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Sunday, January 13, 2013

3 Common Mistakes an Equity Investor Makes

3 Stock Investing Mistakes & How you can Avoid them?

Mistake 1 – Not investing in stocks when market is down and quoting below long term average valuations.

This is a life-changing mistake though many do not realize. If an investor makes this first mistake, he/she is more likely to make the other two mistakes, no matter how much does one try to keep away from stocks.

In order to fulfill one’s basic needs and lead a healthy and wealthy life, an investor should invest his savings at lows and sell at highs and thus accumulate decent corpus over a period of time.

In the above case, investors make a mistake of extrapolating the short term downtrend and thus fall in the trap of believing that markets will fall indefinitely.

With the above psychology investors defer their investments, assuming they will get to know when the market will bottom out and start investing then.

End result - Investors get to know about market bottoms only in hindsight and thus miss out investing at market lows.

Mistake 2 – Not investing in stocks when market rebounds from lows and quoting at long term average valuations

This is another major mistake made by investors in their attempt to act smart. After missing out investing at very low market valuations (Investing mistake 1) in their attempt to time markets, investors miss out investing at very low valuations.

Later on, to their utter surprise they find markets already up 30-50% from the lows and individual stocks up by 50-100% in many cases, though still quoting at reasonable valuations.

At this point of time, the feeling of being left out starts creeping in and in order to avoid looking foolish, investors make a promise to themselves that they will invest in stocks in case the market retracts back to lows they witnessed some time back.

End result – Markets usually do not correct back to previous lows, though consolidate or correct marginally and thus an investor again misses out on buying stocks on reasonable valuations.

Mistake 3 – Investing in stocks when markets are at really high valuations with every Ram, Shyam & Ghanshyam discussing stocks

Not investing in stocks when market is at low or reasonable valuations, exposes one to opportunity cost and negative real returns (7-8% FD return against 8-9% inflation) in most of the other asset classes.

However, the biggest mistake an investor makes and which brings about absolute capital loss is when an investor takes a plunge into markets at really high valuations.

After missing out investing in the above two instances, 4-5 years down the line when markets have appreciated enormously, it catches the fancy of every investor on the street. By that time, stocks of good companies have usually appreciated by 5-10 times and even more.

The realization that they missed the bus hits them hard.

By then, the news flow is so good and the economy seems so resilient that investors convince themselves of the infallibility of the economy and the markets. Yes, in order to justify to themselves and cover up their foolishness of buying the stocks at high valuations and missing out when the valuations were low, they support their decision with positives about the economy.

Here again investors make a mistake of extrapolating the uptrend and thus fall in the trap of believing that markets will rise indefinitely.

With the above psychology, they invest in stocks at very high valuations, assuming they will be able to predict and exit at market peak.

End result - Investors get to know about market peak only in hindsight. Also, as per the famous adage, “Market goes up by stairs and comes down by lift”, investors witness value erosion on their respective investments and generate sub-standard returns on their investments for the next 3-4 years.

Since majority of the investors commit the above 3 mistakes, equities get a bad name, though we leave it to you to decide who is at fault.

If you have read this far, you may have already realized that by not buying stocks of good companies that are available at low valuations, you are committing Mistake 1 and thus very likely to commit Mistake 2 and Mistake 3 in the subsequent years. Simply speaking, it would be a loss of 5-7 good years for letting your wealth grow several folds and capital loss if you commit Mistake 3 at the end.

When it comes to investing in stocks, no one is perfect, including the Great Warren Buffett and everyone learns with experience, however one can always accelerate the process by learning from other’s experiences and mistakes. It’s great to learn from your mistakes, but it’s even better when you can learn from the mistakes of others.