investment advice, investing mistakes, CFA Institute

How to avoid these six common investing mistakes

18.05.2007

by Tim Bennett

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By making common investment mistakes, investors often prove to be their own worst enemy, says the CFA Institute. So what are the main errors and how can you avoid them?

Investment advice #1: Have a game plan

Like betting on horses or buying lottery tickets, random stock-picking can be fun, but is unlikely to make you rich. Having a long-term investment strategy may sound like hard work, but it is vital for anyone hoping to be the next Warren Buffett. So how do you go about it?

Start by working out your investment objectives and time horizons (in other words, how much wealth you would like and by when). Also consider your risk appetite (generally the longer your time horizon, the more risk you can afford to take). Next come asset allocation decisions (the amount you plan to invest in equities, bonds, cash and property, for example) and finally individual stock selection and trading strategy (the criteria you will use to decide when to buy and when to sell). Morningstar suggests setting parameters so that individual shares are only traded if the overall equity allocation moves more than, say, 5% from the original target. Bestinvest also suggests asset allocations to suit most risk appetites (www.bestinvest.co.uk).

Investment advice #2: Don’t get too cocky

Consider yourself a good driver? If so, you join the 90% of people who rate themselves above average, according to a survey by Princeton University. They also discovered that 81% of budding entrepreneurs think their business has a strong chance of success, whereas in fact 65% fail within the first five years.

There is nothing wrong with having a “glass half-full” attitude to life. But when it comes to investing, it pays to be realistic about your chances of spotting the next Microsoft or consistently coming out on top. Even professional fund managers find it hard to beat the market and you have to accept that not all of your investments will be winners. So, what is the best approach? Spread your risk by not putting all of your eggs in one basket, says Motley Fool. Diversification reduces the risk of being wiped out by a single poor performer. Index trackers, or exchange-traded funds, are a cheap and easy way of adding diversity to any portfolio.

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Investment advice #3: Keep an eye on trading costs

Every share trade attracts a host of costs; stamp duty, commissions and bid/offer spreads, all of which eat away at profits. Suppose you buy 1,000 shares at a mid-market price of £1.40, hold them for a month and then sell at £1.50. That’s a profit of 10p a share, or £100. Except it’s not. Let’s say the bid/offer spread quoted by the broker was 4p (so, in fact, the shares were bought for £1.42 and sold at £1.48), dealing commissions were £20 (£10 to buy and sell) and stamp duty was 0.5% of the purchase price. The overall profit comes to just £33 – and that assumes the shares went up in the first place. Studies by the University of California on trading behaviour from 1991 and 1996 showed that those who traded frequently earned a net annualised return of 11.4% whereas inactive accounts made 18.5%. The conclusion? Leave day trading to the professionals or you risk losing most of your capital in fees, spreads and tax.

Investment advice #4: Don’t forget about dividends

Many investors still equate stockmarket success purely with capital gains. They either ignore yields when picking shares, or fritter away dividends. This is a mistake. Since 1952, according to UBS, the S&P 500 has provided a simple return of 7.65% per year, but with all dividends reinvested on a quarterly basis, this jumps to 11.5%. So, although individual dividends may seem tiny, reinvested and allowed to compound they can make a substantial long-term contribution to your portfolio.

Investment advice #5: Cut your losses

Many investors take a “wait and see” approach towards poor performers, hoping that losses can be recouped. But meanwhile, the invested funds could be earning a far better return elsewhere. As Rajiv Vyas of MTB Investment Advisers says: “Their ego refuses to acknowledge the mistake of buying an investment at a high price.” So, be prepared to admit mistakes, cut your losses and move on.

Investment advice #6: Don’t be swayed by the herd

A study of 550 investment magazine cover stories, quoted by The Economist, revealed that the most negatively portrayed companies subsequently beat the market over the next 500 days by 12.4% on average, while the media darlings only managed 4.2% over the same period. This is evidence of what psychologists term “recency bias” or “an ingrained tendency to assume that past trends will continue”. To avoid this trap, stick to your investment strategy and avoid being pulled too far away from it by the latest hot sector, stock or share tip – as the risk warnings say, the past is not a reliable guide to the future.

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