Investors work against their own best interest by making foolish, emotion-driven mistakes. It is this lack of rationality, combined with an inability to stick with a valuation-based or systematic-based approach to equity acquisition.
All of this while paying little attention to marketing timing, which explains the research from studies put out by Morningstar and others that show investor returns are often far worse than the returns on the stocks those same investors own.
In fact, in one study, at a time when stocks returned 9 percent, the typical investor only earned 3 percent. Take into consideration all of the risks of owning stocks and enjoying a fraction of the reward being too busy trying to profit from a quick flip rather than seeking foreign cash-generating enterprises that might enrich your portfolio for the medium to long term.
We will address five of the most common investing mistakes inexperienced investors make. Though the list certainly isn’t comprehensive, it should give you a good starting point in avoiding moves that may come back to haunt you:
Paying Too Much for an Asset in Relation to Its Cash Flows
Any investment you buy is ultimately worth no more, and no less, than the present value of the discounted cash flows it will produce.
If you pay a higher price, you earn a lower return. If you pay a lower price, you earn a higher return.
The solution is to use the P/E ratio.Know how to compare the earnings yield of a stock to the long-term. This is basic stuff that is covered in beginner’s finance. If you’re unable to do it, you are one of the people who have no business owning individual stocks.
Incurring Fees and Expenses That Are Too High
Whether you are investing in stocks or a bonds costs matter. You have to know which costs are reasonable and which costs are not worth the expense. It can be tricky, but the consequences are too high to waive it away.
Focus on your purchasing power. Imagine you buy $100,000 worth of 30-year bonds that yield 4 percent after taxes. You reinvest your interest income into more bonds, also achieving a 4 percent return. During that time, inflation runs 4 percent.
At the end of the 3 decades, it doesn’t matter that you now have $311,865. It will still buy you the same amount you could have bought three decades earlier with $100,000. In short, your investments were a failure. You went 30 years without enjoying your money, and you received nothing in return.
Choosing a Cheap Bargain Over a Great Business
Warren Buffett warns against this in more shareholders letters than we care to count. If history is any indication, investors, are likely to have a much better chance at amassing substantial wealth by owning an excellent business that enjoys rich returns on capital and strong competitive positions, provided your stake was acquired at a reasonable price. This is especially true when compared with the opposite approach — acquiring cheap, terrible businesses that struggle with low returns on equity and low returns on assets.
Buying What You Don’t Understand
Many losses could have been avoided if investors followed one, simple rule: If you can’t explain how the asset you own makes money, in two or three sentences, and in a way easy enough for a kindergartner to understand the basic mechanics, walk away from the position. This concept is called Invest in What You Know. You should almost never — and some would say, absolutely never — deviate from it.