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FINANCIAL CHRONICLE™ » FINANCIAL CHRONICLE™ » Investing in the Stock Market: Twelve common mistakes

Investing in the Stock Market: Twelve common mistakes

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windi5

windi5
Moderator
Moderator
By repeatedly committing one or several common investment mistakes,
individual investors often prove to be their own worst enemy.
Unfortunately, even seemingly simple missteps can, over time, have a
dramatic impact on overall returns. Recently, CFA Institute, which
administers the prestigious Chartered Financial Analyst® (CFA®) Program
worldwide, asked selected members to share their perspectives on some of
the most common and costly mistakes they witness individual investors
make.
Among the most common mistakes:
No investment strategy.
From the outset, every investor should form an investment strategy that serves as a framework to guide future
decisions. A well-planned strategy takes into account several important
factors, including time horizon, tolerance for risk, amount of
investable assets, and planned future contributions. “At the outset,
individuals should have a clear sense of what they want to accomplish
and the amount of volatility they’re willing to bear,” said Jeanie
Wyatt, CFA, CEO of San Antonio-based South Texas Money Management.
Investing in individual stocks
Investing in an individual stock increases risk versus investing in an
already-diversified mutual fund or index fund. Investors should maintain
a broadly diversified portfolio incorporating different asset classes
and investment styles. Failing to diversify leaves individuals
vulnerable to fluctuations in a particular security or sector. Also,
don’t confuse mutual fund diversification with portfolio
diversification, said Brian Breidenbach, CFA, CPA, Managing Principal of
Breidenbach Capital Consulting, LLC in Louisville, KY. You may own
multiple funds but find, on closer examination, that they are invested
in similar industries and even the same individual securities.
However, remember that it is also possible to over-diversify and own
too many investment products − particularly if an investor has a modest
portfolio − generating higher overall fees relative to the portfolio
size, said Wyatt. The best course of action is to seek a delicate
balance between the two. Often, this can best be done with the advice of
a professional or trusted advisor.

