Navigating the investing world can be exciting and rewarding, offering the potential to build wealth and secure your financial future. However, the path to investment success is not without its pitfalls, and many fall prey to avoidable investing mistakes that can derail their financial goals.
In this article, we’ll cover five common mistakes and how to avoid them if you want to be successful at investing.
Mistake 1: Not Understanding The Company
Investing in companies because they are going up is not an appropriate reason to invest in them. A company could be one week away from reporting underwhelming results, and there goes a good chunk of your money when its stock sells off – all because you didn’t take the time to research and understand the company.
Peter Lynch, a successful American investor, says the most important thing when investing is to:
Know what you own – if you don’t understand it, it doesn’t work.
Peter Lynch
As manager of the Fidelity Magellan Fund, he turned $18 million into $14 billion over 13 years – an average annual return of 29.2%. (Bear in mind that the S&P 500, a proxy for the US stock market, has returned 10% annually on average over long periods).
Peter Lynch outperformed the S&P 500 in all but two years by owning companies he understands and understands well. If it worked for him, it can work for you.
Reading company reports is the best way to understand a company. Annual reports detail the company’s business model and the risks it faces. They also explain the company’s financial statements.
Behind every stock is a company. Understanding how that company makes money, its financial position and performance, who its competitors are, its competitive advantages and expected growth rates are the keys to successful investing.
Mistake 2: Letting Emotions Dictate Your Decisions
Letting your emotions take precedence in decision-making is one sure way to lose money on an investment.
Getting attached to a company and believing it cannot fall any lower than it already has when the facts say otherwise can lead to unfavourable investment results. Similarly, if a company is prospering financially, but its shares declined dramatically for some illogical reason, listening to that devil on your shoulder and ‘panic selling’ probably isn’t the best course of action.
I’m not emotional about investments. Investing is something where you have to be purely rational and not let emotion affect your decision making – just the facts.
Bill Ackman
Emotional discipline is as important, if not more important, than intellect when investing. Whenever emotions are involved, your perception of reality becomes distorted. Following the facts is a far more beneficial approach to investing.
If a company you own is fundamentally sound – strong financials, high growth prospects, low debt and positive and growing free cash flow – but its shares have sold off irrationally in the market, don’t join the market by selling. Instead, view the selloff as an opportunity to accumulate cheaper shares (these cheaper shares reduce your cost basis and increase your future potential returns).
On the other hand, if a company’s fundamentals begin to deteriorate and its stock starts to decline, it may be best to lock in whatever gains you have and sell…even if it is your favourite investment.
Ignore your emotions. Act on facts.
If you haven’t noticed, the solution to this common mistake relies on the solution from above (understanding the companies you invest in). Only by understanding your investments can you conclude if a company is thriving or its fundamentals are deteriorating.
Mistake 3: Speculating, Not Investing
Jumping into and out of stocks for no concrete reason yields proportional results. Investing in a company purely because it ‘will’ beat analyst expectations or because someone told you ‘it’s bound to go up’ is a dangerous game.
What happens if the company misses expectations and its stock falls 20% on the day? What happens if the company loses 50% of its value in three months when its stock ‘was’ bound to go up?
What then?
Investing is filled with plenty of unknowables, so staying on top of the few knowables is crucial. You can’t control a company’s ability to beat analyst expectations, but you can understand how it makes money and its financial and market position.
Making decisions based on company fundamentals (investing) and not hunches (speculating) helps mitigate unnecessary risks and improve the likelihood of investing success.
Mistake 4: Chasing Trends, Chasing Stocks
Another trap investors fall prey to is FOMO – the Fear Of Missing Out.
Identifying and getting in on a trend just before it takes off can make you a lot of money, and rightly so. But buying when a stock is up 80% in two months may not be the best idea. It is unlikely that the stock will keep up this trajectory and will likely fall back to reasonable prices.
Couple this with the fact that you may not understand the company in question – thereby being optimistically biased because ‘it went up so much already, what’s stopping it from doing so again?’ – and now you’re in no man’s land. When the share price eventually falls, you won’t know whether to accumulate ‘cheaper’ shares or sell your position to cut your losses.
The great investors avoid trends and focus on the companies they know and understand well. If they miss out on a good company, they wait until its stock falls to a price they’re willing to pay. If it doesn’t do so, they move on.
Being capable of moving on from a company is an essential tool in an investor’s toolbox.
Mistake 5: Overpaying For A Company
The main aim of investing is to buy companies when they are cheap and sell when they become expensive – buy low, sell high. But all too often, it’s the other way around – buy high, sell low – and here is where a lot of money is lost.
Investing in overvalued companies (or buying high) means there are two likely ways for a company’s share price to go:
- Sideways – no significant capital appreciation/investment growth as the company’s fundamentals try to catch up with its price.
- Down – no explanation needed.
Price is what you pay, value is what you get.
Warren Buffett
To avoid overpaying for a company’s shares, investors often assess its relative value using the price-to-earnings (PE) ratio. This ratio divides a company’s market value by its annual profits and indicates what the market would pay for £1 of profit.
For example, a PE ratio of 10 means the market would pay £10 for £1 of a company’s profits. The higher the PE ratio, the more expensive a stock is relative to the company’s profits.
A high P/E can suggest a company is overvalued, but there are some complications:
- One-off expenses may decrease profit, thereby increasing the P/E ratio. A company may be fairly valued or undervalued, but this transaction hides that fact.
- A high-growth company that isn’t focusing on profitability may have a high or no P/E, so it may be difficult to assess its value using price-to-earnings ratios.
- The sector in which the company is in may have a high average P/E ratio, so the company’s P/E may be typical rather than elevated.
Because metrics, like the PE ratio, only suggest a relative value, investors resort to financial models for an absolute/intrinsic value (a company’s underlying value based on its future growth potential). The most popular is the Discounted Cash Flow (DCF) Model.
The DCF Model estimates intrinsic value by forecasting a company’s free cash flows and discounting them back to today’s value. A company is considered overvalued if its market price exceeds its estimated intrinsic value.
N.B. – Because the free cash flow forecasts are based on individual assumptions, intrinsic value is subjective – your estimate will differ from everyone else’s.
Summary
Embarking on your investing journey can be an enriching experience and offers an opportunity to accumulate wealth and secure your financial future. However, the path to investment success is not without its bumps.
To stack the odds in your favour, some common mistakes to avoid include not understanding the company before you invest, following your emotions rather than the facts, being a speculator and not an investor, chasing trends, and overpaying for a company.
If you haven’t realised yet, all the mentioned mistakes are linked in one way or another to the first one (not understanding the company before investing). If you can avoid this mistake, the remaining four should take care of themselves.
Share this post:
