Making mistakes is part of the learning process when it comes to trading or investing. Investors are typically involved in longer-term holdings and will trade in stocks, exchange-traded funds, and other securities. Traders generally buy and sell futures and options, hold those positions for shorter periods, and are involved in a greater number of transactions.
While traders and investors use two different types of trading transactions, they often are guilty of making the same types of mistakes. Some mistakes are more harmful to the investor, and others cause more harm to the trader. Both would do well to remember these common blunders and try to avoid them.
Whether you're new to investing or you're a seasoned pro, you're bound to make mistakes. As you gain more experience with the market, you'll be less prone to making impulse decisions. However, there's one mistake that all investors are bound to make at one point or another – trying to time the market.
While you may think that you've got a good handle on the ups and downs of the market, think again. Trying to figure out the exact right time to move your money in and out of the market requires a crystal ball. Not even the experts know for sure when the next downturn or upward swing of the market will happen.
If you've ever tried to time the market and succeeded, you may think you have the golden touch. Congratulations – you got lucky! While it seems that you have the market figured out, data show a different picture altogether.
According to a study published in the Journal of Finance, mutual fund managers who do this for a living are wrong 99.4 per cent of the time. If professionals who spend their lives studying the market can be so spectacularly wrong, the odds that the average investor can get it right are pretty slim.
No Trading Plan
Experienced traders get into a trade with a well-defined plan. They know their exact entry and exit points, the amount of capital to invest in the trade and the maximum loss they are willing to take.
Beginner traders may not have a trading plan in place before they commence trading. Even if they have a plan, they may be more prone to stray from the defined plan than would seasoned traders. Novice traders may reverse course altogether. For example, going short after initially buying securities because the share price is declining—only to end up getting whipsawed.
Chasing After Performance
Many investors or traders will select asset classes, strategies, managers, and funds based on current strong performance. The feeling that "I'm missing out on great returns" has probably led to more bad investment decisions than any other single factor.
If a particular asset class, strategy, or fund has done extremely well for three or four years, we know one thing with certainty: We should have invested three or four years ago. Now, however, the particular cycle that led to this great performance may be nearing its end. The smart money is moving out, and the dumb money is pouring in.
Not Regaining Balance
Rebalancing is the process of returning your portfolio to its target asset allocation as outlined in your investment plan. Rebalancing is difficult because it may force you to sell the asset class that is performing well and buy more of your worst-performing asset class. This contrarian action is very difficult for many novice investors.
However, a portfolio allowed to drift with market returns guarantees that asset classes will be overweighted at market peaks and underweighted at market lows—a formula for poor performance. Rebalance religiously and reap the long-term rewards.
Ignoring Risk Aversion
Do not lose sight of your risk tolerance or your capacity to take on risk. Some investors can't stomach volatility and the ups and downs associated with the stock market or more speculative trades. Other investors may need secure, regular interest income. These low-risk tolerance investors would be better off investing in the blue-chip stocks of established firms and should stay away from more volatile growth and startup companies shares.
Remember that any investment return comes with a risk. The lowest risk investment available is U.S. Treasury bonds, bills, and notes. From there, various types of investments move up in the risk ladder, and will also offer larger returns to compensate for the higher risk undertaken. If an investment offers very attractive returns, also look at its risk profile and see how much money you could lose if things go wrong. Never invest more than you can afford to lose.
Forgetting Your Time Horizon
Don't invest without a time horizon in mind. Think about if you will need the funds you are locking up into an investment before entering the trade. Also, determine how long—the time horizon—you have to save up for your retirement, a downpayment on a home, or a college education for your child.
If you are planning to accumulate money to buy a house, that could be more of a medium-term time frame. However, if you are investing in financing a young child's college education, that is more of a long-term investment. If you are saving for retirement 30 years; hence, what the stock market does this year or next shouldn't be the biggest concern.
Once you understand your horizon, you can find investments that match that profile.
Not Using Stop-Loss Orders
A big sign that you don't have a trading plan is not using stop-loss orders. Stop orders come in several varieties and can limit losses due to adverse movement in a stock or the market as a whole. These orders will execute automatically once perimeters you set are met.
Tight stop losses generally mean that losses are capped before they become sizeable. However, there is a risk that a stop order on long positions may be implemented at levels below those specified should the security suddenly gap lower—as happened to many investors during the Flash Crash. Even with that thought in mind, the benefits of stop orders far outweigh the risk of stopping out at an unplanned price.
