Avoiding 10 Common Mistakes
As a starting point in defining your market strategy, examine the basic assumptions that go into how and why you have made past decisions. How do you pick a company? Do you study its fundamentals, follow price chart patterns, or buy stocks on the basis of name recognition?
Smart Investor TipYour methods for picking stocks should be carefully and completely defined.
- Failing to follow your own rules. Many people define themselves as believers in the fundamentals, and then contradict their own standards. Instead of monitoring trends in the important areas of statements, they find themselves tracking stock charts or making decisions based on index movements.
The market is full of temptations, promises of easy money, and artificial excitement. But it is also a dangerous place. With the benefit of history, it is easy for you to recognize the real situation at any given time. However, in the heat of the moment, many investors give way to an emotional response to information. If you hear a stock is about to "take off," the human tendency is to want to buy some before that happens. A logical, rational approach would tell you otherwise. If the person giving you this tip does actually have insider information, it is illegal to pass that information on to othersâand it is illegal for others to act on the information. If the person does not have insider information, then it could be only a rumor, in which case you should not act on the information. It could also be a pump-and-dump move. This occurs when someone owns a stock whose price has fallen. They want to get the price up so they can sell their shares at a profit, so they promote (pump) the company, get others to buy, and then they sell (dump) inflated shares.
- Forgetting your risk tolerance limits. More than anything else, continually examine and reexamine your limitations. Risk tolerance means just that: the amount of risk you can afford to take and are willing to take. If you cannot afford to lose, then you should not expose yourself to a high risk of loss.
Identifying risk tolerance levels should be thought of as the first step in beginning an investment program. When someone buys their first house, they identify how expensive a home they can afford, the level of down payment required, market trends, and other important factors. This is all part of risk tolerance. However, the same people may enter the market with little or no thought to the level of risk. Unfortunately, this approach has consequences. If you cannot afford to lose money, you need to question whether a particular strategy is appropriate. This applies not only to trading in options, but to every market and strategy. Knowing your risk tolerance is essential.
- Trying to make up for past losses with aggressive market decisions. Losses can happen very suddenly, or they can accumulate over time, eroding your portfolio value. In either case, losses represent ill-timed decisions. Avoid the tendency to try to make up for big losses by taking unacceptable risks.
The reason it is so important to identify your risk tolerance is to avoid making big mistakes when your decisions don't go the way you planned. Many investors try to offset unexpected losses by taking ever-higher risks in the hope of getting their losses back. When those investor begin this practice, they cease being investors and become gamblers. And most gamblers lose. It makes more sense to accept losses as part of the outcome within your portfolio, learn from those losses, and take steps to decrease losses in the future. Those steps can include better stock selection, protective measures (including the use of options, for example), and diversification.
- Investing on the basis of rumor or questionable advice. The Internet chat room is not a good place to get market information. Unsolicited phone calls, pop-up advertisements, or mail solicitations for investment solutions, promising fast and easy profits, are not going to make anyone rich. Advice from friends, relatives, coworkers, or people you talk to on the bus or train should be discarded.
If you are intent on getting advice from someone else, think carefully before you pay for that advice. The history of analytical services offered by the big brokerage firms has been quite poor. Not only have these firms given historically poor advice; it would often have been more profitable to do the exact opposite. The big firms have also been fined millions of dollars for knowingly giving poor advice to clients. With today's Internet-based market, a lot of free advice is available from many different places. You can also act based on advice from friends, relatives or coworkers. But the truth is, no one is going to give you free good advice. Making smart investment decisions invariably requires that you perform your own research, apply your own standards based on clearly identified risk standards, and do your homework directly.
