5 Ways to Avoid Common Investing Pitfalls
Emotions and ignorance can cloud your judgment and hurt your portfolio. Here’s how to stay clearheaded and focused.
The start of a new year brings hope and optimism and an opportunity to reflect on some of our financial decisions. Many investors are happy to put 2015 behind them. No asset class performed very well last year. The best of the bunch, equities, yielded a modest 2%, according to data from Societe General, which would make 2015 the hardest year to make money in the markets since 1937. (The 2008-2009 market meltdown was a disaster for equities, but people forget that another asset class, Treasuries, performed strongly during the recent downturn). Even in strong markets, investors often fall into unnecessary traps. Here are five of the most common investment pitfalls and ways to avoid them:
1. Getting emotional about the market. The ever-developing field of Behavioral Finance teaches us that people often rely on shortcuts or "rules of thumb" in an effort to simplify complex scenarios. Many experts believe that these shortcuts in the decision-making process, commonly known as heuristics, are behind many of the financial bubbles that we have seen throughout history.
Take the availability heuristic, for example. It leads investors to make judgments based on how easily a set of circumstances can be recalled. Hearing a glowing report on a stock in the media, for example, or seeing a friend succeed financially, may lead us to believe the odds of success are greater than they actually are. In the late 1990s, we saw dot-com mania. Investors piled into shares of dozens of Internet start-up companies without regard for a company's business model or fundamentals, simply because the hype was everywhere.
Investment performance tends to suffer when we let emotions cloud our judgment. When things are going well, our mindset tends to shift toward feelings of invincibility and euphoria. We take on more risk than we should and, often, more risk than we realize. Conversely, studies have shown that losses hurt more than twice as much as gains bring pleasure. So we get defensive at precisely the wrong time.
Solution: Create a financial plan, and revisit it at least annually to track your performance, update assumptions, and reassess your risk tolerance. Remember, it doesn't matter if you beat your friends' performance or any other arbitrary benchmark. The only thing that matters is whether you can meet your financial goals (i.e., retire at a particular age, buy that beach house, pay for your children's college education, etc.).
2. Confusing good stocks with good companies (and vice versa). In the 1980s, Peter Lynch, one of the best money managers of all-time, preached "buy what you know." He suggested that there was money to be made by investing in companies whose products and services you were already familiar with. This simplistic strategy would often lead you to buy well-known companies with share prices that had already run up. The companies you know may be great companies but are often expensive stocks.
Solution: Market moves are usually exaggerated on both the upside and downside. The stock market is the only place where people rush to buy when prices go up and flee when prices go down. Remember that when shares go on sale, you can find bargains. Make a list of investments that you'd like to own and the prices you're willing to pay. When the market sells off, your list will help you stay disciplined.
3. Failing to recognize where we are in the business cycle. The peaks, troughs, and length of time between each phase may differ, but never forget that our economy is cyclical. The Federal Reserve manages monetary policy to maintain reasonable levels of inflation and low rates of unemployment. The result is that expansions always follow recessions, and the cycle continues. If the macroeconomic environment is weak or weakening, even the best stocks will usually decline.
Solution: Keep an eye on the overall economy, and familiarize yourself with how certain asset classes perform at different points in the business cycle. Morningstar groups the major sectors of the equity markets into three "super sectors": Cyclical, Defensive, and Sensitive. Each will react differently as we move through the business cycle.
4. Not knowing what you own. In days gone by, you could pick up your account statement and read the names of the companies that you were invested in. Today, with the widespread use of different types of investment vehicles, figuring out exactly what you own is not as straightforward. You may think you are diversified because you own various investments, but there may be significant overlap in the underlying holdings.
Solution: If you work with a financial adviser, ask for a Stock Intersection report. This is a report that shows your top individual holdings across your entire portfolio (in dollar value and as a percentage) and how many of your investments hold each position.
5. Not knowing when to sell. There are two predominant ways to analyze investments: Fundamental and Technical. Fundamental analysis looks at the underlying strength of the business and factors such as profit margins, revenue growth, cash flow, and management effectiveness. Technical analysis focuses on price movements, charts, and trends. If you are fortunate enough to have some winners in your portfolio, do not become emotionally attached. Nobody wants to miss out on additional upside. But sometimes you need to book your profits.
Solution: Have a predetermined exit price. If you make investment decisions based on fundamentals, your sell price could be based on attaining a specific Price-to-Earnings or Price-to-Cash Flow level. If you utilize technical analysis, you might exit based on a stock breaching a Moving Average or Relative Strength level. You may miss out on some upside using this approach, but you'll have locked in your gains and can now look for new investment opportunities.
Bryan Koslow, MBA, CFP®, CPA, PFS, CDFA™ is the President of Clarus Financial Inc., an Integrated Wealth Management firm with offices in NYC & NJ.
About the Author
Founder & President, Clarus Financial Inc.
Bryan is the Founder & President of Clarus Financial Inc., an Integrated Wealth Management firm with offices in New York City and New Jersey.
Bryan is a Certified Public Accountant (CPA), Certified Financial Planner™ (CFP®), a Personal Financial Specialist (PFS), and a Certified Divorce Financial Analyst (CDFA™). He holds FINRA securities registrations Series 7, 63, 65, and has his New Jersey Life and Health Insurance license.