Making mistakes is part of life. We make mistakes and hope to learn from them so that we do not repeat them in the future. Some errors are minor with insignificant repercussions while others can be devastating and life changing. Investing mistakes fall somewhere in the middle. The good news is that you don’t need to make these mistakes first-hand to become wiser. Others have been unfortunate enough to have committed them, so let’s learn from them and review a few common investor mistakes to avoid.
- Mismatch Time Horizon and Investment Strategy
A crucial component of investing is having an investment plan and outlining your goals and investing time horizon. You often will have multiple goals with various timelines such as buying a house, children’s education and retirement. You surely won’t be buying a house, sending your kids to school and retiring at the same time. All these will have different timelines. One of the most common mistakes investors make is not realizing time is a key variable in determining investing style. This often results in taking too much risk for short-term goals. If you are planning on buying a house next year, you should not be investing in stocks. On the flip side, it can lead to taking too little risk, such as investing retirement funds in short-term bonds.
Matching time-horizon with investing style is vital in making sure investing and personal goals are met.
If one does some essential reading on investing, you will come across the concept of diversification. Diversification is a simple notion: invest in various instruments with low correlation. However, investors too often randomly buy a myriad of instruments without realizing that they are all highly correlated therefore their portfolio is not diversified at all. Holding several stocks within the same industry is not diversification, nor is holding various instruments, such as stocks and bonds, issued by the same company.
- Focus on Stocks Instead of Asset Allocation
Asset Allocation is a vital part of your investment returns. Sadly, investors are too often too focused on the actual stocks they hold than develop a proper asset allocation based on their risk profile and goals. The correct asset allocation distributes your investments over the various asset classes: equities, fixed income, commodities and cash. These asset classes tend to have low correlation with each other and therefore provide protection and diversification. Picking good stocks is important, but not at the expense of diverging too far from your optimal asset allocation.
Leverage will amplify your returns, but will also amplify your losses. The mistake is not realizing that leverage goes both ways and you end up over-leveraging your portfolio. During a market correction, an over-leveraged position will not only magnify your losses, but can force you to sell other holdings to cover your losses. Imagine being forced to sell a core holding to cover your losses in a bad stock. Leverage is a good strategy to improve returns, but over-leveraging can be devastating.