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Monday, March 15, 2010

Investment Portfolio Guide: Investment Mistakes to Avoid

“Wide diversification is only required when investors do not understand what they are doing.”
 - Warren Buffett (Investment Genius & Philanthropist)

Investing Mistake # 1: Spreading your Investments beyond Indexes

Over the past several decades, Sensex has preached the virtues of diversification, drilling it into the minds of every investor within earshot. Everyone from the CEO to the delivery boy knows that you shouldn't keep all your eggs in one basket - but there's much more to it than that. In fact, many people are doing more damage than appreciation in their investments by the effort to diversify. Like everything in life, diversification can be taken too far. If you split your1000 Rs into one hundred different companies, each of those companies can, at best, have a tiny impact on your portfolio. In the end, the brokerage fees and other transaction costs may even squeeze the profit from your investments. Investors that are prone to this "dig-a-thousand-holes-and-put-a-coin-in-each" philosophy would be better served by investing in an index fund which, by its very nature, is made up of many companies. Additionally, your returns will mimic those of the overall market in almost perfect lockstep.

Investing Mistake # 2: Not Accounting for Time Horizon

The type of asset in which you invest should be chosen based upon your time frame. Regardless of your age, if you have capital that you will need in a short period of time (six month or one year, for example), you should not invest that money in the stock market or equity based mutual funds. Although these types of investments offer the greatest chance for long-term wealth building, they frequently experience short-term gyrations that can wipe out your holdings if you are forced to liquidate. Likewise, if your horizon is greater than ten years, it makes no sense for you to invest a majority of your funds in bonds or fixed income investments unless you believe the stock market is grossly overvalued.

Investing Mistake # 3: Frequent Trading

We can name ten investors on the Forbes list, but not one person who made their fortune from frequent trading. When you invest, your fortune is tied to the fortune of the company. You are a part-owner of a business; as the company prospers, so do you. Hence, the investor who takes the time to select a great company has to do nothing more than sit back, develop a rupee cost averaging plan, enroll in the dividend reinvestment program and live his life. Daily quotations are of no interest to him because he has no desire to sell. Over time, his intelligent decision will pay off handsomely as the value of his shares appreciates.
A trader, on the other hand, is one who buys a company because he expects the stock to jump in price, at which point he will quickly dump it and move on to his next target. Because it is not tied to the economics of a company, but rather chance and human emotion, trading is a form of gambling that has earned its reputation as a money maker because of the few success stories (such stories never tell you about the millionaire who lost it all on his next bet... traders, like gamblers, have a very poor memory when it comes to how much they have lost).

Investing Mistake # 4: Fear Based Decisions


The costliest mistakes are usually fear based. Many investors do their research, select a great company, and when the market hits a bump in the road - dump their stock for fear of losing money. This behavior is absolutely foolish. The company is the same company as it was before the market as a whole fell, only now it is selling for a cheaper price. Common sense would dictate that you would purchase more at these lower levels (indeed, companies such as Pantaloon have become giants because people like a bargain. It seems this behavior extends to everything but their portfolio). The key to being a successful investor is to, as one very wise man said, "...buy when blood is running in the streets."

The simple formula of "buy low / sell high" has been around forever, and most people can recite it to you. In practice, only a handful of investors do it. Most see the crowd heading for the exit door and fire escapes, and instead of staying around and buying up a company for ridiculous levels, panic and run out with them. True money is made when you, as an investor, are willing to sit down in the empty room that everyone else has left, and wait until they recognize the value they left behind. When they do run back in, you will be holding all of the cards. Your patience will be rewarded with profit and you will be considered "brilliant" (ironically by the same people that called you an idiot for holding on to the company's stock in the first place).