any consistency. This is so even for investment professionals. The common-stock investments of the overwhelming majority of mutual funds, pension funds, bank trust accounts, and investment advisors fail to achieve the returns indicated by the popular stock indexes. By the law of averages, some may do spectacularly well in any given year, and these are often flooded with so much new money to invest that they don't know what to do with it. But very few investors manage to beat the market over long periods.
Buying Shares in a Business Which You Do Not Understand
Too often, investors gravitate towards the latest "hot" or fancy-sounding industry. They may know very little, or even nothing, about technology, or biotech, or the specific business the underlying company is engaged within.
Of course, that does not stop them from trying to jump on to what they expect to be the next profitable train. In this scenario, the investor is overlooking all the advantages and benefits they would have over investors who know little about the industry itself.
When you understand a business, you have a naturally built-in advantage over most other investors. For example, if you run a restaurant, you'll be in tune with businesses involved with restaurant franchising.
You will also see first-hand (and before they become public knowledge) the habits of the patrons. By extension, you will know if the industry is booming, getting slower, or cooling down, well before the vast majority of investors.
To take our scenario a step further, by seeing the trends in the industry in which you are engaged, you should be able to spot some opportunities to make great investment decisions. First-hand knowledge, it would seem, can mean investment profits (or avoiding losses).
When you invest in a company that is "above your pay grade," you may not understand the subtleties and the complexity of the business in question. This is not to say that you need to be a gold miner to invest in gold mining companies, or a medical doctor to invest in healthcare, but that certainly wouldn't hurt!
Anytime you can have an unfair advantage over most investors, you should press that advantage as far as you can. If you are a lawyer, you may do better with knowing when to invest in businesses which make their revenues through litigation. If you are a surgeon, you'll have a better understanding about how well (or poorly) a surgery robot is performing their task, and as such may have an inside track on how well the underlying stock may perform.
Expecting Too Much From the Stock
This is especially true when dealing with penny stocks. Most people treat low-priced stocks like lottery tickets and anticipate that they can turn their $500 or $2000 into a small fortune.
Of course, this can sometimes be true, but it is not an appropriate mindset to have when you're getting into investing. You need to be realistic about what you are going to expect from the performance of the shares, even if such numbers are much more boring and mundane than the pie-in-the-sky levels for which you may hope.
Look at the performance of the stock up until this point. Also, watch all the other investments that are competitors in the same industry. Historically, has the underlying investment gained 5% or 10% per year, or have those moves been closer to hundreds of percentages? Do most companies in the industry see their shares moving 1% at a time, or is it more common for them to jump by tens of percentages?
Based on the previous performance, while not indicative of what may be to come, you could get an idea of the volatility and trading activity of the underlying shares. Typically, a stock will continue to act mainly as it has in the past, and usually, that will be inline with the overall industry.
Using Money You Cannot Afford to Risk
You would be blown away if you could see how different your trading style becomes when you are using money which you cannot afford to risk. Your emotions get heightened, your stress level goes through the roof, and you make buy and sell decisions which you otherwise would have never made.
An old Japanese proverb says that "you will eventually lose every dollar with which you gamble." You should never put yourself into the high-pressure situation where you are putting money on the line which you need for other reasons.
When you invest with money that you can afford to risk, you will make much more relaxed trading decisions. Generally, you will have much more success with your trades, which will not be driven by negative emotions or fear.
Being Driven by Impatience
We may have touched on the different emotions you can have when you're investing, but one of the most costly ones is impatience. Remember that stocks are shares in a particular business — businesses operate much more slowly than most of us would typically like to see or even than most of us would expect.
When management comes up with a new strategy, it may take many months, if not several years, for that new approach to start playing out. Too often, investors will buy shares of the stock, and then immediately expect the shares to act in their best interest.
This completely ignores the much more realistic timeline under which companies operate. In general, stocks will take much longer to make the moves that you are hoping for or anticipating. When people first get involved with shares of the company, they must not let impatience get the best of them or their wallet!
