Beginning investors often think that the secret to successful investing is finding the perfect stock. But over the long haul, missing out on the best stocks isn't what's most likely to destroy your retirement dreams. Instead, too many people never think about how they're likely to react to the inevitable swings that the markets make, and as a result, they make costly mistakes that endanger their financial security.
Below, I'll show you some tips to help you pick an investing strategy that fits well with your temperament and risk tolerance. First, though, let's take a look at one of the most common mistakes that investors tend to make.
A simple rule that's hard to follow
Perhaps the most basic rule of investing is to buy low and sell high. Given how simple that rule is, it's surprising how hard it is to actually follow it. Why do so many investors buy high and sell low?
The secret to understanding this mistake is in psychology. When stocks are low, it's usually because prospects for stocks don't look very promising. Few people have the temperament to put their money into stocks that aren't performing well and that show few signs of an imminent turnaround. By contrast, rising stocks usually report good news and have things going their way, making it easy to choose them to put your money to work.
Cyclical stocks are the best example of how this can come back to bite investors. For instance, until recently, Caterpillar (NYSE:CAT) enjoyed huge gains on the back of strong growth in emerging-market economies like China. With heavy spending on infrastructure and construction projects, Caterpillar's equipment was in high demand, and it was easy for investors to be bullish.
But more recently, as fears of a Chinese slowdown have hit the emerging economy, Caterpillar has pulled back. With the company warning on earnings several years into the future, investors are far less comfortable with the stock.
You've seen similar trends in several industries. For steelmaker ArcelorMittal (NYSE:MT), European weakness has combined with the emerging-market slowdown to hurt sales and force a proposed dividend cut. Cliffs Natural Resources (NYSE:CLF), which supplies iron ore for steel production, has also languished from the same effect.
Meanwhile, some stocks are at the opposite end of their cycle. For home-improvement retailer Home Depot (NYSE:HD) and homebuilder Standard Pacific (NYSE: SPF), for instance, a potential rebound in housing started pushing shares higher a while ago. At this point, both stocks have already put in strong performances, yet that momentum is drawing new investors in -- despite a somewhat disappointing earnings report from Standard Pacific late last month.
Investor, know thyself
If you fall prey to that mind-set, you'll buy every stock at its cyclical high, setting yourself up for a drop that will challenge your discipline. Dealing with a quick loss after buying a stock is hard for even the most experienced investors.
On the other hand, if you know you're liable to be attracted to high-flying stocks, you can take steps to counteract your temptation. Value-investing techniques can help you pinpoint stocks whose true potential makes them worth more than their current stock prices, while also identifying overvalued stocks that might otherwise trap you.
In addition, be more disciplined about what you invest in before you buy shares. For instance, a process that includes a written explanation of your thoughts about a particular company will slow you down from making an imuplsive purchase as well as give you something to reassure you if the stock falls after you buy it.
Finally, gravitate toward companies and industries that you know particularly well, especially if you're just starting out. If you're already familiar with a company's products and competitive environment, it'll be easier for you to ignore noise and focus on the truly important news that affects its stock.
Finding a blockbuster investment before it takes off is the Holy Grail of investing. But without the discipline to take advantage of profitable opportunities when they arise, you won't get as much value from your best investments as you should. By investing in line with your own knowledge base and with your behavior in mind, you'll be able to enhance your returns and avoid mistakes that so many other investors make.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.You can follow him on Twitter @DanCaplinger.