Four Investing Mistakes to Avoid

Investing Mistake 1: Spreading your investments too thin

Over the past several decades, Wall Street has preached the virtues of diversification, drilling it into the minds of every investor within earshot. Everyone from the CEO to the delivery boy knows that you shouldn't keep all your eggs in one basket - but there's much more to it than that. In fact, many people are doing more damage than good in their effort to diversify. Like everything in life, diversification can be taken too far. If you split up $100 into one hundred different companies, each of those companies can, at best, have a tiny impact on your portfolio. In the end, the brokerage fees and other transaction costs may even exceed the profit from your investments. Investors that are prone to this "dig-a-thousand-holes-and-put-a-dollar-in-each" philosophy would be better served by investing in an index fund which, by its very nature, is made up of many companies. Additionally, your returns will mimic those of the overall market in almost perfect lockstep.

Investing Mistake 2: Not accounting for time horizon

The type of asset in which you invest should be chosen based upon your time frame. Regardless of your age, if you have capital that you will need in a short period of time (one or two years, for example), you should not invest that money in the stock market or equity based mutual funds. Although these types of investments offer the greatest chance for long-term wealth building, they frequently experience short-term gyrations that can wipe out your holdings if you are forced to liquidate. Likewise, if your horizon is greater than ten years, it makes no sense for you to invest a majority of your funds in bonds or fixed income investments unless you believe the stock market is grossly overvalued.

Investing Mistake 3: Frequent trading

I can name ten investors on the Forbes list, but not one person who made their fortune from frequent trading. When you invest, your fortune is tied to the fortune of the company. You are a part-owner of a business; as the company prospers, so do you. Hence, the investor who takes the time to select a great company has to do nothing more than sit back, develop a dollar cost averaging plan, enroll in the DRV or dividend reinvestment programand live his life. Daily quotations are of no interest to him because he has no desire to sell. Over time, his intelligent decision will pay off handsomely as the value of his shares appreciates.

A trader, on the other hand, is one who buys a company because he expects the stock to jump in price, at which point he will quickly dump it and move on to his next target. Because it is not tied to the economics of a company, but rather chance and human emotion, trading is a form of gambling that has earned its reputation as a money maker because of the few success stories (they never tell you about the millionaire who lost it all on his next bet... traders, like gamblers, have a very poor memory when it comes to how much they have lost).

Investing Mistake 4: Fear based decisions

The costliest mistakes are usually fear based. Many investors do their research, select a great company, and when the market hits a bump in the road - dump their stock for fear of losing money. This behavior is absolutely foolish. The company is the same company as it was before the market as a whole fell, only now it is selling for a cheaper price. Common sense would dictate that you would purchase more at these lower levels (indeed, companies such as Wal-Mart have become giants because people like a bargain. It seems this behavior extends to everything but their portfolio). The key to being a successful investor is to, as one very wise man said, "..buy when blood is running in the streets."

The simple formula of "buy low / sell high" has been around forever, and most people can recite it to you. In practice, only a handful of investors do it. Most see the crowd heading for the exit door and fire escapes, and instead of staying around and buying up a company for ridiculous levels, panic and run out with them. True money is made when you, as an investor, are willing to sit down in the empty room that everyone else has left, and wait until they recognize the value they left behind. When they do run back in, you will be holding all of the cards. Your patience will be rewarded with profit and you will be considered "brilliant" (ironically by the same people that called you an idiot for holding on to the company's stock in the first place).

Surviving a Roller Coaster Stock Market

Surviving a Roller Coaster Stock Market

There have been a number of research papers proving that investors, as a whole, experience far lower returns than the stock market itself as a result of frequent trading. It's not difficult to see why: Men and women, with no training in finance, attempting to manage their own 401k, Roth IRA, or Traditional IRA, or retirement accounts, panic when faced with volatility. After building up an investment portfolio over decades of work, a drop in stock prices of only ten or twenty percent can lead to tens, or even hundreds, of thousands of dollars in paper losses.

