The best investors learn from their mistakes over time. And because I've made plenty of mistakes during my career, I'll optimistically say that means I've had lots of room for personal growth. Lucky you, then, for being able to learn from some of the biggest mistakes I've made or witnessed — without having to live through the experiences yourself.
Here are seven of the biggest rookie investing mistakes you can make. Amazingly, I still see pros make these all the time.
1. Panic selling
Picture this: A company you own misses analyst expectations. The stock drops and so does your stomach. You're not alone. Years of experience will help, but you can't escape that sick-to-your-stomach reaction when one of your biggest holdings falls precipitously in a matter of days.
This happened to me back in 2008, when my shares of Credit Corp (ASX: CCP) fell off a cliff after management downgraded its earnings forecast. The stock had already halved, so at $6, I figured it was good value. The stock subsequently crashed to around $0.90 and I couldn't take it anymore. I sold, only to see the stock recover to $6 by April 2011. Ouch.
2. Using leverage
There's no easier way to blow yourself up than by using leverage or buying on margin. Many small investors have used leverage, to amplify their returns when stocks go up. But when their investments fall in value, they're crunched with a margin call, forced selling, and big losses. Even company CEOs and Directors have been forced to sell in downturns after loading up using leverage. Don't put your savings at risk by buying on margin.
Don't ignore how leverage, or using debt, can hurt the companies you own, either. High debt loads put profits under greater pressure during down times and, at their worst, can force companies into bankruptcy.
3. Buying the next big thing
There is always a hot new industry that draws investors like moths to a flame. Usually, investors get smoked by following the lights. Last year, it was social media. In 2006, it was clean tech. And in 1999, it was internet stocks. The list of booms and busts goes on and on. But despite mountains of experience, rookies and pros alike regularly allow greed to get the better of them and chase after returns and their dreams by investing in the next big thing.
4. Relying on analyst guidance
Analysts are notoriously bad forecasters, chronically overestimating companies' prospects. One study by a US University found that, over a 20-year period, analysts consistently missed by a mile-wide margin.
It gets worse. Analysts are chronically overconfident in their buy/sell ratings. There are usually many, many more companies rated 'buy' or 'hold' than 'sell'. A recent research report on Apple (Nasdaq: AAPL) published by Credit Suisse disclosed that only 10% of the stocks rated by Credit Suisse attracted an 'underperform/sell' rating.
Think for yourself when evaluating businesses. If you do rely on analysts' estimates, be sure to stress-test them.
5. Buying 'value traps'
Buying high-quality businesses at out-of-favour prices has worked for Warren Buffett for decades, but a stock isn't an automatic buy just because it is statistically cheap (i.e. a low P/E ratio). Mr. Market might be emotional and short-sighted, but he isn't stupid. Companies with erratic profits, bad management teams, or dim futures are cheap for a reason. Think twice when you're evaluating a business that looks too cheap to be true. You might have found a bargain, but you also might have just stumbled into a value trap.
6. Not analysing your mistakes
You had to know this was coming. An honest appraisal of your mistakes is crucial if you want to develop as an investor. At least once a year, sit down and review what you got wrong with your portfolio's biggest losers and write down the lessons learnt. This will help you avoid those mistakes in the future — or even provide fodder for, say, writing an article about investing mistakes. (Cough.)
7. Trading too often
Day trading might make you feel like a slick wheeler-dealer, but odds are you're just throwing money away. Trading often racks up big commissions and painful short-term capital gains tax bills, undermining all your efforts. Research points to the fact that investors who trade less score higher long-term returns than their overconfident active-trader counterparts.
Contrast that with Warren Buffett, the most successful investor of our era, who has built an epic fortune for himself and his Berkshire Hathaway (NYSE: BRK-A, BRK-B) shareholders by scooping up great businesses at good prices and then letting time, good management, and strong fundamentals do the heavy lifting for him. Plenty of those long-held investments are still delivering for Berkshire today. In fact, Buffett hardly ever sells.
Foolish take-away
It's impossible to actively invest without making some mistakes. Even good investors are only right with 6 out of 10 investments. That's right – you can be wrong from time to time and still stand a good chance of beating the market. The only real dumb mistakes are the ones where you should have known better and the ones you make a second time.
Own your mistakes. Embrace them. Learn from them, and then put those lessons into practice. Rinse and repeat – you'll be a better investor for it.
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Scott Phillips is The Motley Fool's feature columnist. Scott owns his mistakes and shares in Berkshire Hathaway but never did buy back into Credit Corp. You can follow him on Twitter @TMFGilla . The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
A version of this article, written by Joe Magyer, originally appeared on www.fool.com
