Want to Succeed at Investing? Focus on Not Failing

Here are six of the biggest mistakes an investor can make. If you can avoid them, the odds are stacked in your favor.

May 12, 2014 at 2:00PM

The following article is exclusive content from The Motley Fool. While this is typically paid content, we are bringing it to you free because we think it is especially pertinent to your ability to invest wisely.

Anastasiya

Source: Wikimedia Commons user Carschten.

When asked how to succeed in life, Charlie Munger once replied: "Don't do cocaine. Don't race trains. And avoid all AIDS situations." His point: Success isn't just about what you do. It's also about what you don't do, and you can be successful in life just by avoiding major, obvious mistakes.

The same logic applies to investing. In his famous 1975 essay "The Loser's Game" -- later expanded into a best-selling book -- Charlie Ellis compares investing to amateur tennis. Using statistical work and theories developed by scientist Simon Ramo, Ellis points out that amateur tennis players rarely win matches with brilliant shots. In fact, 80% of the time, the winner of an amateur match is the player who makes fewer mistakes. So if you're a beginner who wants to improve, you should start by mastering the basics.

Here are six of the biggest mistakes an investor can make -- a half-dozen financial shots into the net. If you can avoid them, the odds are stacked in your favor.

1. Failing to save
It's obvious, but if you don't save, you can't invest. Unfortunately, nearly a third of Americans don't save anything, according to a survey by the nonprofit Consumer Federation of America. And those who do save don't save that much. The personal savings rate was about 4% to 5% during the past year, according to Federal Reserve data. Admittedly, saving can be hard, but it's important -- you can't win the game if you're not even playing. If this guy can do it, then it should be possible for most people.

2. Not investing in stocks
Over time, stocks have been a gold mine for investors. Fools understand this, but most Americans don't. According to a survey conducted by Gallup, only 24% of Americans think that stocks or mutual funds are the best long-term investment. What do the other 76% think is the best investment? Real estate tops the list at 30%, followed by gold at 24%.

There's no doubt that real estate or real estate investment trusts can earn a good return, but that comes from rental income, not appreciation. According to data going back to 1890 from Yale economist Robert Shiller, the real appreciation of home prices after inflation is 0.2% annually. Too many Americans consider their home to be their biggest "investment." That's a big mistake. Buying a house (or a bigger house), which generates no rental income, won't net much after inflation, at least on average, according to historical data.

Gold isn't much better in terms of returns. According to Greg Mankiw, a Harvard economist, the after-inflation return on gold going back to 1836 has only been about 1%. During the same period, stocks earned more than 7% after inflation.

3. Paying high fees 
Over long periods of time, high fees have an incredibly deleterious effect on your investment returns and your wealth.

Let's say you had $100,000 to invest. So you found an investment advisor who charged 1% of fees to manage your account, and that advisor invested your portfolio in active funds that charged another 1%. So the total fee is 2% of assets -- that's not uncommon. And let's say your account earned 10% annually for 25 years. Your account would be worth $560,409 in the end.

Conversely, if you hadn't hired the advisor and instead decided to manage your account on your own -- building a diversified portfolio of stocks and using low-cost mutual funds -- you probably could've generated the same 10% returns per year. But your costs would've been much lower -- say, 0.3% annually. In that case, after 25 years, you'd have $905,295 in your account.

4. Frequent trading
Trading is hazardous to your wealth. In 2000, Brad Barber and Terrance Odean published a paper by that name investigating the activity and results for 78,000 accounts during a six-year period. During the years the study covered (1991-1996), the market averaged annual gains of 17.9%. Those who traded the most had net average returns of just 11.4%, while those who traded the least achieved net average returns of 18.5% per year.

Why do traders fare so badly? They are overconfident, and their buy and sell decisions are often wrong. And they're wrong at a high cost because they expose themselves to extra frictional costs -- commissions, bid/ask spreads, and taxes.

5. Not diversifying
Economists have described diversification as the only "free lunch" in the markets based on the capital asset pricing model work done by Harry Markowitz. But it's really just common sense: Don't put all your eggs in one basket. The same advice has been suggested by Shakespeare, the Bible, and the Talmud.

There's a good chance that you'll be wrong on a particular investment. Even great stock-pickers like Peter Lynch only aim to be right about 60% of the time. So it makes sense to spread your assets beyond just a few stocks. That's why Motley Fool premium services, such as Stock Advisor, recommend that members own at least 15 stocks.

6. Trying to get rich quick
In investing, the tortoise usually outperforms the hare. Unfortunately, wanting to get rich quick is human nature, and it leads to huge mistakes like buying penny stocks, chasing fads, and taking "hot" tips. If something sounds too good to be true, it probably is.

Since 2009, the Motley Fool has tracked more than 200 "get rich quick" stocks -- mostly penny stocks associated with a hot fad and hyped by promoters -- through a CAPS account called TMFStockSpam. As a group, these stocks have proven woeful. More than 93% have underperformed the market, and the robotic strategy of betting against these stocks resulted in TMFStockSpam outperforming more than 99.99% of the nearly 75,000 players on CAPS.

The Foolish bottom line
If you avoid these six mistakes, you'll be saving regularly, investing in stocks, keeping fees down, holding investments for the long term, diversifying your portfolio, and avoiding scams. This won't guarantee overnight success, but it will heavily tilt the odds of long-term success in your favor. In fact, it would be hard to fail.

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