Avoid 'paralysis,' holding on to losers, buying on price only and overconfidence
In the complex world of finance and economics, investors have plenty of opportunities to make costly mistakes.
Based on my experience, successful investment outcomes are seldom due to the great stock picks people make or to excellent market timing or even good luck. Successful investing is mostly due to avoiding costly mistakes.
To make it most meaningful to my readers, I would like to limit my commentary to what I feel are the most important mistakes that investors make in today's financial market environment.
1. Paralysis by analysis: The most common mistake investors make during a market recovery is to do nothing for too long. Even those trying to make rational decisions are overwhelmed by the contradictory and mostly negative information that one finds in the media. Therefore, it's emotionally easiest to make no decision, despite an advancing stock market. I believe that the $1.5 trillion parked in money market accounts that pay virtually nothing are a reasonable indication of this kind of thinking.
2. Holding onto losing investments too long: Although everyone knows that denial is not a river in Africa, many investors only recently started to open their brokerage statements again. In other words, investors were so shell shocked by last fall's market meltdown that they could not face making any changes to their portfolio. By default, then, they believe that holding on to their decimated investments is the best thing to do when they should be objective and look for a more productive strategy.
If, as I believe, most rational investors would like to recapture their losses, they need to come to grips with reality and look forward. That reality, for me, is that our markets are in the beginning phases of a pronounced and complex economic-sector rotation. Those that ignore this trend, or choose not to participate in it, potentially do so to their own detriment.
3. Confusing price with value: If investors do act, many of them become attracted to low stock prices. It seems so appealing to buy when prices have fallen 50 percent or more because the common wisdom asks, "How much lower can they go?"
In my opinion, that question is not particularly relevant since the investor is primarily interested in future price appreciation. Therefore, one has to ask and, of course, be comfortable with the concept of current value in relationship to its longer-term potential.
For example, is the world's largest bank, Citigroup, a potentially good investment because it's currently down 90 percent from its all-time high? That answer should be pretty obvious.
However, the same question must be asked before making a commitment to any sector as well. For example, both the energy and the emerging markets sectors are "cheap" relative to where they were a year ago. Are they equally good values moving forward?
4. Making investment decisions based on widely known information: Even hours spent reading and researching news will not help one gain an advantage over the market. Why? The financial markets discount widely known information quite efficiently, i.e., the current price of an investment very rapidly reflects any information pertaining to it.