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4 Critical Errors You Must Avoid

For all of the attention lavished on the guys who manage hedge funds and mutual funds, nothing beats being a small investor. Peter Lynch said as much in his classic One Up on Wall Street: Big institutions have the resources, but we have the potential for extraordinary returns.

Poor Warren Buffett?
For one thing, we can invest in any company we like. Warren Buffett would love to be able to say that. Instead, his company, Berkshire Hathaway, holds billions in cash because Buffett can't find anything cheap enough to buy. With so much to invest, he must focus on large-cap, super-liquid companies. It must be dreadful having so much money.

Even better, unlike huge institutional money managers, we don't need to perform every quarter. We don't need to jump on every fad or pretend to be "active" out of a fear of falling behind. We don't worry what our manager or clients think of us. We can focus on buying the best companies at the cheapest prices.

Don't look this gift horse in the mouth
Digging up these rare values is what I -- along with Philip Durell and thousands of "small" value investors -- do every day at Motley Fool Inside Value. Sadly, too many individual investors do not fully exploit these advantages, and never reach their true potential to trounce the market.

Trust me, you do not want to group yourself in with those underachievers. Fortunately, by simply avoiding these four common mistakes -- all of which I've made myself at some point -- you can dramatically increase your long-term returns.

Mistake No. 1: Trying to time the market
Each week, hundreds of stocks move up or down 10%. If you could just figure out which stocks will move which way, you'd be rich in no time. Some even seem to bounce between price levels, the way Motorola (NYSE: MOT  ) bounced between $11 and $18 from 2001 to 2006. If you could just buy at the lows and sell at the highs, you'd have a profit machine!

It's a great idea ... except that it doesn't work. Over the short term, price changes are essentially random. People are masters at spotting patterns, even in random data. Look at a chart long enough, and a winning strategy will appear -- only to evaporate when real money is at stake. Sometimes you win with such a strategy, and sometimes you lose. So it goes with random events.

When investing, you want your results to be less like the flip of a coin, and more like the flip of a cat. There's some chance of the poor kitty bonking his head, but the smart money says that he'll land on his feet. So don't time the market. Focus on a proven strategy like value investing, where the expected return is significantly higher than average.

Mistake No. 2: Ignoring costs
Fees, trading costs, and taxes are the bane of the small investor. People manage your assets because they want their cut. This can take many forms: fund expenses, trading commissions, account management fees, and the spread between bid and ask prices on stocks. If there's any profit left, the government is quite eager to step in and take its slice.

Always be aware of the fees you'll be paying. Recognize that higher costs mean lower returns, so plan to minimize fees and taxes. Buy funds with low expenses. With your personal portfolio, avoid needlessly swapping Home Depot (NYSE: HD  ) for Lowe's -- two companies in the same industry, with reasonably similar market caps, and comparable long-term performance trends. You'd be amazed by how frequently fund managers do precisely that, and how much it costs you in taxes and commissions.

Mistake No. 3: Buying the hype
China is growing wildly, and Shanda Interactive (Nasdaq: SNDA  ) is a big gaming player in the Chinese Internet industry. With a fast-growing middle class, the eastern nation's population will also be looking to connect online. But the Internet revolution will seem like a blip compared with what will happen with nanotechnology. And with oil so high, the need for alternate energy sources becomes even more pronounced.

All that's true. But that doesn't mean you can buy Fuel Cell Energy (Nasdaq: FCEL  ) simply because it's a leading developer of fuel cell technology, and expect to make a quick fortune. After all, Unisys (NYSE: UIS  ) was an intriguing IT services play at a time when the world's businesses were shifting to the Internet and growing rapidly, yet investors who bought at the highs lost massive amounts of money.

Hype usually involves some truth, but says little about whether something will be a good investment. When confronted with large demographic, political, or technological trends, never just assume that the trend will provide a sufficient tailwind to power your portfolio.

Instead, examine the company-specific factors. A tailwind is nice, but it's critical to understand the competitive advantages of companies in the space. Ask yourself why this company will be able to exploit the trend better than its competitors. Netflix (Nasdaq: NFLX  ) recognized the available opportunity of DVD rental services matched with the ease of an online model and created a fantastic business-- imitators and competitors such as Movie Gallery don't appear to be so lucky.

Mistake No. 4: Betting on the market as a casino
The stock market can feel like Vegas. A gambler can go to Harrah's and get lucky tossing dice. An investor can, in complete ignorance, buy a stock, get lucky, and make money. You don't get turned away from either for lack of knowledge or even common sense -- only lack of cash.

Unlike many Fools, I think it's perfectly reasonable for people to gamble on the stock market for entertainment, just as I think it's perfectly reasonable for people to gamble at casinos for entertainment. But I think gamblers in either case should not be surprised, upset, or outraged if they lose money.

If, on the other hand, your goal is to make extraordinary profits, don't treat the stock market like a casino. Don't buy on hunches or speculations; buy because you understand the company and recognize that it's selling at a discount to its fair value. Always have a good grasp of (1) its fair value, (2) the company's strategy, and (3) the challenges it is likely to face going forward.

Again, I follow this process myself every day -- in my work at Inside Value and when managing my own portfolio. In my experience, this is the only way to buy stocks that offer a superior risk-reward trade-off.

What next?
By simply avoiding these four mistakes, you can dramatically improve your chances of success. Focus on value stocks with a suitable margin of safety, and look at the entire market. Then you can really exploit your advantage as a small and nimble investor. Peter Lynch (and Warren Buffett) would be proud.

If you're interested in finding dirt cheap value stocks, you should chat with one of my favorite investors, Philip Durell. Philip is offering a free 30-day trial to his Motley Fool Inside Value investment service. There's no easier way to discover whether an advisor or a service is right for you. Simply click here to learn more.

This article was originally published on April 26, 2005. It has been updated.

Fool contributor Richard Gibbons, a member of the Inside Value team, has no position in any of the stocks discussed in this article. He tosses cats only infrequently, and no felines were injured during the writing of this article. Netflix is a Stock Advisor selection. Shanda is a Rule Breakers recommendation. Home Depot is an Inside Value recommendation. Berkshire Hathaway is a Stock Advisor and an Inside Value pick. The Motley Fool has a disclosure policy.

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