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The Biggest Mistakes Investors Make When Buying Stocks

The following is a guest post from Ben Carlson at A Wealth of Common Sense. Ben writes about personal finance, investments, investor psychology and building wealth using your common sense.

   

“There’s no way that you can live an adequate life without many mistakes. In fact, one trick in life is to get so you can handle mistakes. Failure to handle psychological denial is a common way for people to go broke.” – Charlie Munger

Most investors focus on how to choose winning investments by making the correct moves all the time. You should actually be happy if you are right just a little more often than you are wrong. One way to increase your odds of success is to instead focus on your mistakes. Admitting your mistakes and working on minimizing unforced errors will help.

Here are some of the biggest mistakes stock investors make when investing in stocks.

Buying Based on a Story Instead of Fundamentals

Investors love to buy a stock that has a great story. It’s sexy to talk with your friends and colleagues about innovative products, growth and revolutionary CEOs. These attributes get us excited about certain stocks.

Losing moneyJust don’t confuse excitement with value. It’s great if you find a stock that has a story, but make sure it has the fundamentals to back it up. In most cases the story has been baked into the price long before you came along to invest in the company. Remember that great companies don’t always make for great stocks if you buy at the wrong price and terrible companies might make for a great investment at the right price.

You should make your purchase on the basis of the fundamentals of the business using a wide variety of valuation methodologies (P/E, P/B, P/S, BV, FCF yield, DCF, dividends or whatever you determine to be important). Also, make sure to buy with a margin of safety in case your analysis proves faulty. As with all financial models – garbage in, garbage out.

Not Defining Your Time Horizon

I feel that the biggest edge that individual investors have over Wall Street is the fact that we don’t have to worry about short-term performance or benchmarks. Wall Street must play in the week to week and quarter to quarter time frame. They must produce results or have their investors look elsewhere. This can lead to big time career risk if they continue to underperform, which causes them to focus on short-term performance.

Individual investors have the luxury or being able to think and act long-term with their stocks. We don’t have to beat the S&P 500 every quarter or calendar year. We have the ability to be patient. Just make sure you know what your time horizon is before you buy a stock so you don’t make unnecessary moves at the wrong time.

Not Having an Exit Strategy

Buying stocks can be difficult, but the majority of the time, stocks are rising. Therefore even though there are a wide range of factors that you must consider before making a purchase, it’s not the hardest part of the stock investing equation.

It’s actually much harder to determine when to sell a security. We’ve all heard war stories from investors that sold too quickly or didn’t sell soon enough.

The sell decision also has to do with your time horizon as an investor. Are you a long-term holder? A short-term trader? An opportunistic investor in periods of volatility?

You must determine whether you will leg into a position over time, buy the dips in price, invest all at once to buy-and-hold or trade around your positions by taking occasional profits. Knowing this ahead of time will give you a better idea about how to handle your sell rules.

Most successful sell rules involve basing them on a rules-based approach. This could be a valuation target such as the P/E multiple over a predetermined long-term average. Another option would be to sell when the dividend growth rate falls or the dividend gets cut. There are tons of data points to choose from. Just make sure the fundamentals you use for your buy decision are the same ones you use for your sell decision.

Not Having a Reaction Plan

Most investors assume that their actions are the most important aspect of their investment plan. Actions are important, but it’s actually your reactions that make the biggest difference in the long-term.

You need to have a process in place that helps you determine what to do in periods of volatility on both the upside and the downside.

What would you do if the stock you just purchased rose 50% in a month? Would you take some gains? Sell the entire position? Continue to hold for the long-term?

What if it dropped 50% in a month? Would you buy more? Get rid of it entirely? Hold tight?Hold tight

Having a plan in place before you make a purchase can help temper your reactions. It won’t always turn out to be the best move and it could be different for each investment, but having a consistent process will take away some of the guess work when markets get crazy.

Summary

Everyone makes mistakes when they invest. It’s the nature of the beast when you are dealing with complex markets full of people and institutions that all have different goals and objectives.

Minimizing the big ones will give you a higher probability for sustained success in the long-run. Sticking to the fundamentals, having a long-term time horizon, developing an exit strategy and creating a process to deal with how you react to uncertainty can help you avoid the mistakes that most investors make time after time.





11 responses to “The Biggest Mistakes Investors Make When Buying Stocks”

  1. […] Hello Suckers covers some common investing mistakes. […]

  2. […] I wrote another guest post this week, this time for Martin at Hello Suckers.  I covered the biggest mistakes investors make when buying stocks. […]

  3. This is a great post. I’m also looking to start investing in the next few months as well. Reading the part about having a reaction plans was very helpful. Having a strategy before you start investing seems to be the wise move here.

    • Martin says:

      I must concur that strategy helps a lot. When I started my options trading the strategy or in other words knowing what to do in several possible scenarios helped me a lot to stay calm and not panicking and overreacting. It is absolutely the same with stocks.

    • Ben says:

      Thanks. Since you’re just starting out, remember that a long time horizon is your friend. Try not to get caught up in the day to day movements of certain stocks or the overall market. Easier said than done.

      • Martin says:

        Many times in the past day by day movements freaked me out. Fortunately I learned to ignore it and in many occasions I laugh when the stocks move up and down and I read the “reasons” in media why that happened.

  4. Jake @ Common Cents Wealth says:

    I’m looking to begin personally investing in the next few months, so these tips are great for me to read right now. I think the toughest one for me will be the exit strategy. Being that I’ll most likely be investing for my retirement which is 30 years out. I guess I maybe won’t worry about my exit strategy until I get closer to needing the money.

    • Ben says:

      Right, keep a long-term perspective. If you are going to invest in individual stocks, that’s the biggest advantage you have right now. If you are not comfortable investing in individual names or don’t have the time to put in the effort, a simple low-cost index fund will be the easiest way to invest.

      • Martin says:

        Agree. there are even commission free mutual funds or ETFs which can lower the cost even more than just simple funds only but purchased at regular cost (if purchased via a broker and not directly thru the fund).

    • Martin says:

      Jake, if you choose dividend growth investing, then your exit strategy will be simple – it will almost never occur. Only when the company cuts the dividend or stops growing it more than inflation. That’s why I like this strategy, it makes investing a lot simpler.

  5. Joe says:

    I’m terrible at the whole exit strategy thing. That’s why I like investing in blue chip stocks. It’s less work for me because it doesn’t fluctuate that much. I have some positions in smaller stocks too and it’s a lot of work to keep close track of them.

    • Ben says:

      Good point. Volatile stocks are much harder to stomach over the short-term, even though theoretically they should offer you a higher return over the long-term. The problem with determining an exit strategy is that you could be wrong in the short-term but right in the long-term, so I’d suggest moving on after a sale an not dwelling on missed opportunities. But making the sell decision is very difficult.

    • Martin says:

      That’s exactly why dividend investing works for me as well. You get dividends every quarter, you are mostly buying blue chips, and never have to think about when to buy and when to sell. I just am trying to buy when the stock is retreating from the upper trend resistance line and buying on the lower trend support line, or major corrections, and that’s it.

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