In any endeavor we undertake, we are sometimes right and make correct decisions and sometimes we are wrong and prone to errors. We are prone to these errors, when we do not have a correct perspective of the environment or lack a correct assessment of the current situation in the environment.
We would have to watch out for these errors to reduce the probability of losses. For instance, it would be very difficult and an error to be in a buy or hold position if the market is in a bearish mode. Similarly, it would be difficult and an error to be in a sell or short position if the market is in a bullish trend. It would be advisable, correct and profitable to trade with the trend and not against it.
Still investors of all hues and levels of experience are prone to errors. Some of these errors are listed and described below:
Goals beyond rational expectation: Here the investor probably thinks that he owns the company lock, stock and barrel. Or that the market owes him his profits for having exposed himself to the market risks. Or the investor may have a targeted expected rate of return beyond what the market would be able to give him consistently over time.
On the other hand, unrealistic goals could also be a result of unjustified claims made by a company going for a new issue. Or misplaced expectations due to exceptionally good past performance of the investment instrument or a mutual fund or a portfolio manager. Or promises not kept by tipsters, market operators and fly by night operators.
An investment policy not clearly defined: This would also include an unclear view on risk. Here, the investor would be prone to greed and fear as the market goes up and down, respectively. This vacillation would cause the investor much loss and pain.
Seat of the pant decision making: Investors without even realizing it base their decisions on incomplete information. Some of the thoughts of the investor would be:
Come on! I know what is going on in the market, and there isn't any time to do a detailed analysis. I don't want an opportunity loss if I delay.
All that hard work is strictly for the mediocre. I know I am right.
He is my guru and can't be wrong.
We must clarify at the beginning whether we are doing an investment exercise or are we indulging in ego satisfaction. If it is investment then do the analysis as the markets and the investment instruments will still be there tomorrow. On the other hand, if it is ego satisfaction, then may the Gods bless you, as other would profit from your market actions.
Another situation could cause the investor a loss of balance. As the market goes up and continues going up, the investor tends to set aside all thoughts on the various investment risks and follows the investing public. Here, the investor is being greedy, and sooner or later would pay the price for this error of judgment.
Stock switching: In this situation, the investor is selling one stock and at the same time buying another stock. This is interesting, as here the investor expects that the first stock would go down in value, while the second stock would go up. This is unique and is rarely successful.
Two scenarios require our attention:
It maybe the right time to sell the first stock, but it may not be the right time to buy the second stock, as that too maybe on its way down.
It maybe the right time to buy the second stock, but it may not be the right time to sell the first stock, as it may still have some upside left.
The love for a cheap stock: A cheap stock is a very attractive proposition for any investor, as he is able to buy large quantities of the same. Investors find it easier to buy 1,000 shares of a INR 10.00 stock, and find it difficult to buy 100 shares of a INR 100.00 stock. The total investment amount is the same in both cases.
In certain situations, when a stock price moves down, investors start buying and continue to buy larger quantities of the same stock. The investor here is averaging his price down. But, he does not have a guarantee that in the foreseeable future the price trend of this stock would reverse and go above his average purchase price. Averaging can be dangerous.
Over-diversification: Is a situation, when an investor has a large number of names in his portfolio, maybe 50 or 60 or even more.
Let's be practical, it is like owning an index and more. Therefore the investor's portfolio performance would be about the same as the index or marginally above or below it depending on the names in the portfolio.
Secondly, managing and monitoring would become a Herculean task. The investor would get a false sense of safety in numbers. Decision-making would become slow and ineffective. If the market goes down due to a systemic risk factor, all the stocks including the best would move down in price. And the investor would not know what to sell, at what price to sell and when to sell.
Ideally, a portfolio should consist of 10-15 well-researched stocks. In any case as individual investors we are not institutions, nor do we have the requisite staffing to effectively monitor and manage a larger number of stocks.
Under-diversification: Is a situation in which an investor has only 1-2 stocks in his portfolio. This maybe due to a situation of over-confidence in the expected performance of these stocks. Or maybe the result of plain complacency.
This is not a good portfolio strategy, as the investor has exposed himself to all market risks to a larger extent due to a lack of diversification. We must always remember that we diversify our portfolio to minimize the systemic or non-diversifiable risks. In any case, this high level of risk exposure is not really necessary if we view ourselves as long term investors.
The lure of known companies: Investors are tempted to buy shares of companies that they know and are familiar with. However, the investor should keep in mind, that his knowing a company is not correlated to the returns he expects to derive from his investments in its stock.
Wrong attitude towards profits and losses: An average investor due to ego and pride does not want to recognize or admit that he may have made a mistake. Let's look at two situations:
An investor buys a stock, and soon thereafter its price goes down. Instead of applying a stop loss and getting out of the stock, the investor holds the stock in expectation of a rebound or trend reversal. However, the price continues moving down with a potential of a further decline. Now, the investor is holding the stock at a 30%-40% loss. Here, the investor wants to postpone the booking of this substantial loss and the acknowledgement of having made a mistake.
When the stock price does move up, the investor is ready and waiting to sell this stock at or marginally above his purchase price, even if the stock is expected to move up into a higher trading range. Here the investor sells to gain the relief of not having incurred a substantial loss and also he does not have to acknowledge his mistake at the start of this investment. Both these situations are loaded towards the reinforcement of losses and not profits.