Having the right knowledge and perspective can shorten the learning curve. And minimize any monetary loss when it comes to investment, especially for those just starting out. Therefore we have listed down here 5 investing mistakes to avoid. So that you can avoid them and increase your investment success rate.
To ensure a comprehensive coverage, we have classified these mistakes into 3 key areas – knowledge, temperament and perspective. So that you can catch yourself when you are about to make these errors and avoid them at all cost.
The first two mistakes pertain to the general knowledge that you need to have in the stock market.
Investing Mistakes 1: Lag Effect Between Company’s Fundamentals And Market Behavior
Source: StockCharts / Sector Rotation
Perhaps you have started your investment journey. Then you may ask why when certain positive news of a particular company is announced, its share price went down. And why when negative news surfaced, its share price went up instead.
This is because the stock market behaves in a forward-looking fashion. However, that’s not to say that the market is always right from its collective forecast of the investors.
But rather, future prospects of the companies are usually priced into their share prices. For example, consider information of positive prospects like growth or potential new business deals. These publicly accessible information would have resulted in higher valuations of the associated companies.
In another scenario, say, there’s potential downturn that a company may face. Or perhaps lose significant business due to up-and-rising competitors. Then its current share price valuation will probably be more depressed than usual.
A Case of Alibaba
A very good example will be the recent $2.8 billion antitrust fine that’s imposed on Alibaba by the Chinese authority. You may be surprised if you are not familiar with the story of the company. Given the negative impact on the company’s bottom line, you would have expected its share price to be penalized.
Instead, Alibaba’s share price soared higher immediately after the announcement. Weird right? What’s happening is that the company had already been under investigation by the Chinese government all these while. The authority had been probing on its monopolistic practice for the past few months. For this case, the market seemed to have already discounted its share price based in relation to the likely penalties outcome.
So, when the government finally announced the fine, it seemed to be less hefty than what the market had assumed. As a result, Alibaba’s share price soared thereafter, given the greater clarity of its antitrust case at the moment.
Well, it may not be easy to assess exactly how the market will react. But the essence here is that the market tends to be forward-looking. It will price in any positive or negative prospects into the companies’ share prices.
A Case of The Coronavirus Market Selloff
Similarly, during recessions such as the recent pandemic-induced selloff in March 2020, the market rallied very quickly thereafter.
This is despite the earnings of the companies continuing to fall in the remaining months of the year. Because the market expects the recovery and higher profits of organizations coming back eventually.
So, that’s why we want to highlight this lag effect between the fundamentals and market behavior first. This is perhaps one of the most common investing mistake that beginners usually overlook.
Because it’s also one of the most difficult to avoid. It requires specific company or market knowledge, or both.
Investing Mistakes 2: Only Look At P/E Ratio
Source: Corporate Finance Institute / Price Earnings Ratio
This is perhaps one of the most common mistakes that beginners make. Because, Price-to-Earnings (P/E) ratio is probably one of the first financial metrics that you will encounter. Same for me when I just started to learn about stocks investing.
But I can understand why most of us fall into the trap of only checking up on P/E ratios. It is easy to understand and intuitive. If you revert the ratio to become E/P, it tells us the fraction or percentage of earnings (E) the companies generate for us shareholders, based on the price (P) we paid for the stock.
So why is looking only at P/E ratio a big mistake?
Well, I would say that there are 2 reasons why.
The Lag Effect Distorts The P/E ratio
The first reason is closely related to the lag effect between a company’s fundamentals and the market behavior. P/E ratios are usually stated based on the current share price (P) with the trailing twelve months earnings (E).
Meaning that it’s a measure based on the past performance (E). But the market is valuing the company (P) based on its forward looking prospects.
For instance, if a company’s earnings last year was $1/share, and it is in a high growth industry projected to grow at 20% per annum. Unlikely the market will value this company’s stock at $15 a share or a P/E of 15. Because, within the next year if its earnings materialize to $1.2/share, then its P/E ratio will become an extremely attractive figure of 12.
Assume if people expect the company to grow 20% per annum for the next 3 to 5 years. A more likely scenario will be the market pricing the company with a trailing twelve month P/E ratio of 40 – 50. If the 20% annual growth rate materializes in the next 5 years, the company’s earnings will grow to about $2.50.
Assume an average P/E of 20 for established companies with slow growth. Its target price should hit $50 in 5 years time.
Hence, the market may be pricing these growth prospects into its current share price. This is why it may be trading at $40 – $50 currently, especially if the growth is expected to sustain over a longer term.
So this is the first reason why relying only on the P/E ratio will be big investing mistakes. Because you will filter out high growth companies that can be potential big winners in the years to come.
P/E Ratio Alone Neglects Other Moving Parts of A Business
The second reason why looking solely at P/E ratio is a mistake is that there’s a lot of moving parts to a business. Especially those giant conglomerates with many operations. So it’s important to assess it with other financial metrics. So that you can get a better view of the financial health of a particular company.
For example, a particular company may have a low P/E ratio of less than 10. On the surface, it may seem like a pretty good deal. Say if you compare it to to another company valued at P/E = 20.
However, there’s likely some reasons for such relatively lower valuation when put side by side with comparable companies. Perhaps this company may be heavily ladened with debt. That’s why the market is discounting its valuation. Because there’s additional financial risk that one has to take when investing in the company.
