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Avoid Mistakes in the Stock Market

Updated on October 18, 2008

Avoid Mistakes in the Stock Market

It is said that the winners of games and even battles are those who make the fewest mistakes. A place where mistakes are easy to make is the stock market, with its thousands of investment opportunities and its un­predictable price movements. Ob­viously, one requirement for suc­cessful investing would be to keep errors to the minimum.

What are the most common ways investors go wrong? Changing Times put this question to a number of suc­cessful investment counselors, analysts and brokers and compiled the following 16 basic mistakes.

1. Not having an investment plan or philosophy. This mistake is on most lists in various forms. Without a long-range objective, the investor doesn't decide in advance what type of company he wants to own stock in growth, cyclical or speculative. He doesn't decide whether he wants current income or capital gains. He doesn't decide whether to make regular additions of capital. He shoots from the hip. If by chance he has a plan, he abandons it when the market is suffused with optimism or pessimism.

2. Trading and speculating. Too many investors have the self-confidence to think they can buy low and sell high, even though it has been proved that professionals can't do it consistently. The "greater fool theory" says that whatever price you pay for a stock, there will always be a greater fool to buy it from you at a higher price. This seldom works out in practice. The trader treats his stocks as pieces of paper to be bought and sold rather than as evidence of ownership in a company he intends to keep indefinitely so long as it makes progress and continues to fit into his investment philosophy.

3. Being optimistic at the top and pessimistic at the bottom. Optimism and bullishness are infectious, as are pessimism and bearishness. Thus, even when the market is high by such objective standards as the ratio of prices to earnings, people buy anyway. They do it because everyone seems to be buying or because they extrapolate recent trends and assume that what has been happening will continue to happen or because they mistakenly think there is an exact cor­relation between the stock market and the level of business. Conversely, people grow increasingly pessimistic as the market drops and tend to reach the nadir of discouragement when stocks are cheap according to such standards as the price-to-earnings ratio. This is when they should be buying, or at least holding what they have.

One broker says that most people time their market activities by the "hand theory." He holds up his hand, fingers together and pointing upward, and says, indicating the top of his thumb, "They're not interested here." Then pointing to his first finger, "They get interested here." Indicating his middle finger, "They buy here," Then, wiggling his fourth finger, "They get discouraged here but not enough to sell. They sell out here," indicating the top of his little finger.

4. Not taking the trouble and time to be informed. One broker says that many investors prove to him that colleges don't teach practical eco­nomics. "Some customers," he says, "don't know the difference between a stock and a bond. They think that if they buy a common stock, they can get their money back any time they want it."

"They don't differentiate between the characteristics of different com­panies but treat all stocks as the same," says an investment analyst.

Failing to get information about the company they invest in is another variation. Says one adviser, "They don't read the annual report or look up the company in the financial manuals. In some cases they don't even know what the company makes or whether its products have any future at all."

5. Not getting the best advice. Many investors don't check on a broker or adviser before doing busi­ness with him. They don't investigate, for example, his educational background, how long he has been in business or been handling other people's money, how well he has done. They don't ask to see sam­ple accounts.

In the words of the manager of a large mutual funds complex, "Fol­lowing the advice of a mediocre broker is known as a 'cut flower' pro­gram. The broker keeps picking flowers and selling them to you. When one bunch withers, he sells you another. It's not like having your own garden."

6. Investing money that should be set aside for another use. Too often people invest money that should be in a savings account available for emergencies or for purchase of a new car or some other predictable expense. If you invest what should be emergency funds, you may be forced into selling stocks at a time not of your own choosing. Fate often decrees that this will be a period of low prices when you must take a loss.

7. Buying on the basis of tips, rumors and reports of new products, new processes, etc. There's hardly any chance that the average investor will get advance or inside information about any company whose stock is publicly held. And even if he does, there is very little chance that it will do him any good. Remember, there are professional speculators watching the Dow Jones broad tape all day long. This tape prints business news as it happens minute by minute. Then there are the specialists who make a market in each stock listed on the various exchanges. At any rumor about a company or any unusual change in the volume of trading, the specialist can call up the company's management and get the pertinent facts. So no matter how hot a tip you hear, remember, someone knew it before you.

8. Selling short, buying on margin, trading in options. About the only people who make money in these operations are the brokers who col­lect the commissions. Short selling by small investors is so notoriously un­successful that it has become a technical indicator of market bottoms.

9. Buying low-priced stocks on the theory that they will show the largest percentage gains. A low-priced stock may be a bargain but not necessarily because it is low-priced. The price of a stock is what the marketplace believes a company to be worth divided by the number of shares outstanding.

10. Becoming sentimental about a stock or an industry. Some investors become fond of their stocks just as they do of pets. As a result, com­panies can be held long after they have lost their potential for growth and profit. A similar mistake is for an I investor to fail to sell a stock because he hates to admit he was wrong in buying it. One adviser says brutally, "Sell when you have a 10% loss,"

11. Letting tax considerations outweigh investment decisions. Many an j investor has lost more capital than he has saved in taxes.

12. Selling the winners and holding the losers. Investors tend to hold stocks in which they have a loss in the hope, often vain, that they will come back. On the other hand, they tend to "nail down profits" by selling stocks in which they have a capital gain. In this way investors sell the best stocks and keep the worst.

13. Letting your reach exceed your grasp; trying for too high goals. Buy­ing high-income stocks, for example, in the expectation that the income will continue.

14. Thinking bonds are safer than they really are. During periods of inflation bonds lose purchasing power.1 The interest is paid at a fixed rate, and these payments also lose value. If in­flation were to get worse, then in­terest rates would rise and the value of outstanding bonds would go down. Bonds will keep the invested dollars safe if they are held to maturity, but they can't protect against inflation by providing a rising value and a rising yield, which is something a selection of good common stocks should do.

15. Not sticking to high quality, especially in the latter stages of a bull market. In the long run the best-managed companies in the fastest-growing industries turn out to be the best investments. But in the excite­ment of a fast-rising stock market, the temptation is to try to double your money in a hurry. No one can do it consistently.

16. Not keeping perspective on the market. Listen to the wise words of a man who made a fortune in the stock market and was able to live a comfor­table life and devote many years to serving the government in times of crisis. "I began a habit I was never to forsake of analyzing my losses to determine where I had made my mistakes. This was a practice I was to develop ever more systematically as my operations grew in size. After each major undertaking and particularly when things had turned sour I would shake loose from Wall Street and go off to some quiet place where I could review what I had done and where I had gone wrong."

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