Most equity markets are no longer rational environments in which the value of a given stock rises and falls in direct proportion to its firm's past financial performance and expected future earnings growth. Rather, they increasingly resemble high-stakes table games in which large sums of money can be made or lost overnight.
Many of the investment products currently in vogue, like ETFs and ETNs, have but a tenuous connection to the performance of individual corporations and commodities. The financial wizards who craft these products often tailor them to deliver exceptional results only in specific situations, making devastating losses possible if circumstances become unfavorable.
EFTs and ETNs
Generally speaking, ETFs and ETNs are meant to be bought and sold on tight time scales, which encourages deep-pocketed investment firms to plow their cash into increasingly complex trading systems and algorithms designed to predict market moves just a hair more quickly than their competitors.
Needless to say, this arrangement is anathema to the traditional buy-and-hold philosophy that characterized investing for centuries and still informs the decision-making of the average retail investor. In such a challenging environment, you'll naturally experience moments of self-doubt as you pour over your portfolio and decide how best to allocate your resources.
Minimizing Investment Mistakes
Even professional investors make mistakes that may compound unfavorable market moves. While business degree programs and other professional training activities may teach you tools to employ when making investment decisions, the skill to using those tools takes time and practice. Many investors don’t have the level of training to even draw upon.
Regardless of your experience or skill level as an investor, you're bound to make mistakes. To minimize the losses that could result from these slip-ups, you need to recognize when you've made a misstep and act to correct it without overcompensating. As there are few tried-and-true rules in the fast-moving world of investing, your success will depend less on making the same decisions regardless of the situation and rather on assessing a given strategy or decision from multiple angles and determining whether it's in your best interest.
Keep in mind that one investor's fatal error is another investor's perfectly sound asset-allocation strategy. In addition to your determining your risk appetite and the asset classes in which you choose to put your money, your personal time horizon exerts tremendous influence over the means by which you dispose of your assets. Depending on the situation, your behavior may magnify, mitigate or completely eliminate common investing errors.
Herd mentality can pay off in the short term, but it's likely to decimate your investment strategy in the long run. It's also a major contributor to the boom-and-bust cycles that have defined the equity markets for years. There's a big distinction between following targeted advice tailored to your needs and jettisoning healthy skepticism in pursuit of returns.
For instance, most mainstream investment professionals recommend buying individual equities on the strength of strong earnings reports and healthy prospects for future growth. Far fewer recommend the wholesale purchase of stock in debt-ridden firms that operate alongside these successful outfits simply because the space as a whole has decent prospects.
Nonetheless, many short-sighted investors enthusiastically plow money into poorly-performing firms in favored industries, citing the old maxim about rising tides lifting all boats. This is dangerous: While even the shoddiest firm may experience an inexplicable increase in market capitalization following a blowout earnings report from a larger competitor, its stock price will crash back to earth at the first sign of financial trouble. If you are going to defy conventional wisdom and play the odds like this, be sure to zero out your position before the party ends and everyone else does the same.
Loss Aversion
Herd psychology often begets loss aversion, which can be just as devastating. According to the research of prospect theory pioneers Daniel Kahneman and Amos Tversky, investors strongly prefer to avoid losses rather than secure gains. As a psychological mechanism, this is understandable: It's preferable to hang on to what you have than to risk it in pursuit of a payoff that's not guaranteed.
It's often an unsound market behavior, however. As the price of a given stock declines, many investors throw in the towel near the bottom of its dive in a process known as capitulation. Plenty of successful investors, from raging iconoclasts to supposedly conservative value-hunters, have made careers out of buying stocks immediately following these high-volume sell-offs. Rather than give in to panic, take the long view and use these scary moments to "average down"—buying stocks that you already own at discounted prices.
Selling Poorly-Performing Equity
Of course, it's not always a bad idea to sell a poorly-performing equity after a major decline. The mean-reversion fallacy, which dictates that a given equity's value will necessarily recover somewhat after a fall, seduces inexperienced retail investors and seasoned professionals alike. If its value loss proves to be permanent, doubling down in the expectation that it will one day rise again is simply throwing good money after bad.
It's human nature to cling to what's familiar, but equity investing requires clear eyes and an unsentimental heart. Don't hold on to a poorly-performing stock simply because you've owned it for years and maintain an unfounded faith that it will turn around. Be especially careful of equities that decline even when the broader market is rising and consistently under-perform relative to their industry peers.
Applying the Value Test
When you're unsure of the reason behind a scary fall in one of your stocks, apply the value test: ask yourself if the underlying firm's financial fundamentals remain strong or if it looks like it's headed for trouble. In the former case, hang tight as the decline may be attributable to a temporary market imbalance.
Whether you've been investing your own money for 60 days or 60 years, you know by now that equities markets have a way of disrupting even the most well-reasoned planning. To minimize and eventually eliminate altogether the losses associated with common investing mistakes, carefully analyze the finances and market movements of each equity that you own and learn as much as possible about their business model and broader industry. More importantly, maintain an even keel and resist the urge to celebrate your gains or lament your losses. In the long run, a clear head carries the day.
Comments