Six investment mistakes to avoid

Summary

The market has been particularly volatile in 2020, making it treacherous for all types of investors.

The pandemic has created tailwinds and headwinds across all industries, and analysts of all kinds are insisting a crash is upon us every day.

In this context, it can be extremely difficult to know what to do, keep your emotions in check, and avoid common investing pitfalls.

That's why today, I want to cover six investment mistakes to avoid, particularly in a frothy market like the current one.

You may have made some or all of these mistakes in the recent months, without realizing it. 

Great investing is not simply about selecting the right investment ideas. The main factor in the success of your investing journey is about avoiding common behavioral mistakes that we all make at one point or another in our lives.

Morgan Housel just released his book The Psychology Of Money, in which I particularly enjoyed a quote that borrows from Napoleon and his definition of a military genius:

"A good definition of an investing genius is the man or woman who can do the average thing when all those around them are going crazy."

The average investor has underperformed almost all investable asset class returns over time, as illustrated below by the data from Richard Bernstein Advisors.

The main cause behind this is behavior and temperament. Most investors are hardwired to get in the way of their portfolio's success over time.

The S&P 500 (SPY) and the Nasdaq (QQQ) both fell around 30% earlier this year before rebounding to new highs in a record time. The volatile time we are all going through since the beginning of the COVID-19 pandemic has a particularly pernicious effect on investor behavior. Volatility has its ways to compel the most counter-intuitive decisions when it comes to portfolio management.

Today, I want to discuss six common investment mistakes you are most likely to make (or have already made) in a frothy market like this year.

Let's review!

1) Trading too much

Great long-term investing is 1% buying, 99% waiting. But most investors feel that they're lazy if they don't tinker with their portfolio regularly one way or another.

A disciplined investor should look beyond the short-term concerns and focus on the long-term growth potential of the market. Looking at the performance of the MSCI World Index in the past 50 years can help gain some perspective. One dollar invested in 1970 would have grown to $68 by 2018. And the journey to get there was filled with financial crisis, wars, terrorist attacks and bear markets of all kinds. None of these disasters have changed the fact that the best course of action over the years was to remain invested through thick and thin and to stay the course.

Despite history telling us that trading in and out of stocks is a weapon of alpha destruction, some investors can't help themselves.

Investment turnover is another symptom that is similar. Many investors can't help but cash in on their gains as soon as a stock is up 20%, 50% or 100%. They might buy back the shares at the same price or higher several months later when they realize their mistake. But the damage has already been done if they are trading in a taxable account. Or worse, they refuse to invest again in great companies they have previously sold at lower prices and leave a long-term compounder such as Amazon (AMZN), Netflix (NFLX), or Salesforce (CRM) out of their portfolio forever.

2) Relying on your emotions

Many biases are at play when we make an investment decision. I've covered previously the common behavioral biases that can adversely affect your temperament, and I've offered strategies to counter them.

Relying on your emotions is a common investment mistake in a volatile market. And unless you are willing to identify it and address it, chances are your emotions will eventually get in the way. We are influenced by our own fear and greed, often better described as fear of joining in or fear of missing out (another topic I've covered more in depth here).

3) Chasing returns

Performance chasing refers to selling a poorly performing investment to buy one that has recently delivered strong returns.

Chasing returns is the practice of taking excessive risk by selling what you own in order to concentrate heavily your portfolio into what everyone else is buying.

4) Staying all in cash

When the market is volatile, it can feel much safer to watch it from the sidelines. And that's generally a mistake.

Cash itself is a depreciating asset, but it's also an essential tool to buy other assets. Finding the right balance of cash in an investment portfolio can be a challenge, particularly for those who are not generating new income or savings to add to their investment portfolio. Warren Buffett has been known for keeping a huge cash allocation in his portfolio at Berkshire Hathaway (BRK.A) (BRK.B). At the end of Q2, Berkshire had $147 billion in cash. But that cash allocation that so many point out to as excessive represents less than 40% of its equity portfolio. And Warren is in the insurance business, which requires large cash allocations for unforeseen events. If you have more than 50% of your liquid assets in cash, you are likely permanently damaging your long-term returns.

If you are a new investor, waiting too long to start is one of the most crucial mistakes a young investor can make. Albert Einstein famously called compound interest the eighth wonder of the world. Thomas Phelps, author of the book 100 to 1 in the Stock Market has provided valuable lessons to better understand the power of compounding.

5) Concentrating too much in risky bets

Seeking alpha is a noble cause (and a great name for a crowd-sourced content service for financial markets), but that doesn't mean you should be actively trying to beat the market.

Beating the market should be a result of your investing habits, not a goal.

If you invest thinking the market averages are not enough, you are likely to go over-board and heavily concentrate into risky investments.

There is always room for risky companies in a portfolio. But your appetite for market-beating returns should never overshadow the importance of position sizing and proper portfolio allocation based on your risk profile.

6) Not understanding what you're doing

As explained by Adam Smith in The Money Game:

"If you don't know who you are, [the stock market] is an expensive place to find out."

Having a clear strategy is probably the most essential aspect of investing, in both bull and bear markets. If you haven't spent the time to think about your goals, time horizon, risk appetite and understanding what you are trying to achieve, you probably need a little bit of soul-searching.

Understanding why you invest is the very first step, one that comes before learning how you want to invest or in what specific opportunities.

Your next question should not be "should I buy this stock now?" Instead, you should ask yourself if you have built a system that makes room for mistakes, unforeseen failures, or simply bad luck. When the tide turns, you'll be prepared to face the consequences and will be far more likely to stay in the game. Investing should be a rewarding and enjoyable journey, not a source of stress and sleepless nights.