A corollary to this common trading mistake is when a trader cancels a stop order on a losing trade just before it can be triggered because they believe that the price trend will reverse.
Some investors have a bad habit of "performance chasing," which involves making investment decisions based on what has recently performed well.
This commonly shows up when investors buy into mutual funds or stocks that have recently reported large, market-beating gains. It can also work the other way when investors bail out of investments that have recently performed poorly.
In general, basing investment decisions on how things have recently performed is not a good strategy.
It's one of the main reasons investors tend to "buy high" (pouring money into investments that are performing well) and "sell low" (abandoning investments that are performing poorly).
It's much more powerful to understand why something has been performing the way it has than just to assume it will continue in that direction.
Trying to Time the Market
It's very hard for investors to time the market correctly, and in trying to do so, they often miss out on big gains.
For most investors, I wouldn't recommend trying to jump in and out of stocks based on short-term forecasts. Instead, invest in the best stocks and always be searching for better alternatives.
The one exception is avoiding recessions based on forecasting economic data. Done correctly, investors can spot painful economic slowdowns in advance and adjust their strategy accordingly.
Looking at Your Investment Portfolio Too Much
I believe in active investing. That means rebalancing your portfolio when needed, reinvesting dividends, and always making sure you're holding the best possible stocks for your investment strategy.
That involves frequently checking your investments, monitoring the market, and researching new stocks.
However, be careful not to look at your portfolio too much. It's a common investor mistake to check your stocks too frequently and fixate on the daily (or hourly) changes in value.
Watching your portfolio's every move up and down tends to activate the emotional pathways of the brain, fueling excitement around gains and disappointment around losses.
And once our emotions around money are excited, it's much harder to make rational decisions that will help us over the long term.
It's good to stay active and engaged with your portfolio. Just be careful not to hyper-focus on your short-term returns, as it can hurt your ability to make solid choices for the long term.
Letting Losses Grow
One of the defining characteristics of successful investors and traders is their ability to take a small loss quickly if a trade is not working out and move on to the next trade idea. Unsuccessful traders, on the other hand, can become paralyzed if a trade goes against them. Rather than taking quick action to cap a loss, they may hold on to a losing position in the hope that the trade will eventually work out. A losing trade can tie up trading capital for a long time and may result in mounting losses and severe depletion of capital.
Averaging Down or Up
Averaging down on a long position in a blue-chip stock may work for an investor who has a long investment horizon. Still, it may be fraught with peril for a trader who is trading volatile and riskier securities. Some of the biggest trading losses in history had occurred because a trader kept adding to a losing position, and was eventually forced to cut the entire position when the magnitude of the loss became untenable. Traders also go short more often than conservative investors and tend toward averaging up, because the security is advancing rather than declining. This is an equally risky move that is another common mistake made by a novice trader.
The Importance of Accepting Losses
Far too often, investors fail to accept the simple fact that they are human and prone to making mistakes just as the greatest investors do. Whether you made a stock purchase in haste or one of your long-time big earners has suddenly taken a turn for the worse, the best thing you can do is accept it. The worst thing you can do is let your pride take priority over your pocketbook and hold on to a losing investment. Or worse yet, buy more shares of the stock as it is much cheaper now.
This is a very common mistake, and those who commit it do so by comparing the current share price with the 52-week high of the stock. Many people using this gauge assume that a fallen share price represents a good buy. However, there was a reason behind that drop and price, and it is up to you to analyze why the price dropped.
Believing False Buy Signals
Deteriorating fundamentals, the resignation of a chief executive officer (CEO), or increased competition are all possible reasons for a lower stock price. These same reasons also provide good clues to suspect that the stock might not increase anytime soon. A company may be worthless now for fundamental reasons. It is important always to have a critical eye, as a low share price might be a false buy signal.
Avoid buying stocks in the bargain basement. In many instances, there is a strong fundamental reason for a price decline. Do your homework and analyze a stock's outlook before you invest in it. You want to invest in companies that will experience sustained growth in the future. A company's future operating performance has nothing to do with the price at which you happened to buy its shares.
Buying With Too Much Margin
Margin—using borrowed money from your broker to purchase securities, usually futures and options. While margin can help you make more money, it can also exaggerate your losses just as much. Make sure you understand how the margin works and when your broker could require you to sell any positions you hold.
