The Biggest Investor Mistake: Common Investing Errors to Avoid

Investing might look like an easy way to make money, but the truth is that the market is hard to beat. Many investors make basic investing mistakes that can ultimately lead to losses. In this article we’ll go through the errors investors make most often and think about how to avoid investing mistakes.

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Is investing easy money?

When share prices are rising, the media fills up with stories about how much this or that person made on the stock exchange. First it’s the brokers, analysts and bank staff who get excited — everyone who sells investments. Then the newspapers, websites and TV commentators turn relentlessly upbeat. That’s how a bull market begins.

Good investing moods are contagious and spread from one place to the next. Eventually you reach the point where, at the hairdresser’s, the topic of investing comes up every hour. Even Mr. Mietek, the local handyman, told you yesterday while fixing your curtain rail that it was his last job. He’s giving up odd jobs and becoming an investor as of tomorrow — from now on the only orders he’ll take are stock-market orders. The icing on the cake is the guests invited onto TV and business programmes. They tell you the era of profits has finally arrived, and that from today the market will only go up, and up, and up. Nothing to do but jump in. Emotions in investing reach their peak.

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The recipe for investing success

It’s so simple, after all. Just buy low and sell high. Take PKN Orlen, for example: a workmate of Mr. Marek bought 35 shares in April 2015 for 1,950 PLN. In the summer of 2016 he sold them for 3,990 PLN! And in October 2017 those same shares cost as much as 4,620 PLN! In three years, by October 2020, they’ll probably be worth around 9,000! In reality that was the very bottom of the bear market, and the 35 shares would have been worth 1,645 PLN. Emotions in investing are a bit like a gold rush — the vision of fast, huge profits brings out people’s dark side. They turn into Gollums from The Lord of the Rings.

Just look at the fortune you can make investing! Warren Buffett, George Soros — the richest people are investors. So why not join them?

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Trying to outsmart the market

After a quick browse online, you’ll read that the stock market returns 8–12% a year on average. “But I’m no average Joe! I’ll earn more!” says Mr. Mietek. “Easily 30, 40, 50%! If Mr. Marek’s workmate made almost 100% in 3 years, why couldn’t I? I’m sure I’ll do even better!”

The plan goes like this: I’ll find the shares that earned the most, read up a bit on the trends, the indicators and the chart patterns. Maybe I’ll even buy a book? Something like “Technical Analysis“. Or “Smart Investing the Warren Buffett Way“? In a month I’ll be ready to buy shares. The strategy is simple: buy shares at the bottom, sell shares at the top, and that’s it. It’s so easy — so what could possibly go wrong?

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How accurate are forecasts?

The data collected by Wealthfront leaves no doubt: the market will outsmart the investor. Trying to predict market moves and managing your emotions while investing means most investors make the same mistakes. Here’s how emotions rule us when we invest.

Look at the chart. The blue area is fund flows (whether investors are buying or selling), and the pink line is the annual return of the S&P 500 index (the U.S. stock market). Just after the moment the market peaks, the most people buy into investment funds. When the market falls, investors sell funds en masse.

The data is merciless and shows investors’ complete lack of success. It’s not easy to understand why people keep making the same investing mistakes. Without a doubt, the biggest mistake an investor can make is trying to find the “best” moment to buy or sell. No one can precisely predict which way prices will move.

The professional investors I’ve had the chance to meet all said the same thing: they get market predictions right about 50% of the time. Sometimes they’re right, sometimes wrong. I drew the same conclusions writing my bachelor’s thesis (“The effectiveness of brokerage recommendations”). I don’t know how many training sessions, workshops and talks on investing I’ve attended, but it’s well over 500. At those sessions I heard all sorts of numbers about the presenters’ accuracy, but the one that stuck with me most was when a speaker once said that:

• 20% of his decisions are failures – the market does exactly the opposite of what he predicted;
• 30% are wrong decisions – the market wavers for a while, only to end up behaving differently than he predicted;
• 20% are a waste of time – the market wavers so much that you neither earn nor lose (money, that is – you do lose time);
• 20% are small wins – the market initially moves the way the investor wanted, but to a far smaller degree;
• 10% are wins – the market behaves as expected or better.

I don’t remember exactly who said it, but those were honest, true words that I stand behind. That’s the real accuracy of even the best investors. So why are they the best? Because they know how to avoid investing mistakes and they use investment strategies – including those developed by behavioral finance, which take into account that people are often wrong. But at the same time, when the market rises, they let it earn for them. They cut their losses and let their profits run.

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Emotions in investing intensify during a crisis

Behavioral finance researchers watch with fascination as investors shoot themselves in the foot trying to beat the market, making the worst investing mistakes in the process. The data you can find in academic studies is fairly clear. It shows that investors aren’t always successful.

Let’s go back to the chart once more. Notice that when share prices are high, money usually flows into investment funds. But when prices are low, investors withdraw their money. The message is clear: investors are guided above all by return figures. When they see the percentages are green, they buy, because they want to earn. And when they see the percentages are red, they sell, because they don’t want to lose any more. Behavioral finance discusses this mechanism in great detail.

Investors put in the most money in the first quarter of 2000 – at the very peak of the dot-com bubble! When prices started to fall, investors stopped buying new units. And when prices hit rock bottom (in the fourth quarter of 2002), they began withdrawing en masse. And that’s exactly when prices started rising again. The third quarter of 2008 is even more telling: when most share prices were at record lows (during the financial crisis), investors sold an unprecedented number of fund units.