Investing in stocks instead of in companies
Investing is not gambling and shouldn’t be treated as a hit-or-miss
proposition. Investing is assuming a reasonable amount of risk to help
finance enterprises you believe have positive long-term growth
potential. Analyze the fundamentals of the company and industry, not
day-to-day shifts in stock price. “Buying a particular stock purely on
the basis of market momentum or because you like a company’s product or
service is a sure fire way to lose money,” commented Bob Bilkie, CFA,
president of Southfield, MI-based Sigma Investment Counselors. In
addition, examine a company’s corporate governance profile to make sure
it has basic corporate governance protections. It may help you avoid a
future problem.
Buying high
The fundamental principle of investing is buy low and sell high. So why
do so many investors get that backwards? The main reason is
“performance chasing,” notes Beth Hamilton-Keen, CFA, of Mawer
Investment Management Ltd in Calgary, Alberta. “Too many people invest
in the asset class or asset type that did well last year or for the last
couple of years, assuming that because it seems to have done well in
the past it should do well in the future. That is absolutely a false
assumption.” Cathy Tuckwell, CFA, of Scotia Cassels Investment Counsel
in Toronto, Ontario agrees: “The classic buy-high/sell-low investor
profile is someone who has a long-term investment strategy,
but doesn’t have the tenacity to stick with it,” she said. “They throw
their strategy out the window in response to short-term blips in the
market and invest tactically instead of strategically.”
Others at risk for “buying high” are those who follow investment fads,
buying the “popular” stocks of the day. Typically, these investments
become fashionable for brief periods, leading many to invest at the
height of a cycle or trend − just in time to ride it downward. Always
look critically at the prospects for future performance of a given
investment, not just past performance, Tuckwell emphasized.
Selling low
The flip side of the buy-high-sell-low mistake can be just as costly.
“Too many investors are reluctant to sell a stock until they recoup
their losses,” said Rajiv Vyas, CFA, of MTB Investment Advisors in
Baltimore, MD. “Their ego refuses to acknowledge a mistake of buying an
investment at a high price.” Smart investors realize that may never
happen and cut their losses. Keep in mind not every investment will
increase in value and that even professional investors have difficulty
beating the S&P 500 index in a given year. Always have a stop-loss
order on a stock. It’s far better to take the loss and redeploy the
assets toward a more promising investment.
Churning your investments
Too-frequent trading cuts into investment returns more than anything
else. A study by two professors at the University of California at Davis
examined the stock portfolios of 64,615 individual investors at a large
discount brokerage firm between 1991 and 1996. The study found that,
without transaction costs, these investors received a 17.7% annualized
return, which was 0.6% per year better than the stock market itself.
But, after transaction costs were included, investors’ returns dropped
to 15.3% per year, or 1.8% per year below the market. Again, the
solution is a long-term buy-and–hold strategy, rather than an active
trading approach.
Acting on “tips” and “soundbites.”
“Listening to the media for their sole source of investment thinking
rather than pursuing a professional relationship with an advisor is a
far too common investor mistake,” said Todd Lowe, CFA, at Parthenon LLC
in Louisville, KY. While breaking news and “insider tips” may seem like a
promising way to give your portfolio a quick boost, always remember you
are investing against professionals who have access to teams of
research analysts. Seasoned investors gather information from several
independent sources and conduct their own proprietary research and
analysis before making an investment decision. “Believing that
information that is new to the investor is not known to anybody else is a
real mistake. A useful rule is that if you’ve heard it, so have many
others, so the information is likely already factored into the market
price,” counseled Bilkie.
Paying too much in fees, commissions
Incredibly, investors are often hard-pressed to cite specifics on the
fee structure employed by their investment service provider, including
management fees and transactions costs. Investors should, as a
precondition to opening an account, make sure they are fully informed
as to the associated expenses that accompany every potential investment
decision, emphasized Wyatt. In addition, investment returns should be
adjusted for all expenses paid to ascertain overall performance.
Decision-making by tax avoidance
While individuals should be aware of the tax implications of their
actions, the first objective should always be to make the fundamentally
sound investment decision. Some investors, rather than pay a large
capital gains tax, will allow the value of shares in a well-performing
stock to grow so large it accounts for an inordinate percentage of their
overall portfolio. Similarly, when it’s time to harvest a gain,
investors shouldn’t be overly concerned with holding onto the security
past the one-year purchase date simply to take advantage of the lower
capital gains rate. A wiser move is to simply find a good tax advisor.
This is not applicable to Sri Lanka since there is no capital gains tax
on shares provided it is not considered a trading income.
Unrealistic expectations
As we witnessed during the recent bubble, investors can periodically
exhibit a lack of patience that leads to excessive risk-taking. It is
important to take a longterm view of investing and not allow external
factors cloud actions and cause you to make a sudden and significant
change in strategy. Comparing the performance of your portfolio with
relevant benchmark indexes can help an individual develop realistic
expectations, said Robert R. Johnson, CFA, managing director of the CFA
and CGIPS Programs at CFA Institute. According to Ibbotson Associates,
the compound annual return on common stocks from 1926-2001 was 10.7%
before taxes and inflation and 4.7% after taxes and inflation. Returns
on long-term bonds over the same time period were 5.3% before taxes and
inflation and 0.6% after taxes and inflation. “Expecting returns of
20-25% annually will set an investor up for disappointment,” Johnson
noted.
Neglect
Individuals often fail to begin an investment program simply because
they lack basic knowledge of where or how to start. Likewise, periods of
inactivity are frequently the result of discouragement over previous
investment losses or negative growth in the equities markets. To be
certain, investors should continue investing in every market − albeit
through different investment vehicles − as well as establish a mechanism
to make regular contributions to their portfolios. Investors should
also regularly review their holdings to ensure they are adhering to
their overall strategy.
Not knowing your real tolerance for risk
Keep in mind that there is no such thing as risk-free investing, said
Johnson. Determining your appetite for risk involves measuring the
potential impact of a real dollar loss of assets on both your portfolio
and psyche. In general, individuals planning for long-term goals should
be willing to assume more risk in exchange for the possibility of
greater rewards. However, don’t wait until a sudden or near-term drop in
the value of your assets to conduct an evaluation of your level of
tolerance for risk. “The encouraging aspect for investors is that, with a
little diligence, all of these mistakes are easily avoidable,” added
Wyatt. (Source CFA Sri Lanka).

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