Monday, December 17, 2012

Ten investing Mistakes to Avoid

Everyone has a list, and well, I have quite a few including the ten mental errors of investing that few can afford to make. We all make mistakes showing great insight at times, but at other points may lapse into 'less than bright'. Today's topic includes a few of the 'less than bright'.

Over Confidence                  

Forecasting errors often begin with an over confidence in our own abilities, experiences, and what we qualify as knowledge. And of all the mental errors, overconfidence is perhaps the most deadly. We are just sure we can pick a bottom, catch a falling knife, or just know that Company ABC is the next great winner.

And sometimes it is, but then, if we were to take a room of 5,000 people, have each flip a coin 5 times in a row, we're going to have 'winners' who can hit heads every time. In fact I should have approximately (5,000)(.5)^(5) or ...a lot! The result is that we may be chasing ghosts/coin tosses that represent little more than a random walk through a lot of noise and events.

Similarly, studies of physicians and how well they predict their score on upcoming medical exams, drivers in Sweden of which the majority believe they are better than average, and how we score out our 'looks' all hold the same key element -- we are too confident. My favorite is to ask a room of people to write down on a scale of 1-10 how attractive they are. Psst -- the average score is 7!

Overconfidence is also a major factor in trading too frequently for the retail investor. Round trip (a buy & sell) trading costs that include broker fees and the bid/ask spread are expensive but only part of the problem. Even more importantly is the temptation to time the market, and may result in missing out on big moves.

We also tend to rely too much on our familiarity with one or more companies only to find out that its a great company, but a poor choice for an investment. We've worked at Company ABC for years, and it really is a good company to work for, but maybe not so much to overload in our portfolio.

Too frequently we may take advantage of company investment plans that over invest in our employer, when we need to diversify. Ask any employee that held WorldCom as a main stay of their retirement package, but do so gingerly. With sufficient diversification most, if not all, company specific risk can be removed, e.g., if we are holding a portfolio of 50 assets, the impact of a single company risk is reduced.

Similarly, we make be overconfident in our stock picking skills, thinking that we have diversified our portfolio only to find that the assets are highly correlated.  In other words, we have chosen stocks that are very similar in behavior and move together in tandem or near tandem.

Hint: Index based ETF's  or no-load, low fee index mutual funds provide an alternative without the trading costs and experience essential to diversify portfolios.

Regret Avoidance                  

Regret avoidance and how we reference information often lead to some interesting results. Pride can be an awful thing in finance, and the cold market can relieve us rather quickly of the burden of investing when we hold on to stocks that have clearly gone south. It's a sunk cost, and the sell button must catch up with the pride button!

A common failing is to hold on to a stock until it gets back to its purchase price (a reference point). And if we become fixated or anchored on not showing a loss, well, we could miss out on many other opportunities (an opportunity cost) by not re-balancing our portfolio.

Mental Accounts                  

Makes sense doesn't it -- to have a ultra safe retirement account, a separate college account, a mad money account, a (fill in the blank). Missed is the risk/reward available through a well managed portfolio combining both risk free and risky assets.

And Finally...                  

Actually, there is no finally but if there was it might be the decision to do nothing! The years will roll on, a few crow's feet may set in, or perhaps some gray hair. Social Security has (past tense) provided a safety net for many, but a safety net is a far cry from living well. Living well with the resources to pursue our dreams and to bless others is a good thing. Nuff' said.

Oh, and one last thought -- as a recent Wall Street Journal article pointed out "Goldman Sachs is faster than you", i.e., in an age of high frequency trading attempting to trade on the latest news/noise may not produce the results that one might be seeking.

These comments are meant for informational / discussion purposes only, and are not intended to represent a specific recommendation to buy or sell any security.

© 2012 by James Spruell All rights reserved