5 common mistakes people make when investing
Tom Bulford examines five common mistakes that private investors make, and explains how you can avoid them.
Recently I attended a meeting of a local share club. I enjoyed it. The meeting was held in the pub and the atmosphere was convivial. After two hours of lively discussion, the club decided to sell one share from its small portfolio and add a new one.
From what I know of share clubs, I think that this one was pretty typical. The members were mainly retired gentlemen, who met once a month. They all make regular small contributions to the club's funds, they all take an interest in the stock market and they are clearly intelligent, worldly and successful. And yet their overall investment return has been modest.
Why have they not done better? I detected five mistakes which I believe you should try to avoid.
1: A lack of an overriding strategy
Insofar as the club had any overriding investment strategy, this seemed to be a moving feast. They had tried high yielding blue chips, they had flirted with racier small caps and they had tried to identify some long-term investment themes. But with many different voices around the table and a determination to trade shares on a regular basis, they had never really stuck with anything.
My opinion has always been that investment works best when it is comes from personal conviction based upon research-based knowledge and adherence to a clear investment strategy. I do not think that it matters too much what that investment strategy is. If you are comfortable buying high yielders, then buy high yielders. If you like short-term gambles, then identify these.
Any one single strategy is better than none at all, or than a strategy that changes from one month to the next. But investment by committee will always struggle to find that essential consistency of approach.
2: Making decisions for the sake of them
This club meets once a month. Each time one member is asked to recommend a new share for the portfolio. This is then discussed and unless there is no strong objection it probably gets bought. Warren Buffett once described the stock market as a "no-called strike game". "You don't have to swing at everything", he went on. "You can wait for your pitch."
What this baseball analogy means is that you never have to make investment decisions and you should never do so unless you feel sure that you are making a good one. By forcing yourself to make an investment decision just because it happens to be the date of the monthly meeting or because you happen to have some money burning a hole in your pocket, you are putting the cart before the horse.
3: Lack of understanding of valuation
Valuing shares is a dark art otherwise prices would not be so volatile. But my advice to any investor would be to spend a little time learning about the basics of price/earnings ratios; cash flow; return on capital; debt/equity ratios; stock market capitalisation, etc.
I like to use the analogy of a Rolls-Royce and a Ford Escort. If you were asked which you would prefer, you would naturally opt for the former. But if you were asked to choose between a Rolls-Royce for £1m or a Ford Escort for £100, then you might opt for the latter. Similarly it is one thing to argue that Google is a great business, but is it really worth $156bn? Unless you have some means of relating the strengths and weaknesses of the Google business to its stock market value you will always be a speculator rather than a genuine investor.
4: Poor sources of information
The members of this particular share club seemed to rely mainly upon the Daily Telegraph and the Investors Chronicle. Nothing wrong with these, but by the time news gets reported here it is history so far as share prices are concerned. Rather than relying on old news and second hand opinions investors need to do some primary research. Sites such as FE Investegate, Digital Look (both free) and companies' own websites have a mass of information from which investors can draw their own conclusions.
Of course, if you want specific stock ideas in the small cap arena, then you can get those in my paid newsletter, Red Hot Penny Shares.
5: Determination to take profits
Most successful investors would probably agree that the bulk of their return has come from a handful of really successful companies that they have stuck with over the years. To get these really big returns, you need to stay with these companies and allow them to multiply your invested capital over time. Far too many investors and this seemed to be true of this share club are in too much of a hurry take a profit. This can turn what might ultimately become a really big profit into an immediate, but much smaller one.
Most share club members say that they do it as much for the camaraderie as the profit. But their pleasure would be much enhanced if they made more money. With just a little bit of discipline and work, I am sure that many investment clubs could do so even if they do decide to spend it in the pub.
Note:This is an updated version of an article that was first published in 2011.
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