I talk with investors almost every day, and over time the same themes emerge and I hear the same mistakes over and over again. So, to help save you from repeating the same mistakes and losing a lot of money to learn the lessons, I’ve jotted down some of the most common investing mistakes.
Most come down to two basic types of errors. One error is to let emotions get the better of you. I’m amazed at the reasons people build to justify making the investments that make them feel better even if, in the long run, they’ll be poorer for having done them. The second error is to not build a plan and think things through. As one planner told me, “People don’t know what they bought or why they bought it.”
Mistake 1 | Reacting to short-term returns.
Towards the end of the year or start of the next one, investors tend to sell the fund with the worst 1-year returns and buy the one with the best returns. It makes them feel better, and they will tell you that the new fund is ahead of the curve and run by a smart manager and the old one has lost its touch. What they won’t say is that they are buying high and selling low. Nor will they say that short-term returns are just noise. You are better off buying funds with lagging short-term performance than those with top-quartile returns.
Mistake 2 | Basing sell decision on cost basis.
You bought fund A at Rs 10 and now its NAV is Rs 5. You bought fund B at Rs 10 and now it’s Rs 20. Which should you hold, and which should you sell? I have no idea. What matters is which will have better returns over your investment horizon. If the answer is fund B, then sell fund A and put the proceeds in fund B. The problem is that people have an emotional attachment to the price. Some are afraid to book losses, and others are too anxious to sell a winner for fear that they’ll miss out on gains. What matters is whether the funds have strong fundamentals.
Mistake 3 | Selling after the market falls.
The short-term direction of the stock market is unpredictable; yet selling in reaction to market moves implies that you can predict short-term moves. The markets are not perfectly efficient from minute to minute, but they quickly reflect a best guess based on new information. Fear is one of the greatest enemies of successful investing. When you’re worried about your money, you want to make it safe. However, you risk missing out on the next rally, and you might not even keep pace with inflation. From a long-term perspective, cash is very risky and stocks are low risk. Put another way, this is another example of selling low and buying high. Savvy investors go bargain hunting when the market is oversold; you should, too.
Mistake 4 | Accumulating too many niche funds.
In 2007, infrastructure funds were the rage and the timing turned out to be terrible. These specialist funds are exciting and fun to buy, but they will mess up your portfolio if you let them. Yet you can get the same exposure to sectors through more diversified funds. Niche add extra volatility and make managing your portfolio more difficult.
Mistake 5 | Failing to build an overall plan.
This is a biggie. Spend a little time to spell out your goals, how you’ll meet them, and the role of each investment. This is an enormous help in figuring out how to get to your goals and how to adapt along the way. Make a plan, and your day-to-day investment decisions will become easier and less stressful.
Once you’ve got your plan, spell out why you own each investment and what would lead you to sell. For example, you could say that you own a focused equity fund as a long-term 20-year investment for its manager and its strategy. You’d sell if the manager left or asset bloat forced a change in strategy. If you have doubts about the fund in the future, you can turn to that document when you may well have forgotten what the draw was in the first place.
Mistake 6 | Making things needlessly complex.
The financial industry works overtime to sell the message that investing is complicated, messy stuff that you couldn’t possibly undertake on your own. Is it any wonder that so many investors are paralyzed with fear and indecision? Actually, buying and holding a portfolio composed of plain-vanilla funds –with perhaps a dash of a “diversifier” such as a sector fund –is more than adequate to help us reach our goals. That’s also the kind of portfolio that you can easily manage yourself. By building a sturdy, streamlined portfolio, you’ll have fewer moving parts to monitor.
Mistake 7 | Not understanding the risks.
Narrowly focusing on recent returns can blind investors to risks. If a fund has a long track record, you can easily get a handle on risk by looking at annual returns. In a bad year, the stock market can lose 30% or more. In a bad 3-year period, it can lose 60%. It’s reasonable to assume that nearly any stock fund can do at least that badly. This is why stocks are for 10- or 20-year time horizons or longer. If you know that going in, you stand a much better chance of earning a healthy return.
Mistake 8 | Not diversifying properly.
The 2008 bear market punished financials the most, while energy fared best. In some markets, growth stocks get crushed, in others mid and small caps. Every down period is different, so be sure to diversify between market caps, equity and debt, and maybe even some amount of foreign exposure.
Mistake 9 | Not saving enough.
Start early – in your 20s or 30s. And never stop. If you are diligent and consistent, reaching your goals will be quite manageable. If you don’t, you better make a killing later on.
Mistake 10 | Failing to rebalance.
When the markets really move, your portfolio can go off-kilter and mess up your nicely laid plan. Rebalance yearly so that you’ll be buying low and selling high.
Mistake 11 | Failing to factor taxes into portfolio decisions.
Taxes play a huge role in your long-term success. But don’t buy equity linked savings funds, or ELSS, or insurance plans in a last minute bid to save taxes. Tax planning must be an integral part of your portfolio planning. Also, ensure that you sell your fund units in a way to avoid or minimize tax.
Mistake 12 | Not building up an emergency fund.
Have at least six months’ worth of living expenses in a bank fixed deposit. Or maybe an ultra-short term debt fund. This emergency stash is vital in case you lose your job or have a medical emergency or unexpected but crucial home repairs.
Mistake 13 | Misreading your own abilities.
People who treat gambling addicts say that it’s the big winning bet that hooks gamblers. They get high and want to repeat that high. Fund investors can be a little like that. They remember that one time they accurately called the direction of the market or picked a sector fund, and they forget all the times their calls were off. Go back over your past investments. See what you do well, and figure out a solution for the areas where you didn’t do well. Maybe your individual stock picks aren’t that great. Maybe you are drawn to too many thematic or sector funds. Maybe your bond fund is a consistent underperformer.
Mistake 14 | Worrying about daily ups and downs.
Don’t get stressed watching business TV or tracking the market online. Those activities are exciting and often informative but not always helpful for long-term investors. Reporting on the markets, whether online, in print or on TV, requires putting a lot of experts on to make predictions. If they were honest and said they didn’t know what would happen the next week but that you should buy and hold, no one would watch. All those ups and downs have no bearing on your long-term goals. Warren Buffett advocates buying stocks you feel so strongly about that you wouldn’t care if the stock market took a two-year holiday. The same goes for funds. Buy them and tune out the noise.