Investing in the stock market isn’t always easy. When emotions cloud your judgment, poor investment decisions often follow. Even with my background, I’ve fallen victim to common investment pitfalls. It’s all part of being human! Here are five frequent traps to look out for:
1. The illusion of knowledge
I remember a client—an experienced investor—who asked me to invest in a stock that had reached a low point in its usual price range. He said, “I’ve been watching this stock for two years and since it’s currently at an all-time low, this is a sure bet.” His confidence surprised me, and I had to remind him that if investing in the stock market was that easy, we’d all be rich!
Then there was another client who followed my recommendations and obtained 40% returns within a single year. That was in 1999, when exceptional returns were fairly common. This strong start made the client feel invincible. Sure that his winning streak would never end, he started making choices that seemed smart to him, but risky to me. His bubble burst when the market experienced a dramatic correction the following year.
It’s easy to fall into the illusion of knowledge trap when the markets are strong, when you’ve had a certain degree of success or when you’ve been watching the market for a long time.
There’s a lot I could say on this subject, but the key takeaway is that you can never know enough. The stock market is a little like learning grammar—there’s an exception to every rule! In other words, the only guarantee is that there are no guarantees.
2. Unfounded optimism
Sorry folks, but optimism isn’t an investment strategy! While it’s true that the stock market is driven by a certain amount of faith, it’s important to be wary of unrealistic expectations. If you’re holding on to a stock that took a serious hit several years ago and has never recovered, it’s probably unlikely that it will rebound and become the next Apple. When a share falls, it falls for a reason.
Rumours can also be dangerous. How often do I hear clients say, “My brother-in-law has a friend whose cousin knows the president of a promising startup. Even Barack Obama is investing in it.” And just like that, the client is convinced that this investment is a surefire winner. Buyer beware: it’s probably nothing more than an illusion.
3. Emulating your neighbour
Everyone wants to keep up with the Joneses. You know, the neighbour whose luck knows no bounds. The girl who always picks the right stocks. At least, that’s what she says. But remember that few people are vocal about the times they lost big on the stock market, and your neighbour is no exception. The next time she boasts about her incredible track record, take it with a grain of salt.
The problem with listening to your neighbour is that you can find yourself wanting to achieve the same results, even if it means exposing yourself to risks that you’re not comfortable with.
4. Falling in love with an investment
A share is not a person, so please refrain from falling in love. Sound laughable? Let me tell you a story. I had a client who held Bombardier shares for more than 25 years. Back in the 1990s, anyone and everyone who invested in Bombardier made money. The company was doing great and many people became temporary millionaires on its back.
But everything changed in 2001. After peaking at $26, the company’s share price started to fall, lower and lower. I repeatedly advised my client to let go of her Bombardier shares, which no longer matched her investor profile. For a long time, she clung to the hope that the spark would be rekindled, but eventually sold them. And then, just a day later, she asked me to buy them back. “I’m sorry,” she said, “but I’m just not ready to divorce Bombardier.”
Love is blind, even when it comes to stocks. It can prevent you from seeing if a company is weathering a little cold or has an incurable disease.
5. The fear of regret
Sometimes you buy a stock with a clear intention to sell it once it hits a certain price. But when that day comes, you choke. What if the price continues to climb and you miss out on the gains?
Holding onto the stock puts you at risk of falling in love with it. Even if it falls, you may find yourself optimistically waiting for it to bounce back.
Selling a stock that is performing well is very hard to do. You have to accept that you might miss out on its peak price. But once its value takes a tumble, you’ll be glad you let it go.
When it comes to investing, your overall strategy is more important than the specific assets you buy. Make sure you’ve got a sound strategy and that you stick to it, no matter how the markets behave. For example, let’s suppose your strategy calls for the following asset mix: 60% equity 40% fixed income (the secure portion of your portfolio)
If the stock market does well, you may be tempted to chase better returns by increasing your equity investments to 75% for a one-year term. But if a market correction occurs during the next 12 months, you’ll end up bitterly regretting your decision.
No matter what strategy you choose, you have to be comfortable with it and willing to see it through. There’s no magic rule in the stock market.
By sticking to your strategy, you’ll avoid the above-mentioned pitfalls and come out ahead over the long term.