Skating to Where the Puck Was
Individual investors often do far worse, buying into the very peaks of a market fad, and selling out (or being sold out) after the inevitable crash. They buy the stock of manufacturers of pin-spotting machines right before the last bowling alley is built. They sink funds into oil-drilling programs in marginal areas. (Some readers may remember the "overthrust" belt in the early 1980s at the peak of petroleum prices.)
They chase after new issues and obscure companies with a story (typically some new technological wonder) in hopes of "getting in on the ground floor." If such a company does manage to do well, they will bid its price up to fantastic levels, only to ride it down when the euphoria ends. One sports-minded observer has described the strategy of the average investor as "skating to where the puck was."
It is usual to attribute this phenomenon to the conflicting human emotions of fear and greed. When people (including the professionals, who are, after all, human beings, too) see others benefiting from an upward market move, they are prompted to get in on it, too. This process can often propel the prices of the object of speculation to previously unimaginable highs. The upward trend continues until the last buyer has been suckered in. When the inevitable crash comes, fear then drives the market and prices decrease sharply until the last speculator is flushed out. This often occurs at prices not only far below what was paid but also well below any reasonable standards of worth.
As an aspect of human behaviour, the tides of speculative price movements and manias have long been well described. But they remain little understood. In particular, no one has ever come up with a way of predicting the duration of a particular mania or to what highs or lows a mania will propel prices.
Investors need to be constantly on guard against falling in with the crowd and succumbing to the conflicting emotions of fear and greed, and the main reason investors become their own worst enemies. The investment approach we advocate in this book can accomplish much in this regard.
Limiting oneself to index funds holding hundreds or even thousands of stocks, or to the mundane stocks that typically turn up in the HYD strategy, will not give you much to brag about at cocktail parties. But it will enable you to avoid the ruinous love affairs that so many investors seem to develop with their favourite stocks.
More importantly, our approach should enable you to overcome perhaps the most basic impulse of investors, which is to want to have more of whatever has gone up and less of what has gone down.
This is the impulse that presumably contributes to the manias and speculative peaks and troughs. But, the punch bowl always runs dry just when the party is getting good, to paraphrase longtime Federal Reserve Chairman William McChesney Martin. By selling into rallies and buying into declines, you will miss much of the euphoria, but you will suffer far less when the inevitable reaction occurs.
There is another important factor in investment success: reasonable expectations. As Richard Russell, famed author of the Dow Theory Letters has written:
The wealthy investor never feels pressured to "make money" in the market. The wealthy investor tends to be an expert on values.… And if there are no outstanding values, the wealthy investor waits. He can afford to wait. He has money coming in daily, weekly, monthly. In other words, he doesn't NEED the market. He knows what he's looking for, and he doesn't mind waiting weeks, months or years (they call that patience).
What about the little guy? This fellow always feels pressured to "make money" to "force the market to do something for him." The little guy doesn't understand compounding, and he doesn't understand money.
… He's impatient, and he constantly feels pressured. He tells himself he has to make money fast. And he dreams of "big bucks." In the end, the little guy wastes his money in the market, and he loses his money on gambling, he dribbles it away on senseless schemes. In brief, this "money nerd" spends his life running up the down escalator.
Now here's the ironic part of it. If from the beginning, the little guy had adopted a strict policy of never spending more than his income, if he had taken that extra income and compounded it in safe, income-producing securities—in due time he'd have money coming in daily, weekly, and monthly just like the rich guy. And, in due time he'd start acting and thinking like the rich guy. In short, the little guy would become a financial winner instead of a loser.
The Deception of the Dollar
The continuing depreciation of the purchasing power of the dollar can distort investors' perceptions. Without diminishing a portfolio's purchasing power, a prudent investor nowadays cannot expect the portfolio to provide more real spendable income than 3 to 4 per cent of the principal's value. This is the same return that conservative bond investors received when currency values were stable. In an age of chronic inflating and punitive taxation of nominal capital gains, even that level of returns may be difficult to match.