- Trusting the wrong people with your money. As a group, analysts' advice has led to net losses for their clients. The problem is not limited to analysts' conflicts of interest. As a group, analysts tend to pick earnings and price targets rather than try to find solid fundamental strength in companies. This makes analysts a poor source for market information; you are better off on your own. If you do intend to hire someone to advise you, make sure they base their investment advice on sound fundamentals. If you check, you will discover that the majority of financial advisers and analysts know little or nothing about accounting standards and rules and do not base decisions on tried-and-true fundamental principles. It is more likely that a financial adviser will try to steer you into mutual funds rather than stocks because funds pay more than 8 percent commission to salespeople; and, of course, investors pay this through a sales load. For example, if commission is 8.25 percent, that means that out of every $100 you invest, only $91.75 goes into the investment; the rest goes to the salesperson (financial adviser). You do not need to pay commissions to find sound investments; and by definition, anyone buying stocks and trading options should be making their own decisions and not relying on expensive advice.
- Adopting beliefs that simply are not true about the markets. The market thrives on beliefs that, although strongly held, are simply not true. Widespread beliefs are difficult to overcome, but it is wise to question convention, especially when you see time and again that those beliefs are invariably misleading.
For example, many investors insist on believing that there are secret, magic formulas that guarantee success in the stock market. Even though the facts clearly dispute this belief, thousands of people send away money every year to learn these "insider secrets" to market wealth. You will never meet anyone who has become rich in the market by following any formula that they paid to find out about.
- Becoming inflexible even when conditions have changed. You may find a method that works for you, so you stick with it, even when conditions have changed and the strategies are no longer working. You need to maintain your flexibility, because markets are in a continual state of change.
The market is constantly evolving and changing. Very little remains true for long, so even today's favorite stock or market sector could easily be out of favor next month. You only need to look back over history to realize how easily an industry can become obsolete. Before 1900, auto and airline stocks did not exist, and before 2000, digital cameras were not widely known, so companies such as Polaroid and Kodak dominated the film markets. A review of the fundamentals for any company out of favor today reveals falling stock prices, lower profits, and a relentless decline in all of the fundamental indicators. There are good lessons to be learned from history, and the market reflects change as a constant element.
- Taking profits at the wrong time. The temptation to take profits when available is a strong one. However, the timing of profit taking should depend more on your overall strategy than on a momentary opportunity. If you always take profits when available, you will end up with a portfolio full of stocks whose current market value is lower than your original cost.
Using options as a secondary strategy in your stock portfolio enables you to take profits without needing to sell stock. This can be accomplished in several ways. For example, when stock values climb high, you can sell covered calls or buy puts. If and when market values fall back to previous levels, the short call or long put positions can be closed at a profitâbut you continue to hold your long-term stock. When stock values fall, you can also take advantage of the temporary panic, by buying calls (you can also sell puts in this situation, a topic covered in Combined Techniques: Creative Risk Management). When the stock price rises back to previous levels, the option positions can be closed at a profit.
- Selling low and buying high. The advice to buy low and sell high is easily given but harder to follow. It is all too easy to make investment decisions on the basis of panic (at the bottom) or greed (at the top). A worthwhile piece of market wisdom states that bulls and bears are often overruled by pigs and chickens.
It is not easy to resist the emotions of greed and panic; but you need to think long term when you invest in stock. If you select companies based on sound criteria, you do not need to be concerned about short-term price movement, not to mention rumor and speculation about what will happen tomorrow. Options can also be useful in overcoming the paradoxical temptation of long-term investors, which is to act like short-term speculators and against their own best interests. Options are excellent instruments for hedging other positions, riding short-term price movement, and taking profits, all without having to sell stock before you really want to (on the upside) or because prices fall temporarily (on the downside).
- Following the trend instead of thinking independently. Crowd mentality is most likely to be wrong. Crowds don't think; they react. So mistakes are likely to occur when you follow the crowd instead of thinking for yourself.
Successful investors learn to think for themselves and to avoid crowd thinking. This means not only resisting the temptation to follow the majority, but also to recognize that the majority is usually wrong. This contrarian approach to investing has proven to be successful historically because crowd mentality is a misguided way to think.