Don't panic and sell when the markets fall or get into the market only when it is on a run. By doing that you defeat yourself.
Mistakes cost investors dearly. Here are three common mistakes explained by renowned investors from across the globe.
Having a short time horizon
Almost a decade ago, James Montier penned Seven Sins of Fund Management, a behavioural critique. One of the observations he makes is with regards to a short time horizon which results in overtrading.
Many investors seem to end up trying to perform on very short time horizons and overtrade as a consequence. Because so many investors end up confusing noise with news, and trying to out-smart each other, they end up with ridiculously short time horizons.
The average holding period for a stock on the New York Stock Exchange is 11 months! Over 11 months your return is just a function of price changes. It has nothing to do with intrinsic value or discounted cash flow. It is just people punting on stocks, speculating not investing.
Recent evidence suggests that the average holding period of mutual fund investors has fallen from over 10 years in the 1950s to around a few years currently.
ADHD (Attention Deficit Hyperactivity Disorder) seems to plague financial markets at all levels. Performance is measured on increasingly short time horizons. Such myopia is often self-fulfilling, the more an investment is checked the more likely you are to find a loss.
The way out
Extend your time horizon. And when trying to assess the validity of an investment thesis or making a buy or sell call, avoid distraction and the noise. If you are likely to be distracted then either wait until later, when you can give the assessment the time and effort it requires.
Investors seem to frame their worlds in terms of stories rather than facts. All too often they are sucked into plausible sounding stories. Indeed, underlying some of the most noted bubbles in history are kernels of truth.
For instance, the story that the internet would alter the way the world did business is probably true, but it doesn't necessarily translate into profits for investors.
Not being mindful of risk
Seth Klarman is one of the world's most astute investors at the helm of one of the largest hedge funds in the world.
He believes that risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty -- such as in the fall of 2008 -- drives securities prices to especially low levels, they often become less risky investments.
The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance.
You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers.
Price is perhaps the single most important criterion in sound investment decision making. Every security or asset is a "buy" at one price, a "hold" at a higher price, and a "sell" at some still higher price. Yet most investors prefer what is performing well to what has recently lagged, often regardless of price.
Letting your emotions get the better of you
Investment guru Howard Marks, in one of his memos, explains to readers why they can invest in the best of companies (or a great mutual fund) and have a bad experience, or invest in the worst and have a good experience.
He believes that most of the risk in investing comes from the behaviour of investors.
Economies rise and fall quite moderately. Companies see their profits fluctuate much more because of operating and financial leverage. But market gyrations make the former look mild.
Why do the prices of stocks rise and fall much more than profits? The answer lies in the dramatic ups and downs in investor psychology.
There are no checks on the swings of investor psychology. Investors get crazily bullish and imagine no limits on prosperity, growth and appreciation. At other times, they get despondent and conclude that the "worst case" scenario they prepared for isn't negative enough.
A too-high price can make something risky. A too-low price can make it safe. Naturally, it's naive to assume that price is the only factor at play. Deterioration of an asset can cause a loss, as can its failure to produce expected profits. But, all other things being equal, the price of an asset is the principal determinant of its riskiness.
The bottom line on this is simple: No asset is so good that it can't be bid up to the point where it's overpriced and thus dangerous. And few assets are so bad that they can't become underpriced and thus safe. Since humans set security prices, it's their behaviour that creates most of the risk in investing.
Even if you are not a stock picker but invest in funds, you would do well to heed his advice. Don't panic and sell when the markets fall or get into the market only when it is on a run. By doing that you defeat yourself.
When investor Jean Marie Eveillard was asked to describe the characteristics of a good analyst at a presentation, his response was "the capacity to suffer". Money manager Thomas Russo picked it up and popularised it.
A smart investor must have the ability to suffer though periods of bad performance. If your fund manager is sticking to his investment style, there would be periods when his portfolio is terribly out of favour relative to the forces that are driving the market at the time. You will be able to stay the course if you have the ability to suffer. You can do that if you invest for the long haul and have a strong thesis as to why you have invested in that fund in the first place.
Don't lose focus.
Photograph: L'oeil étranger/Creative Commons