For individuals who depend on investment income for living expenses, the issue can become crucial if they wish to preserve their purchasing power and pass on the principal to their heirs. Much interest income is not income at all, but compensation for the diminished purchasing power of the principal, and because capital gains may be simply inflationary illusions. This may lead investors to believe that their financial position has improved when it has, in fact, deteriorated.
A possible solution for such investors would be to follow the procedures now used for the endowment funds of many nonprofit organizations: Keep a running total or moving average of the value of your investment assets and withdraw a fixed percentage each year, without regard to the nominal income received.
Learning About Stocks to Invest in From the Wrong Places
This is an extremely important point. There is no shortage of so-called experts who are willing to tell you their opinions, while packaging and presenting them as if they are educated and endlessly correct knowledge.
One of the most significant parts to investing well is to identify and isolate sources of guidance which consistently help you achieve profits. For every good piece of information which may be of benefit, you will probably see hundreds of pieces of really horrible guidance.
Always remember that just because someone is being featured or interviewed by top media, does not mean they know what they are talking about. And indeed, even if they do have a stellar grasp of their topic, that still does not mean they will be right.
Thus, your job as an investor is to assess which sources of information should be trusted and have demonstrated a reliable and ongoing trend of wisdom. Once you have identified those individuals or service, which may lead to profits, you should still only partially rely on their thoughts — combine those with your own due diligence and opinions to construct your trading decisions.
If you hear about a stock for free, especially a penny stock, it is almost certainly being driven by players with significant hidden motivations. This may not be true if you hear about a professional's opinion on something such as CNBC. Still, it is absolutely and un-categorically true when you hear about the latest "hot penny stock" that is going to go through the roof (according to greedy promoters).
There is an endless line of dishonest stock promoters out there. Their obsession is to find ways to profit from your actions you lose so that they can gain.
The bad side is that for them to profit, you will probably need to lose. Investing in speculative shares is mainly a zero-sum game, meaning for someone to make a dollar; someone else has to lose a dollar.
This is why scam artists and promoters take such efforts to drive up worthless shares. The more money they get to push the stock prices higher, the greater the profit they'll make when they walk away and leave everyone else in the dust and broke.
Following the Crowd
In many cases, the majority of people only hear about an investment when it has already performed well. If certain types of stocks double or triple in price, the mainstream media tends to cover that move and tell everyone about how hot the shares have been.
Unfortunately, by the time that the media tends to get involved with a story about shares rising, it is usually after the stock has reached its peak. This point overvalues the investment, and the media coverage comes late to the game. Regardless, the television, newspaper, internet, and radio coverage push the stocks even higher into excessively overvalued territory.
We have seen this trend play out recently with the recreational marijuana stocks. Some of these tiny companies had only two or three employees, but that did not stop them from being valued at a corporate worth of about half of one billion dollars!
In other instances, an old nearly defunct gold mine would add 'cannabis' or 'marijuana' to the name of their company, and the shares would instantly double or triple in price. At no point were investors looking into the company deep enough to realize all the problems; tens of millions of dollars in debt; no revenues; millions in ongoing losses each month.
In order to avoid making bad decisions, do the research necessary to find a fee-only advisor who will take the time to ask you the important questions about your life, your goals, your concerns and your financial resources and construct an appropriate financial roadmap to achieve rational goals.
Don't rely on online media, brokers who wish to sell you something, or your own unrealistic optimism for success-it takes time, discipline and steadfast conviction to avoid the many pitfalls and achieve desired outcomes.
Despite being all set to invest in the long term, most of us fail to manage our investment portfolios. A lot of us are short-term thinkers, which directly contradicts with our long term investment goals. Likewise, we fail to create a proper investing strategy, leading to our psychological mistakes.