The worst thing you can do as a new trader is become carried away with what seems like free money. If you use margin and your investment doesn't go the way you planned, then you end up with a large debt obligation for nothing. Ask yourself if you would buy stocks with your credit card. Of course, you wouldn't. Using margin excessively is essentially the same thing, albeit likely at a lower interest rate.
Further, using margin requires you to monitor your positions much more closely. Exaggerated gains and losses that accompany small movements in price can spell disaster. If you don't have the time or knowledge to keep a close eye on and make decisions about your positions, and their values drop then your brokerage firm will sell your stock to recover any losses you have accrued.
As a new trader use margin sparingly, if at all; and only if you understand all of its aspects and dangers. It can force you to sell all your positions at the bottom, the point at which you should be in the market for the big turnaround.
Running With Leverage
According to a well-known investment cliché, leverage is a double-edged sword because it can boost returns for profitable trades and exacerbate losses on losing trades. Just as you shouldn't run with scissors, you shouldn't run to leverage. Beginner traders may get dazzled by the degree of leverage they possess—especially in forex (FX) trading—but may soon discover that excessive leverage can destroy trading capital in a flash. If a leverage ratio of 50:1 is employed—which is not uncommon in retail forex trading—all it takes is a 2% adverse move to wipe out one's capital. Forex brokers like IG Group must disclose to traders that more than three-quarters of traders lose money because of the complexity of the market and the downside of leverage.
Investing in style instead of substance
Too many times, investors look for the next Microsoft, Apple, or Google. While it is important to devote a significant portion of your portfolio to more speculative growth-oriented companies, the bulk of your portfolio should be in stable, profitable, dividend-paying companies. Over the last 50-100 years, most of the gains investors have seen from the stock market have come from dividends and not the price of stock actually appreciating. Value companies have noticeably outperformed growth companies over every time frame you could think of. A portfolio featuring Johnson & Johnson, General Electric, and Exxon Mobil might not be as "sexy" as one featuring Baidu and Apple. Still, you will likely get better returns in the long run with the former.
Trading too regularly
Investing is not easy; making a profit by trading is almost impossible. The pro's of Wall Street have trouble with trading and being profitable over time, what makes you think you will make a fortune doing it? Even if you think that you have a proven day trading "strategy" your plan will likely be foiled. Emotions drive humans. Losing money is one of the strongest emotions that can be evoked. You will be struck with the urge to sell the second that your "trade" turns south which will ruin your chances of succeeding.
The average investor makes two different mistakes when it comes to diversification. The first is holding way too much of their companies stock. No single stock should ever make up more than 10% of your portfolio, no matter what. You are already counting on your company for your paycheck and livelihood, and it is not a good idea to rely on your company for any more than you need to financially. The second mistake is having too much of your portfolio in one sector. If your portfolio were full of tech stocks in the early 2000s or financial stocks a few years ago, you would be wiped out in an instant. Do not let one sector make up more than 20% of your portfolio.
Investing in mutual funds instead of index funds
Mutual funds lose to indexes 80% of the time once you factor in all of the fees that they can and do charge. Why would you ever make a decision where there is an 80% chance that you would be wrong? The 2% fee that mutual funds normally charge a year may not seem like much, but it is huge over time. Once you factor in the fact that many funds charge front or back end loads, the choice is clear. Index funds charge .1-.2% in fees and do not have any loads. You will be getting the same return the market gets, which is all you should need to succeed over time.
Ignoring the rest of the world
It is not wise these days to devote 100% of your portfolio to American companies. China and other countries are growing very quickly. China is expected to grow its GDP at 8% a year when America is growing at between 0-3%. American companies should still make up the bulk of your portfolio but save 15-30% for companies in China and elsewhere.
If you have the money to invest and can avoid these beginner mistakes, you could make your investments pay off; and getting a good return on your investments could take you closer to your financial goals.
With the stock market's penchant for producing large gains (and losses), there is no shortage of faulty advice and irrational decision making. As an individual investor, the best thing you can do to pad your portfolio for the long term is to implement a rational investment strategy that you are comfortable with and willing to stick to.
If you are looking to make a big win by betting your money on your gut feelings, try a casino. Take pride in your investment decisions, and in the long run, your portfolio will grow to reflect the soundness of your actions.