The best investors learn from their mistakes over time. And because I've made plenty of mistakes during my career, I'll optimistically say that means I've had lots of room for personal growth. Lucky you, then, for being able to learn from some of the biggest mistakes I've made or witnessed -- without having to live through the experiences yourself.
Here are seven of the biggest rookie investing mistakes you can make. Amazingly, I still see pros make these all the time.
1. Panic selling
Picture this: A company you own whiffs on meeting Wall Street's expectations. The stock drops and so does your stomach. You're not alone. Years of experience will harden your stomach, but there's no shaking the primal reaction to hurl breakfast when one of your biggest holdings falls, say, 30% in a single day.
This happened to me back in 2003, when my shares of Philip Morris, now split into Altria (NYSE: MO) and Philip Morris International (NYSE: PM), fell off a cliff when the Justice Department announced it was seeking $289 billion from Big Tobacco. I panic-sold, only to watch the stock climb back and sheepishly repurchase my shares at a higher price. Ugh.
Panic selling in response to bad news is one of the worst mistakes you can make. Instead of letting your emotions get the better of you, review your original investment case and think about how new information affects the story. Even better, keep an investment journal in which you outline at the time you buy a stock what would make you decide to sell later on. And remember, big drops in a stock price can actually make for great buying opportunities. As Warren Buffett says, be fearful when others are greedy and greedy when others are fearful.
2. Using leverage
There's no easier way to blow yourself up than by using leverage or buying on margin. Many small investors have used leverage, or margin, to amplify their returns when stocks go up. But when their investments fall in value, they're crunched with margin call, forced selling, and big losses. Chesapeake Energy CEO Aubrey McClendon learned this lesson the hard way in 2008 when, after loading up on leverage to juice his upside on Chesapeake's stock, he instead got crushed by the stock's collapse. Don't put your savings at risk by buying on margin.
Don't ignore how leverage, or using debt, can hurt the companies you own, either. Liquidity is like oxygen: You don't appreciate it until it drifts away. Companies that rely on short-term funding to fuel their business find themselves gasping for air when liquidity seeps away. High debt loads also put profits under greater pressure during down times and, at their worst, can force companies into bankruptcy.
3. Buying the next new thing
There is always a hot new industry that draws investors like moths to a flame. Usually, investors get smoked by following the lights. Last year, it was social media. In 2006, it was clean tech. And in 1999, it was Internet stocks. The list of booms and busts goes on and on. But despite mountains of experience, rookies and pros alike regularly allow greed to get the better of them and chase after returns and their dreams by investing in the next new thing.
4. Relying on Wall Street guidance
Wall Street analysts are notoriously bad forecasters, chronically overestimating companies' prospects. A study by Patrick Cusatis and J. Randall Woolridge of Penn State University found that, over a 20-year period, analysts consistently missed by a mile-wide margin.
|
Time Frame |
Estimated Growth |
Actual Growth |
Overestimated By |
|---|---|---|---|
| 1 year | 13.8% | 9.8% | 4% |
| 5 years | 14.9% | 9.1% | 5.8% |
Source: "The Accuracy of Analysts' Long-Term Earnings-Per-Share Forecasts," Cusatis and Woolridge.
It gets worse. Analysts are lemming-like when it comes to buy/hold/sell ratings. According to Yahoo! Finance, 50 out of 55 analysts covering Apple (Nasdaq: AAPL) rate the stock a buy. The problem doesn't get any better when you zoom out. For example, if you read the fine print in Credit Suisse's research report on Apple's stock, you'll find that Credit Suisse only rated 10% of the stocks in its universe underperform/sell as of Jan. 20, 2012. That doesn't mean that Apple deserves to be a sell -- but surely more than 10% of all the stocks out there do.
Think for yourself when evaluating businesses. If you do rely on analysts' estimates, be sure to give them an appropriate haircut.
5. Buying value traps
Buying high-quality businesses at out-of-favor prices has worked for Buffett for decades, but a stock isn't an automatic buy just because it is statistically cheap (i.e., has a low P/E ratio). Mr. Market might be emotional and short-sighted, but he isn't stupid. Companies with erratic profits, bad management teams, or dim futures are cheap for a reason. Think twice when you're evaluating a business that looks too cheap to be true. You might have found a bargain, but you also might have just stumbled into a value trap.
6. Not analyzing your mistakes
You had to know this was coming. An honest appraisal of your mistakes is crucial if you want to develop as an investor. At least once a year, sit down and review what you got wrong with your portfolio's biggest losers and write down the takeaways. This will help you avoid those mistakes in the future -- or even provide fodder for, say, writing an article about investing mistakes. (Cough.)
7. Trading too often
Day trading might make you feel like a slick wheeler-dealer, but odds are you're just throwing money away. Trading often racks up big commissions and painful short-term capital gains tax bills, undermining all your efforts. Research points to the fact that investors who trade less score higher long-term returns than their overconfident active-trader counterparts.
Contrast that with Warren Buffett, the most successful investor of our era, who has built an epic fortune for himself and his Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) shareholders by scooping up great businesses at good prices and then letting time, good management, and strong fundamentals do the heavy lifting for him. Plenty of those long-held investments are still delivering for Berkshire today. In fact, Buffett hardly ever sells.
One to grow on
You'll avoid most of these mistakes if you're an independent, long-view thinker. That mind-set is what has served Warren Buffett so well over the years and helped drive my contrarian investing newsletter, Motley Fool Inside Value, to be rated by MarketWatch as one of the top 10 best-performing investing newsletters of 2011.
A long-view mentality is also what drives the strategy of one of my favorite stocks -- a company that has modeled itself after Berkshire Hathaway, and whose stock I own. Its chief investment officer, whom I've met, isn't prone to making the seven mistakes I've outlined above. You can learn more about this great company with this special free report. And that's one to grow on.
