How to avoid these 5 common investment mistakes

If you ask enough investors about their journey and mistakes they’ve made along the way, there tend to be some common threads. For example, decisions driven by emotion or ‘hot tips’ without research, diversification for diversification’s sake, trying to time the market and not thinking long term. It’s not just beginners who make mistakes – no investor is perfect after all – so I’ve taken a look at some of the most common mistakes investors make and how to avoid them.

1. Emotional decisions

Like any other purchase in our lives, it’s easy to attach some emotion to it. That company you just have a “good feeling” about, the first investment you ever made, or the fund run by a celebrity investor you admire. I’m not saying you can’t have strong emotions about your purchases – but the best investment decisions are made with a cold rational eye.

So what should you do instead?

“Success within the equities component of your portfolio starts with a quality assessment of the company, and a valuation, which includes an assessment of the company’s prospects,” says Roger Montgomery, Montgomery Investment Management

Education

Three timeless lessons for long-term investing

View

Get back to basics, research the sector and the fundamentals of the investment. How you do this will vary on the type of investment. For example, if you are looking at a managed fund, you might look at the strategy and the consistency of application to the portfolio, performance over market cycles and fees. 

If you are looking at an individual company, you might look at company fundamentals, such as return on capital or balance sheet strength. Both of these were recently nominated in a Buy Hold Sell episode as key investment factors by Hayborough Investment Partner’s Will Granger and Airlie Funds Management’s Ben Rundle.

“When we’re thinking about return on capital, we really think it’s the best quantitative measure of a business’s quality, and we’re really looking for businesses that generate high returns through the cycle. So, regardless of the economic backdrop. 

In terms of balance sheet, we’re really focused on downside protection and ensuring we’re not going to get ourselves in a situation where there’s going to be a dilutive equity raise that hurts shareholder returns,” says Granger.

This also applies to recognising when it’s time to exit a position. Go back to the basics and assess the investment. If it no longer meets your criteria and your portfolio, it’s time to sell – even if it has the sentimental benefit of being your first investment.

2. Poor diversification

Most people have heard the saying that diversification is the only free lunch in finance. It can smooth out returns and help you manage market cycles by using varying styles, sectors or assets that aren’t correlated and will perform differently at different times. But… there’s diversification and there’s ‘diworsification’. You might not be diversified enough – or you might be overdiversified and unable to generate any sort of return.

For example, an investor might diversify by spreading across lots of companies… but the selected companies might be largely from the same industry and sector, or all be cyclical companies and so they don’t really receive the benefits of diversification at all – when the market goes down, all of the investments go down.

“The most common thing I assist clients with initially is increasing the diversification of investments within their portfolio – many of them have a handful of concentrated shares in either one industry or market and they’re holding themselves back from other opportunities,” says Shayne Sommer, Shadforth Financial Group

So what should you do instead?

If you’re looking at your portfolio now and have too much of the ‘same’, i.e. you hold equal amounts of Coles (ASX: COL) and Woolworths (ASX: WOW), along with Qantas (ASX: QAN), Regional Express Holdings (ASX: REX) and Air New Zealand (ASX: AIZ), it may be time to think about your portfolio and what really belongs in it.

Diversification is about a careful spread across asset types, investment styles, sectors and countries – but to work, it also needs to fit your investment strategy. Some investors find it easiest to speak to an expert to help them adequately diversify, while others might look to portfolio construction best practises and do their own research.

One example of portfolio construction that might assist with how you think about diversifying is Atrium Investments’ risk-targeted bucket approach.

“The three buckets include preservers which are typically term deposits, cash, government bonds, derivative strategies or option strategies; growth drivers which are more typical growth assets like equities and credit; and then we think about diversifiers where we put things like liquid alternatives, private markets and commodities,” says Tony Edwards, chief investment officer and executive director for Atrium.

3. Trying to ‘time’ the market

No one really knows the exact moment the market cycle will turn, but you’ll hear plenty of armchair experts with a strong opinion. Everyone dreams of buying at the bottom and making millions, or selling out at the top and watching everyone else fall. The truth is, most people will fail at trying to pick the top or the bottom and there’s a cost to that. You may miss out on market recovery, or you may also miss out on the benefits of compounded returns over time from just staying the course.

I once worked in a company where an investor was known for pulling all their investments into cash the second there was any dip in the stock market and thereby crystallised their losses. The same investor always bought back in during recovery – at a higher price than they’d sold too. It happened a few times. It was immensely frustrating to watch – and I can imagine painful to the investor’s wallet too.

“The number one issue by far is selling when markets drop and buying again when people are confident that they have recovered. I believe more money is lost by doing this than any other mistake," says Daniel Thompson, Finnacle

So what should you do instead?

If an investment still meets your goals and strategy and you are still comfortable with the fundamentals, then hold the course. That said, if your research shows an investment is a ‘dog’ and doesn’t match your strategy, then it’s ok to have an exit strategy and take a hit. Just make sure you reinvest in a quality investment in its place.

Some investors also use an approach called dollar-cost averaging to avoid focusing on market cycle timing. In dollar-cost averaging, you consistently invest a set amount and ignore market noise. You can read more here.

4. Focusing on short-term noise

There will always be market noise. Sometimes it will be those jumping on a hot trend. Sometimes it will be doomsayers telling you to get out. Sometimes the noise will actually be on to something but oftentimes, you are best ignoring it.

Some examples of this include the short squeeze on GameStop in 2021 caused by users of r/wallstreetbets, or any company related tweets (or should that be x’s) from Elon Musk. It can also relate to market bubbles, such as the tech boom in the past. There are some fears that the current AI-boom fuelling the tech resurgence could result in a bubble.

So what should you do instead?

“There are few things that matter more in investing than making a reasonable judgement and backing yourself - no matter what scary news story or ‘expert’ prediction threatens Armageddon,” says Jackson (one of our recent Meet the investors)

It's also worth remembering that volatility in markets is part and parcel of investing. If your investments are sound and match your strategy, then they should be able to ride out the noise. If you are investing for the long-term, you need to look at longer trends and market activity rather than temporary events.

5. Lack of investment goals and strategy

As the saying goes ‘failing to plan is planning to fail’. It’s easy to get sucked up in noise and unsuitable investments if you don’t have a clear strategy for investing and know why you are doing it.

So what should you do instead?

Take a big step back from your portfolio and work out your goals for investing, then your overall strategy and what you need to build it. When you research investments, consider how it fits within the overall portfolio. Finally, seek expert help if you need it. There’s no shame in not being the next Warren Buffett after all.

And at the end of the day, sometimes boring is best when it comes to investing. 

Have you made any investment mistakes in the past? Let us know some of your tips for avoiding them in the comments.