Therefore, just by looking at the P/E ratio and jumping into investing decisions is definitely a mistake to be avoided.
The next two mistakes pertain to the temperament of investors, and how to avoid them.
Investing Mistakes 3: Timing The Market
Source: CFA Institute / Timing the Market: Momentum and Beyond
This is also a very common trait among not only beginners but also long-time investors as well.
Have you ever felt that you should have bought a particular stock a long time ago? Especially since now that it has already climbed 20%.
Or perhaps, you should have waited slightly longer for a stock to drop another 5% before entering a position?
Well, this kind of struggle going back and forth in our mind is nothing more than greed playing the devil.
The truth is, we can never catch the bottom to buy in or sell at the top. There’s too much variability and uncertainties in the market. It is not a wise choice spending all your time executing this impossible mission.
A Better Strategy
A better strategy is to buy into great companies at reasonable prices. So that you don’t have to worry when the share price falls.
Because you know that given the great businesses you own, the stock price will recover eventually. And perhaps, you can also save some cash to acquire more positions if the share price falls.
Benchmark your new investment idea with the current and potential returns that you are getting for your existing portfolio. Then decide whether to invest in something that can boost your return, or at least generate similar ROI. If not, then it may be better for you to add more positions in the shares you are holding currently.
Source: Daily Quotes / Warren Buffett Quotes On Timing The Market
As Warren Buffett says, “The real fortunes in this country have been made by people who have been right about the business they invested in, and not about the timing of the stock market.”
Again, you will not know what will happen in the future. So, trying to time the market is a fool’s game. Spend your time researching and add those good investment ideas to your watchlist. When opportunity presents itself, make your move!
Investing Mistakes 4: Lack of Patience To Enter And Exit – Popularity VS Fear
Patience is perhaps the most important virtue when it comes to investing, whether we are talking about buying or selling.
Whether it’s following the herd to chase after the next hot stock. Or that you can’t wait for its share price to drop to more reasonable levels. It will reduce the margin of safety you can enjoy.
Now say if short-term pessimism in the market creates the fear in you to selloff like the general market. Then you may not see the kind of returns that long-term investing can offer.
But I recognize that this is easier said than done. When the share price keeps climbing higher, you may fear missing out the wave. On the other hand, when the market sinks, you cannot help but to doubt the recovery of businesses. And perhaps even question yourself whether your previous assessments were right after all.
I admit that I struggle to be patient when it comes to buying and selling my investments as well. We are humans. This emotional side is something that we need to control. But, at least now you understand this potential pitfall, you can catch yourself when your animal instinct sets in. Just keep practising.
As Buffett says, “To make money in stocks you must have the vision to see them, the courage to buy them, and the patience to hold them.”
The last mistake that we want to highlight pertains more to having the right perspective when it comes to investing.
Investing Mistakes 5: Set Unrealistic Expectations of Your ROI
Source: Martech Advisor / Attributing ROI to your CDP
This final mistake can be a subtle but grave mistake. Especially for beginners who haven’t had a feel of the kind of potential returns on investment (ROI) one can generate.
Investing is a life-long journey and a process of learning. Most people fall short when it comes to investing. Because it’s not a discipline that people would want to master. Most of the time we have our own careers and businesses to run.
So, you should base your expectation on the amount of time and effort you are putting in.
If your hectic work schedule and family life can’t even spare you at least 30 minutes a week to update yourself with the economy and do some research, then how can you expect a consistent return of 20% annually?
The problem is not setting unrealistically high ROI targets itself. The real problem lies in how our psychology sets in when we are not able to attain these goals.
The Effect of Unrealistic Expectation On Our Psychology
According to a study, we tend to fail to refocus on the reward after we have set the goals. Once the actual work starts, our focus shifts to the tremendous amount of effort required to hit these goals rather than the reward itself. Eventually we realize the effort is too much and so we give up.
So, I think the very same phenomenon applies when we set unrealistic ROI targets. Instead of pushing us to work harder towards selecting better investment ideas, people tend to fall back and give up on putting in the work required.
Therefore, it may appear as inconsequential when it comes to setting unrealistic investment targets at first. But going down this path can have a more dire consequence on your investment journey in the long run, if you fail to follow through with consistent investing research.
This mistake is something that you really have to keep in mind.
Source: AZ Quotes / Warren Buffett on Mistakes
Here we have highlighted 5 key investing mistakes that beginners make. They are in the areas of knowledge, temperament and perspective that investors should avoid.
Having the right knowledge like understanding how there’s a lag effect between companies’ fundamentals and market behavior can help you make more informed decisions.
Looking beyond P/E ratios will give you a more comprehensive view of the companies that you are interested in. And make a better assessment of their investment potentials.
In terms of having the right temperament, we should definitely heed the advice of Warren Buffett, the legendary investor. Don’t try to time the market. And in the process of investing, be patient if you want to make big returns from your investments.
And finally, setting realistic investment targets can be more important than many realize. Without the right goals and motivation, it is difficult to build real wealth by reaping the value of the compounding effect. Because that requires consistent effort in the long run.
Most importantly, understand that making investing mistakes is part of the process.
Understanding these five important mistakes can help you avoid them and give you a step ahead of others. But, failing to take any action may be the worst mistake that one can ever make.
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Keep learning and happy investing. 🙂