Top 5 Investing Mistakes

I have previously posted several series discussing some of the top investing mistakes people make as I see it.  Well I consolidated all of my past posts into one and added my final point.   It’s a bit long but here it is:

1. Investing Against the Trend

2. Holding Stocks Too Long or Too Short

3. Using Too Much Leverage to Trade

4. Investing Based on Past Trend and Performance With Confidence

5. Giving Up

Investing Against The Trend

One of the biggest mistakes I’ve made that led to big losses is betting against the trend.  When I first started investing before this whole crash happened, the market was trending up, and I was successful with it.  Stocks were going up, mutual funds were going up, and IPOs almost seemed invulnerable. I remember investing in Visa (V) when it first launched in March of 2008 and watching the stock sky rocket almost every day.  I felt like I would never see a red and that this was my ultimate solution to early retirement.

As ignorant and naïve as I was, I happened to be doing something right at the time without even fully understanding it – investing with the trend.  Despite the fact that I only knew how to “buy” stocks and knew very little about “shorting” the stocks, I happened to be buying during the bullish times, which helped me reduce risks and gave me an edge.

In my mind, this is one of the simplest, yet most powerful strategies one can employ as an investing technique.  I simply lost the battle (but not the war) in the last year or two because I kept buying stocks when the market started turning, hoping it would reverse when the underlying trend was clearly bear (Dow going from 14,000 down to 6400s is nothing but a down trend).  If I had simply learned this lesson early on and invested on the bear side (shorting stocks), I would have been very “successful” without even knowing much about investing in general.  I kept telling myself “it’s gone down too far”, “it can’t go down any further”, or “the market HAS to turn around”, which ultimately hurt me in the end.

The tide seems to be turning now after hitting the recent bottom of Dow Jones at 6470 in March (temporary?) The market has rallied over 35%, the biggest rally since 1933, and still hasn’t lost its fume.  Some are still calling this a bear-market rally, but more are starting to recognize this strength as a reversal into a bull market.  Hell some went as far as calling the March 2009 low as THE bottom.

I personally am skeptical that we’ve hit the bottom, but the market is clearly trending up, and I would be very cautious if you’re betting against the bulls still.

Holding Stocks Too Long or Too Short

You often hear experts and articles suggesting you not to get too greedy because it will always bite you with force.  While there is a lot of truth in that statement, I believe the opposite is true under certain circumstances.

People have the tendency to hold onto their losses too long while holding onto their gains too short.  When the stock is advancing, people are “educated” to take gains because that is the right thing to do, right?  Greed is the quickest way to lose money.  Sure, there is a lot of validity to that, and that is definitely a great strategy to quickly take gains and minimize exposure to sudden reversals derived from major news, earnings, government intervention, and hell even Swine Flu as suggested by the CNBC experts.  However, this strategy significantly puts investors who also hold onto losses too long at risk.

One of the hardest challenges an investor faces is accepting one’s loss and moving on before the situation worsens.  Many investors made the same mistake in the last 2 years when the stock quickly depleted in price.  Originating from the fear of missing the “bottom” on its way to recovery and the hopes that the stocks will soon recover, investors struggle to let go of their position and cut the loss.  How many people do you know personally who employed this behavior and ended up paying an immense penalty last year?  Probably plenty.

When an investor starts to hold onto losses for a prolonged period of time and lets the losses grow, but sells the stocks too soon when the stocks do finally recover fearing that it will soon head south again, he/she is certainly guaranteed a loss.  To make the matter worse, an investor repeats that behavior multiple times for a longer time period, you are looking at a portfolio position that is rapidly losing value.

It is much easier to sell and take profit than to sell and take a loss because it is emotionally far easier to leave a position with a win than with a loss.  However, this very behavior puts investors at risk and can quickly lead to depletion of his/her position.  Therefore, I argue that sometimes it is important to hold onto your stocks when they are going up, not because you are greedy, but because it is important to recognize a trend and take full advantage of the uptrend.  On the other side, it is absolutely critical to recognize the trend down and cut your losses early regardless of how hard it is to accept a loss.

Bottom line, don’t hold onto your position too long or too short.  Have a plan both ways and stick to it.

Using Too Much Leverage to Trade

One beauty of the investing market is the ability to borrow money from your broker at a reasonable rate and trade stocks with the money you normally wouldn’t have.  For example, if you put $30,000 into a “margin account” with broker X, you actually may gain the ability to trade $50,000 worth of stocks by borrowing money from the broker and pay certain interests.

While margin accounts provide investors with an additional boost to their investing power and may help profit much more than otherwise, margins can also be extremely dangerous and can put investors at a disadvantage.