For an experienced investor with little or no debt, such a drop would be a non-event. They would know why they own the companies they hold, have estimated the future profitability, and calculated that into a discounted cash flow formula that gives them a rough idea of what their rate of return should be provided the variables they plugged in are accurate or conservatively projected. In fact, these investors (what have been called "true" investors) would welcome price drops, even if it meant half of their net worth disappeared from their monthly statements. I can tell you with absolute certainty that, all else being equal, if Berkshire Hathaway were to fall from $120,000 per share to $50,000 per share compared to its $72,000 per share book value, I would not for a moment lament the paper loss in my net worth, but rather back up the truck and attempt to buy as many shares as possible, even selling off other assets to fund the acquisition. There's a good chance the folks at my office would have to stop me from doing cartwheels. That's because I know the company, how it generates its cash, and have a rough approximation, adjusted on a rolling basis, of its intrinsic value.

In this article, I'm going to attempt to lay an intellectual foundation to help you think differently about stock market volatility, as well as provide you with some tips and tricks that might help traversing the stormy seas of Wall Street a whole lot easier.

Lay the Foundation

First, and please correct me if I'm wrong here, but you probably want to retire comfortably. You work hard, and want to be rewarded for that work; because of that, I want you to bookmark your page right here and take a moment to lay the foundation of what we're going to discuss by reading How to Think About Stock Prices, Price is Paramount, and Defensive Investing: Building a Portfolio for Volatile Markets. These three pieces of content will arm you with some background that allows me to go further in this discussion, making it easier to serve you better.
It's All About the History Books

Bill Gross, arguably the greatest pure bond investor alive today, has said that if he were only able to study one book, it would be a comprehensive history of the financial markets. That's because it can provide a framework for understanding financial psychology. Most people make the mistake of thinking that investing success is related to intelligence. I want you to repeat after me: Being a successful investor isn't about intelligence. Isaac Newton, one of the most brilliant minds the human race has ever produced, was wiped out in the Dutch Tulip Bubble.
A good place to start is the Ibbotson & Associates Stocks, Bonds, Bills, and Inflation Classic Yearbook. Although it costs around $100 per hard bound copy, it provides data about market levels and returns for more than a century. A quick glance, and you'll be comforted to see that over periods of ten years or longer, the stock market almost always performs well, especially when coupled with a dollar cost averaging plan that allows you to take advantage of low prices and fat dividend yields.

Some Checkpoints to Lower Your Risk

If you are worried about risk management and not necessarily generating maximum returns (which most likely describes 99% of the readers), here are some things to consider:

· The price-to-earnings ratio of your portfolio is no more than 10% higher than the market as a whole.

· The price-to-earnings ratio of your portfolio is no higher than twenty.

· You have a diversified base of stocks and bonds appropriate for your distance from
retirement (you should own more and more fixed income or cash equivalents as you approach the end of your working career).

· Focus on mutual funds with low expense ratios, good historical performance ratings and established management who invest in the funds they manage.

· If you are interested in long-term (five years or more) returns that are competitive, stop moving assets around in your retirement account. You don't know more than the market, and you aren't experienced enough to make rational judgment calls. Stick to your plan, continue your contributions, and wait until retirement. Unless there is a fundamental deterioration in the underlying asset, the stupidest time to sell anything is after it has fallen in price.
Get Competent Professional Advice

If you don't know what to do or feel completely lost, seek out a competent, well respected, and conservative financial adviser or planner. You want someone who has a good record and can explain, in one short paragraph, the rational for each investment held in your portfolio. You want someone who values your needs and listens to you; what good is it to have someone managing the money for which you work so hard if they don't understand what it is you are trying to accomplish?

Why It Might Be a Horrible Mistake to Sell Out During a Down Market

f you are more than five years away from retirement, your 401(k) was invested in a broadly diversified, low-cost index fund, and you’ve sold off your assets as the market has collapsed, you have made a very, very stupid long-term decision. Believe me, I wish it could be sugar coated, but you’ve effectively just dumped your ownership of great American businesses such as Johnson & Johnson, Coca-Cola, Wal-Mart Stores, and General Electric to value investors at a fraction of their intrinsic value. After years of diligently building your wealth, you’ve turned them over to hedge fund managers, well-heeled executives, and disciplined personal investors that have the emotional strength to ignore volatility and instead do what makes sense five or ten years from now.

