1. Waiting to Get Even
To avoid the pain of acknowledging that the market developed differently than expected, Investors avoid selling a loser until it recovers its original entry cost. The entry price, while irrelevant for future decision making, becomes the “anchor” or reference price. This behavior is explained by the behavioral finance concept of loss aversion – humans relate more strongly to losses compared to gains.
Possible results are:
– The investment may continue to slide (in some cases to the point of zero).
– Capital is not preserved and put to use elsewhere.
– The realized (early) loss may have had tax benefits in the current period if it could have been applied towards gains in other positions.
How to avoid this mistake?
Always develop a plan and set stop loss limits. The early loss is often the better option. Ask yourself if you did not already own the asset, would you buy it at today’s price?
2. Selling Winners early and holding on to Losers
Early Investors in Microsoft, Amazon, Apple, Starbucks, Alibaba, Tencent, Tesla, etc. should all have fantastic wealth. Most of them however sold too early (failing to HODL). The disposition effect in behavioral finance describes the desire to avoid regret and seek pride.
One technique that helps to better manage this issue is to set trailing stop orders which adjust as the price increases.
3. Not having clear investment goals and not having an appropriate time horizon
Rather than focusing on the short term and getting in and out of the latest hot stocks, it is better to develop a diversified portfolio that has a high probability of achieving long-term investment goals.
4. Failing to diversify enough
Investors often have too much exposure to specific assets or asset classes. Investing in assets with lower correlation to existing assets improves portfolio performance – significantly reducing portfolio volatility without sacrificing potential returns. Many investors have a country bias and fail to invest internationally. Bonds, large caps versus small caps and different industries are additional opportunities to diversify. A lack of diversification is related to “familiarity bias” which means that investors prefer assets they are familiar with (their own country and well known brand names). Many additional options for diversification exist (e.g. real estate, commodities, crypto, artwork).
5. Paying high fees and commissions
Small differences in fees can have dramatic effects on your portfolio over the long term. Actively managed funds typically come with significantly higher fees compared to index funds. Few managed funds are able to outperform index funds and even fewer are able to do so consistently. Providers of 401K and other retirement accounts offer many rather high fee products and few lower fee products.
6. Trying to time the market
Successful market timing is rare even for professional investors. Investors are better off to contribute consistently to their portfolio and benefit from dollar-cost averaging. It is relatively easy to sell when the market ‘appears’ to turn, but much harder to determine when to get back in. The risk of missing out on large upward moves is higher than staying invested over time.
7. Not doing enough research
What is the credit worthiness of organizations and the knowledge of individuals involved in managing your money? Do you understand the product you are investing in? Is your bank FDIC insured? Will your life insurance company be around in 20 years from now? Do your own research (DYOR) and ask questions. When doing research, avoid confirmation bias (which means that we have a tendency to ignore and filter out information that does not align with our preconceived notions).
8. FOMOing (Fear Of Missing Out)
Investors at times rush into assets due to social media mentions or impressive price action (e.g. momentum for meme stocks and crypto assets). The risk of FOMO is that you are buying at peak prices and are left holding the bag for what turns out to be only a temporary spike. Don’t get influenced and DYOR. Replace FOMO with JOMO (Joy of Missing Out on those online illusions).
9. Overtrading
Overconfident investors tend to mistake luck for skill. Success is something they have caused, and losses are caused by external factors. They underestimate risk and trade too often and with poor risk management. Highly selective trading is typically more successful. Better yet for most is buy and hold.
10. Underestimating life expectancy and failure to accumulate appropriate retirement funds
Investors do not take into account increasingly rapid improvements in health care and life expectancy. Money has to last longer and investors overestimate what they may get via Social Security benefits and fail to save enough via tax advantaged tools (e.g. 401K, Roth IRA, traditional IRA).