Following Trends – Being the Bigger Idiot
At least, since the beginning of public investment markets, there have been bubbles. Investors see the price of something increasing, and want to own that thing. Isaac Newton, the renowned physicist and at one time, the head of the English mint, lost a vast sum of money in a 17th century bubble.
As humans, we are all susceptible to bubble thinking. An investor thinks, “I can buy this thing and resell it to someone else after it goes up in price by a lot.” An old Wall Street saying calls this the bigger idiot strategy: it depends on there being an even bigger idiot to buy from the first investor. But, of course, the price will only go up when there are more buyers who want it at a higher price.
Bubbles burst when the last buyers are found and the demand collapses. By following hot investment trends, investors are opening themselves up to being the last idiots who can only sell at a much lower price.
Not Analysing investments
Investors should purchase index funds if they are unwilling to analyse individual companies or investment opportunities. For most people, their investment funds are far too important to their retirement or other life goals to gamble in the stock market.
Not periodically reviewing investments
Another common mistake is putting investments on auto pilot. Investors who are unwilling to at least periodically review their investments should put their money into index funds. Investments, especially common stocks, can rapidly change characteristics from a safe investment to a very risky one in only a few years (or even shorter). If an investor fails to periodically review his or her investment portfolio, he or she may suffer serious losses.
Sunk Cost Fallacy – Hoping a losing investment will come back
Refusing to accept a loss is a very common mistake among all investors. Human nature and psychology keep us hoping that a losing investment will come back. That is the wrong reason for keeping an investment.
One way to beat this thinking is for investors to consider whether they would purchase the investment they are now holding. If the answer is no, then the investor should sell the investment. There is no economic or rational difference between buying an investment with cash or holding an investment that could be turned into cash.
However, human psychology creates a logical fallacy called the “sunk cost” fallacy, which is particularly dangerous in investment contexts. One result of the fallacy is that investors who fall into it keep their worst investments. Their portfolio then actually represents a bias toward their worst investment ideas.
Not diversifying
A simple, common investment mistake is not diversifying. Often called the only free lunch on Wall Street, diversification ensures that an investment portfolio isn’t wiped out by some negative event.
While certain negative events like global economic downturns will affect almost all investments, the effects of some negative events like earnings misses or industry obsolescence can be lessened with proper diversification, which calls for spreading investments among a number of assets with different investment features.
Over-diversifying
Another investment mistake represents the opposite extreme from not diversifying: over-diversification. An investor who analyzes individual investments should take care not to spread his or her money among too many different investment ideas. At some point, the investor’s next investment idea is simply much weaker than his or her best, second best, or fifth best idea.
In addition, diversification among dozens of investments will likely lead to poor analysis as an investor simply does not have time to properly analyze and research dozens of investment ideas. And such an investor will also probably fail to keep up-to-date on so many different investments, which could lead to an improperly monitored portfolio.
In short, diversification is good but is not a substitute for analysis. Investors who feel unable to perform good analysis should not purchase individual investments but invest in an index fund.
Investors who take the responsibility seriously and analyze investments may do well, but investors who are unwilling to deeply analyze investments are merely gambling with their future. These investors are practically guaranteed to do poorly, and would be better served by a simple index fund or group of index funds that would be much safer than unintelligent investing.