There are species that are rare, and those – like the dodo – that are extinct. And then there are some that probably never existed at all, like the unicorn or the investor who has never made a mistake.
That said, not all mistakes are created equal. You might kick yourself for not selling a stock at its peak, or for not jumping into the market at its trough. (Hands up: How many readers spotted the moment back in March 2009 when the current bull market began to take shape? And of those, how many acted on it?) Remember, then, that you’ve likely saved yourself more pain by not trying to time the market.
Then there is the feeling you get when a nasty earnings surprise comes out of left field and knocks 5 percent or 10 percent off the value of one of your holdings. You forget for a while the meaning of the word “surprise,” and kick yourself for not realizing that there were problems just waiting to be revealed.
In some cases, these aren’t really mistakes. In others, perhaps there was a chance you could have identified that something wasn’t quite right, and a chance that you would have responded correctly within the right time frame. But these are what I’d call “normal mistakes”; the kind we’re all going to make on occasion and that, when set beside the bits of good luck that we have, tend to balance out.
Then there are the other kinds of mistakes: the kinds that can be avoided with a bit of forethought and common sense. These are the ones that can do more damage to your portfolio because sometimes you don’t even realize that you’ve made them and thus keep repeating them.
Here’s a short list of four of the most common of these big investor goofs:
1. Confusing Volatility and Risk
The Volatility Index, or VIX, is used as a measure of the fear or anxiety in the market based on what’s happening to S&P 500 index options. Really, all that option movement tells us is how driven traders feel to protect their portfolios. Even actual market volatility – the extent to which price swings in either direction increase in volatility or frequency – isn’t a real measure of risk. For most of us, risk is a broader and far more important concept: At its most general, it’s the risk that we’ll outlive our savings. On a day-to-day level, risk is what we have to take in order to generate the returns that will help us achieve our goals. Excess risk, in a reasonable investment climate, is what you want to avoid.
2. Confusing Price and Value
This is an easy mistake to make, because when you hear someone on CNBC talking about a company’s “valuation,” he or she is probably referring to its market capitalization, calculated by multiplying the current stock price by the number of shares outstanding. Investors goof when they conflate the two ideas. In fact, what may be happening is that others are overpaying for what value exists within that company’s current and future cash flow. Yes, you’ll hear folks argue that the market is efficient and thus the market price always represents a consensus about value. But if a short-term consensus and long-term reality were the same thing, there would be no jobs out there for financial journalists; the world would become a rather dull place.
3. Tracking the Market Rather Than Your Own Goals
Clearly, your right level of “risk” is something very personal to you: It will hinge on your financial circumstances, your personal circumstances, whether you want to retire at 55 or 70, whether you want to travel the world or live in a cabin in the mountains and grow your own food; it will even depend on how long-lived your family is and whether you’ve been diagnosed with anything that might shorten your lifespan. Similarly, the return objectives you should have are all tied to those same long-term strategic goals.
In that context, it doesn’t matter whether your portfolio failed to beat the S&P 500 this year. What matters is whether the collective impact of all your assets generated enough of a return that, compounded over time, will get you where you need to be. In fact, there’s a risk that if one of the mutual funds in your portfolio beat the S&P 500 dramatically this year, it’s because it took on a lot of risk – perhaps by concentrating in just a handful of stocks, or by investing in lower-quality stocks. That strategy may not continue to pay off – there’s a reason why managers rarely manage to beat the index for more than a few quarters in a row. Pay attention to where you are relative to your long-term plan rather than to the market.
4. Confusing Emotion with Judgment
The biggest mistake any investor can make is to react to what is happening in the financial markets out of fear or greed, and find a kind of “logic” to support their ill-conceived decisions.
Just ask anyone who rationalized their investments in dotcom stocks in the late ‘90s about how they convinced themselves that the number of “eyeballs” a new Internet portal could attract was somehow more important than the cash flow the company could generate. It’s human nature to seek out opinions that agree with the ones we have already formed – a phenomenon known as “confirmation bias” – and it’s what keeps us from behaving rationally, even in normal times.
We might know that Twitter doesn’t really belong in our portfolios and yet be unable to resist the urge to chase after the stock simply because it’s the first chance anyone outside the company’s group of insiders has had to profit from the growth in the Twittersphere. Or we might agree with our financial advisors that the odds are in favor of an increase in bond yields – and another selloff in the fixed income market – but be unable to leave what we see as the safe haven of Treasury bonds.