Investment Basics - Common Mistakes

It has happened to most of us at some time or another: You're at a cocktail party enjoying your drink and hors d'ouevres, and "the blowhard" happens your way. You know he's going to brag about his latest "giant accomplishment". This time, he's taken a long position in Widgets Plus.com, the latest, greatest online marketer of household gadgets.

You come to find he knows nothing about the company, is still completely enamored with it and has invested 25% of his portfolio in it hoping he can double his money quickly.

Despite your resistance to hearing him drone on, you start to feel comfortable and smug in knowing that he has committed at least four common investing mistakes and that hopefully, this time he'll learn his lesson. This article will address eight of those common mistakes, including: investing in something you don't understand, falling in love with a company, lack of patience, turning over your portfolio too often, market-timing, waiting to get even, failing to diversify and letting your emotions rule the process.

1. Investing in Something You Don't Understand
One of the world's most successful investors, Warren Buffett, cautions against investing in businesses you don't understand. This means that you should not be buying stock in companies if you don't understand their business models. The best way to avoid this is to build a diversified portfolio of exchange-trade funds (ETFs) or mutual funds. If you do invest in individual stocks, make sure you thoroughly understand each company those stocks represent before you invest.

2. Falling in Love with a Company
Too often, when we see a company we've invested in do well, it's easy to fall in love with it and forget that we bought the stock as an investment. Remember: you bought this stock to make money. If any of the fundamentals that prompted you to buy into the company change, consider selling the stock.

3. Lack of Patience
How many times has the power of slow and steady progress become imminently clear? Slow and steady usually comes out on top - bet it at the gym, in school or in your career. Why, then, do we expect it to be different with investing? A slow, steady and disciplined approach will go a lot farther over the long haul than going for the "Hail Mary" last-minute plays. Expecting our portfolios to do something other than what they're designed to do is a recipe for disaster. This means you need to keep your expectations realistic in regard to the length, time and growth that each stock will encounter.

4. Too Much Investment Turnover
Turnover, or jumping in and out of positions, is another return killer. Unless you're an institutional investor with the benefit of low commission rates, the transaction costs can eat you alive - not to mention short-term tax rates and the opportunity cost of missing out on the long-term gains of good investments. (Warren Buffett has mastered the art of knowing when to invest.

5. Market Timing
Market timing, turnover's evil cousin, also kills returns. Successfully timing the market is extremely difficult to do. Even institutional investors often fail to do it successfully. A well-known study, "Determinants of Portfolio Performance" (Financial Analysts Journal, 1986), conducted by Gary P. Brinson, L. Randolph Hood and Gilbert Beerbower covered U.S. pension-fund returns. This study showed that, on average, nearly 94% of the variation of returns over time was explained by the investment policy decision. In laymen's terms, this indicates that, normally, most of a portfolio's return can be explained by the asset allocation decisions you make, not by timing or even security selection.

6. Waiting to Get Even
Getting even is just another way to ensure you lose any profit you might have made. This means you are waiting to sell a loser until it gets back to its original cost basis. Behavioral finance calls this a "cognitive error". By failing to realize a loss, investors are actually losing in two ways: First, they avoid selling a loser, which may continue to slide until it's worthless. Also, there's the opportunity cost of what may be a better use for those investment dollars.

7. Failing to Diversify
While professional investors may be able to generate alpha, (or, excess return over a benchmark) by investing in a few concentrated positions, common investors should not try to do this. Stick to the principal of diversification. In building an ETF or mutual fund portfolio, remember to allocate an exposure to all major spaces. In building an individual stock portfolio, allocate to all major sectors, and selectively to underweight sectors you feel might have potential. Do not allocate more than 5-10% to any one investment.

8. Letting your Emotions Rule the Process
Perhaps the No.1 killer of investment return is your emotions. The axiom that fear and greed rule the market is true. Do not let fear or greed overtake you. Focus on the bigger picture. Stock market returns may deviate wildly over a shorter time frame, but over the long term, historical returns for large cap stocks can average 10-11%. Realize that, over a long time horizon, your portfolio's returns should not deviate much from those averages. In fact, you may benefit from the irrational decisions of other investors.