The real danger is not necessary the fact that you’re borrowing money and paying interests on it (though it’s never good to have debt with stocks), the true danger sneaks in when you borrow too much, to a point where you received a margin call frequently.

Margin call, also known as a maintenance call, occurs when a broker demands an investor using a margin account to deposit additional money or sell the securities owned so that the investor can maintain a certain amount of margin.  In other words, investor’s stock value depreciated to a point where the broker is no longer willing to lend him the same amount of money it did previously.

For example, if your portfolio is worth $30,000, the broker may be willing to lend you $20,000, totaling your “buying power” to $50,000.  However, what would you do if you were the broker, and this same investor’s portfolio is now worth $5,000 because his stocks depreciated in value so much?  Will you still be willing to lend him $20,000 (4x his “liquidity”)?  Probably not.

This is the big danger behind the margin accounts.  While it is nice when you borrow money to make more money, it can be devastating to your account balance if you’re borrowing too much and the stocks you own are depreciating in value quickly.  When you are forced into a margin call, you may not have the additional cash on hand to off-set the depreciating stocks.  If you don’t have the cash, you are forced to sell the stocks at a non-reasonable price.  If you had simply avoided borrowing too much money, it may have allowed you to hold onto the stocks longer until it recovered.

Imagine buying a stock with borrowed money at $20 a share.  You then watch the stock tank to $5 a share due to a poor earnings report driven by the poor economy.  However, you firmly believe in the company and have supporting data behind it, and you know the stocks will recover if you hold long enough. It would be a shame if you were forced to sell the stocks at $5 a share simply because you borrowed too much and are forced into a margin call.

I personally faced this challenge earlier on in my trading career.  I was forced to sell many stocks in the past only to see them recover in 2 weeks.  Learn from my experience folks.  If you are new to this and are thinking about opening up a margin account, think very carefully before making a regrettable decision.

Investing Based on Past Trend and Performance With Confidence

Have you ever looked at a historical chart and determined with absolute assertion that there is a certain pattern to a particular stock?  I certainly have.  Here’s the scoop, you can never assume that history will repeat itself even if there is evidence strong enough to suggest that such a pattern exists.  It becomes especially dangerous if an investor becomes  so convinced that he or she ignores the other supporting data suggesting the opposite.

Take a look at the below example of ProShares UltraShort Financials, or SKF.

As you can see from the above chart, SKF has been a money machine for many aggressive investors who took advantage of the financial crisis and the market’s volatility.  Looking at the historical chart, one could have argued that SKF has very strong support levels around $90-$100 per share.  This chart certainly suggests that you have a good chance of making big money if you just invest in this ETF once SKF hits this “hot zone”.

The reality: one can never be certain that the history will repeat itself, and it is absolutely dangerous to be so fixated to the historical patterns that it impacts one’s ability to make fact driven decisions.

Now look at the current chart of SKF and its price.  Something clearly changed.  In SKF’s case, the financials rallied so significantly since its March 2009 lows that this double short financial ETF tanked from $200+ to now slightly above $40 per share.  For the investors who bought this ETF at $100 per share with the excitement and conviction that SKF will double again in a month, I hope they were able to make the rational decision to accept the loss and sell them before getting down to its recent 52 week low.

The bottom line: when making investing decisions, don’t make them simply based on past trends and performances.  There’s a saying in the financial world – “Yesterday’s winners are today’s losers.” Look at the different supporting facts appropriate for the particular stock and make a logical, unemotional trades that lead to winning plays.

Giving Up

Yes I know I’m stating the obvious.  Giving up is obviously bad right? But I can’t stress enough the importance of this because many people do it over and over again.  It’s always easier to give up and quit than to continue and plow through the tough times.

Investing is a learning process.  There’s not one person who has built a successful investing career without prior mistakes, both big and small.  The cold truth is that most investors lose money.  What separates the good from the bad is the ability to learn from the mistakes and prevail.  The surest way to lose is give up when the going gets tough.

Let me emphasize this point: going broke is not losing. You only lose to the stock market when you give up and decide not to further pursue your goal of becoming a successful investor.  I’ve read and heard stories of successful investors who went broke more than once.  But they are a profitable investor because they never gave up.

If you’re one of the many who has lost money from the stock market and are discouraged from moving forward.  Take a break, think through the reasons why you lost money.  Understand your mistakes, and learn how to avoid making the same mistakes.  If you continue to educate yourself and break through one obstacle at a time, it will lead to success.

Just like anything else, successful investing takes time.  Before you get overly excited or discouraged, prepare yourself with this mindset when it comes to investing.