Who: This post is for people who want to master the Zen of investing. If you often find yourself holding onto stocks for longer than you should or waiting too long to buy stocks, this post is for you.
What: This post outlines some fundamental, psychological errors that investors make. These errors are big reasons why many personal investors lose investment dollars they otherwise would not have lost.

Psychological factors including greed, denial, and fear cost investors bazillions of dollars every single year. This article will discuss some of the biggest errors that investors make. You are probably aware of these in some capacity but they will be stated here explicitly along with some reasons why they are actually mistakes as well as tips to prevent yourself from making these mistakes.

The Myth of the Inside Scoop

This is an error made by investors of many skill levels. When someone gives them a “hot stock tip,” they either immediately go and buy the stock or do a very quick and dirty check and then jump in head first. This is not the way it should be. Every investment decision you make should have sound reasoning behind it or else it is merely speculating.

There are some baseline questions that you should be able to answer before you even think about making an investment. First, why are you making the investment? What *is* the investment you are making? Can you describe how this investment will make you money? If there is an overarching economic reason for the investment and has that rationale already been priced into the investment? What are the factors that may cause the investment to move in the direction opposite of what your hot tip indicates?

Jumping on “tips” without knowing the rationale for the investment is bad for multiple reasons. First, if you don’t know what you are investing in, you may not know all of the risks involved in your investment. Are you investing in something with a lot of leverage? Are you investing in an inherently volatile security? Find out before you make that purchase. Second, if you don’t know exactly what you are investing in or what will drive the price of this investment, then how on earth will you know when to get out? What if the price doubles and you just sit there waiting for the triple when the market realizes the security is overvalued? Finally, if you don’t do your homework and find out what you’re investing in and why, you will never LEARN how to determine if something is a good investment or not.

Buying the Hot Stuff - Selling the Dogs

The conventional wisdom of buying low and selling high is actually very good advice but often people do the exact opposite in practice. By the time you hear about a hot asset class or mutual fund, how many other market participants do you think have heard about the same thing? If something is truly undervalued you can bet that more times than not the market will know about it and the price of security will likely reflect its true value. Of course, there are times when this is not true but the frequency of this is not very high.

The common mistake that investors make is to buy a hot investment when it has already reached or come close to its peak. In the same way, many investors sell investments after a big drop in its price because they are scared of further drops. Not to say that one shouldn’t buy solid investments and sell poor ones, but buying the hot investment near its peak and selling at a trough is not the way one should be investing.

Buy High!  Sell Low! ??

When will an asset class peak? When will it reach its low? If I knew the answers to these questions I would be getting paid a lot of money by an asset management company. Timing the market is difficult… Instead, look to the future and do your analysis from TODAY. Starting TODAY, based on your analysis where will the investment go? If you think an investment is a winner at today’s price, buy it today. If you think an asset is overvalued at today’s price, sell it today.

Know When to Hold Em - Know When to Fold Em - Know When to Double Down

This may be the single most pervasive mistake made by investors. To understand this mistake, one needs to understand the concept of a sunk cost. A sunk cost is a cost that has been incurred and that cannot reasonably be recovered. Sunk costs should not influence decisionmaking processes but they often do. Examples:

  • A (bad) poker player knows with a high degree of certainty that s/he will lose a hand but since s/he has invested so much money into the pot, they continue to play.
  • You buy a movie ticket. You decide later that you don’t want to go to the movie. You cannot sell the ticket. You decide that you have to go to the movie otherwise it would be “wasting” the ticket (which has already been paid for).

I will post more on sunk costs in depth later but for now, just understand the basic concept. So how does this relate to investing mistakes? Good question. Too often, investors will purchase an investment only to have it consistently lose value over a period of time. Since they have already invested their original principle in the investment, they refuse to sell off the losing investment because they don’t want to think that they have made the investment for no reason. Why? I have no idea.

If at any point you would NOT want to hold the investment going forward, SELL IT.

In the same way, when an investment has made an investor lots of money they grow attached to the investments and grow less and less likely to sell them. BAD. Just because an investment made you money in the past does not mean it will do so in the future.

If at any point you would NOT want to hold the investment going forward, SELL IT.

So, What Do I Do William?

Easy. Don’t make these mistakes.

1. Do Your Homework - Make sure you know why you are making an investment. That is the only way to know when you should buy more, hold, or get the heck out.

2. Set Limits - When you purchase an investment, set a target price that you think the investment is worth. When it reaches that point, sell. Don’t let yourself be convinced that you can wait “just a little longer.” Conversely, set a loss limit. If your investment loses a certain amount of its value, promise yourself that you will sell it. STICK TO YOUR LIMITS.

3. Constantly Re-Evaluate - Your limits do not have to be (and should not) be static. If the fundamentals of an underlying investment change (strong earnings potential on a stock increases, etc) then revise your target prices. Remember that a revision should not come because you feel like it. You must be able to JUSTIFY a change in target price or loss limit.

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