The worst part: You sold because other people were selling their stocks (many of them involuntarily due to margin calls). It’s the grown up version of the classic question posed by nearly every mother in history – if your friends jumped off a bridge, would you? Do you really think that Pepsi is going to sell less soft drinks and potato chips over the next twenty years because of a recession? Sure, as Warren Buffett has said, short-term profits are going to get hit at nearly all companies throughout the economy. The long-term health of the United States should continue to trend upward given our social, economic, and legal structures. Just as stocks have been the greatest source of wealth since the market meltdown in 1973 and 1974, they should continue to be the best vehicle for long-term over the next thirty years.

Instead, for those of you who have time to wait out the volatility, it might be a good idea to consider drastically increasing your retirement contributions while the market is falling. Of course, this is only a possibility if you’ve been following all the rules that are constantly espoused by financial advisors such as Suze Orman by establishing an emergency fund, staying out of credit card debt, owning your home, and living well within your means. Otherwise, you simply won’t be able to afford to take advantage of the current prices. (This, it should be noted, is one of the reasons by the rich get richer – when things go south, they can pick up assets on the cheap.)

How do I actually make money from a stock?

How do I actually make money from a stock?” If you’ve ever wondered how the mechanics actually work, print this article, grab a hot cup of coffee, get comfortable in your favorite reading chair, and prepare to learn the basics of common stock.

It's Simple, Really
When you buy a share of stock, you are buying a piece of a company. Imagine that Harrison Fudge Company, a fictional business, has sales of $10,000,000 and net income of $1,000,000. To raise money for expansion, the company’s founders approached a Wall Street underwriting firm (an investment banker) and had them sell stock to the public. They might have said, “Okay, we don’t think your growth rate is great so we are going to price this so that future investors will earn 9% on their investment plus whatever growth you generate … that works out to around $11,000,000+ value for the whole company ($11 million divided by $1 million net income = 9% return on initial investment.)” Now, we’re going to assume that the founders sold out completely instead of issuing stock to the public

The underwriters may say, “You know, we want the stock to sell for $25 per share because that seems affordable so we are going to cut the company into 440,000 pieces, or shares of stock (440,000 shares x $25 = $11,000,000.) That means that each “piece” or share of stock is entitled to $2.72 of the profit ($1,000,000 profit ÷ 440,000 shares outstanding = $2.72 per share.) This figure is known as Basic EPS (short for earnings per share.) In other words, when you buy a share of Harrison Fudge Company, you are buying the right to your pro-rata profits. Were you to acquire 100 shares for $2,500, you would be buying $272 in annual profit plus whatever future growth (or losses) the company generated. If you thought that a new management could cause fudge sales to explode so that your pro-rata profits would be 5x higher in a few years, then this would be an extremely attractive investment.

What Makes It a Bit More Complicated

What muddies up the situation is that you don’t actually see that $2.72 in profit that belongs to you. Instead, management and the Board of Directors have a few options available to them, which will to a large degree determine the success of your holdings:

1. It can send you a cash dividend for some portion or the entirety of your profit. This is one way to “return capital to shareholders.” You could either use this cash to buy more shares or go spend it any way you see fit.

2. It can repurchase shares on the open market and destroy them. For a great explanation of how this can make you very, very rich in the long-run, read Stock Buy Backs: The Golden Egg of Shareholder Value.

3. It can reinvest the funds into future growth by building more factories, stores, hiring more employees, increasing advertising, or any number of additional capital expenditures that are
expected to increase profits. Sometimes, this may include seeking out acquisitions and mergers.

4. It can strengthen the balance sheet by reducing debt or building up liquid assets.

Which way is best for you? That depends entirely upon the rate of return management can earn by reinvesting your money. If you have a phenomenal business – think Microsoft or Wal-Mart in the early days when they were both a tiny fraction of their current size, paying out any cash dividend is likely to be a mistake because those funds could be reinvested at a high rate. There were actually times during the first decade after Wal-Mart went public that it earned more than 60% on shareholder equity. That’s unbelievable. (Check out the DuPont desegregation of ROE for a simple way to understand what this means.) Those kinds of returns typically only exist in fairy tales yet, under the direction of Sam Walton, the Bentonville-based retailer was able to pull it off and make a lot of associates and stockholders rich in the process.