How to avoid investing mistakes? Treat the stock market like a supermarket

Imagine you walk into a supermarket and see a huge crowd buying the most expensive products. The price of apples has hit a record 10 PLN per kilo. Everyone around you is delighted and buying as many as they can, because the price keeps rising. Caught up in the euphoria, you buy apples too – now at 10.99 PLN per kilo – believing the price will climb even higher. This is a textbook example of buying shares at the top.

A few weeks later the price of apples drops to 2 PLN per kilo. The supermarket is almost empty, and the few customers left are anxious and unsure. You feel huge disappointment watching how drastically the price has fallen. In a panic you sell your apples at 1.60 PLN per kilo to avoid further losses. This is a textbook example of selling shares at the bottom.

Logical? Not really. After all, when shopping in a supermarket we’re alert to the red or yellow price tags that signal a promotion, a sale or a price cut from afar. And that’s when we buy the most: when it’s cheap. When things are expensive, our interest in buying drops; we only buy what we need. So why do we behave completely differently on the stock market – irrationally, even – and buy mainly when it’s expensive?

I suspect the main reason for this behavior is a lack of financial knowledge. If you don’t want to end up among the people who buy high and sell low, spend a little time on your education. You’ve just taken a very good first step: Money? Simple! is a personal finance website with a blog and a Financial Primer that are an invaluable source of financial knowledge. Read regularly and put what you find here into practice, and you’ll soon see the results in every aspect of your personal finances: from better planning, through the smart use of loans, all the way to successful investing.

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Two takeaways instead of a summary

First, emotions lead us to sell at the bottom and buy at the top. Second, when investors try to tame the market, they far more often buy and sell at the worst possible moments. Portfolio management is a foreign concept to them; they’re driven purely by emotion. And emotions are…

Emotions are the investor’s greatest enemy

Emotions cause the biggest investing mistakes. A fair amount of academic research has tried to measure the cost of bad decisions about when to enter or exit an investment. It’s rare for researchers to manage this, but the conclusions are fairly consistent. Investors who hunt for chances to buy shares at the bottom and sell at the top achieve worse results than those who buy and hold for the long term. In behavioral finance this phenomenon is called the behavior gap.

The behavior gap is the difference between the theoretical returns an investor could achieve by investing in long-term passive strategies and the actual returns they achieve in practice – often because of emotional and irrational investment decisions. The gap results from behavioral errors that lead investors to make suboptimal decisions, such as buying shares at the top and selling them at the bottom. Dalbar Associates conducts research on the behavior gap: it can run as high as 5 to 6 percentage points a year over the past 20 years. Other studies have estimated somewhat smaller behavior gaps (e.g. Chen 2016). Even so, researchers agree that “market timing” is extremely costly.

The investor is their own worst enemy: buying high and selling low

When an investor tries to predict the exact moment a “top” or “bottom” will occur, they usually buy or sell at the worst possible time. After all, the investor is human and can’t switch off, with some magic button, the emotions that cause investing mistakes. When pessimism attacks from every side, they eventually give in to it. Likewise, when the media, friends and everyone around talk only about how much money there is to be made right now (and a bull market is on), they slip into an (over)optimistic mood.

The research by behavioral finance scholars goes on. Some try to explain it through a crisis of faith at the worst moment: when the market hits bottom, people break down and stop “kidding themselves”. Others look for the explanation in herd behavior: we feel safe going where everyone else is going. If everyone is buying, instinct says buy. If everyone is selling, instinct says sell (Zahera, Bansal 2018).

The truth, though, lies somewhere in between. People want to earn, so when they see others earning, they buy the same shares. There’s a bit of the FOMO effect (Fear of Missing Out) at work here. By the way – the average person believes they’re better than others, so they have strong faith in their own abilities. When share prices start to fall, this person doesn’t believe the bull market is over. They start telling themselves it’s just a correction and the gains will soon return. But prices no longer rise – at least not for the next few months.

When they lose hope, they resignedly sell their shares and so make investing mistakes. Once all the inexperienced investors have sold all their shares, supply falls. By the law of the market, that’s the moment prices start to rise. And so it turns out the investor bought shares when they were most expensive and sold when they were cheapest. That’s how the investor becomes their own worst enemy.

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The solution? How to avoid investing mistakes

I often hear that the best solution is “don’t invest”. I disagree. That’s like saying the best solution to road accidents is “don’t drive”. I have a different, better one for you: try to build your financial awareness, educate yourself in behavioral finance, and create your own investment strategies. Because every one of us has to invest. Those who don’t lose 2.5% of their wealth every year.

To avoid the biggest investing mistakes, the key is to understand how emotions affect our decisions and to use strategies that minimize their negative effects. Treating the stock market like a supermarket – buying when prices are low and selling when they’re high – is one such approach. When you hear from every direction that there’s money to be made on the market, don’t go in. You’ve missed the moment; it’s too late. Wait until people start selling and prices start falling. Unless you use investment strategies such as cost averaging; in that case you should buy regularly, regardless of bull or bear markets.

Managing an investment portfolio should be based on long-term goals and solid fundamentals, not on short-term market swings. Remember that the best results go to those who can stick to their plan and avoid emotional decisions. That’s how they limit their investing mistakes.

References

• Chen, J.M. (2016). Behavioral Gaps Between Hypothetical Investment Returns and Actual Investor Returns. In: Finance and the Behavioral Prospect. Quantitative Perspectives on Behavioral Economics and Finance. Palgrave Macmillan, Cham.
• Zahera, Syed Aliya, and Rohit Bansal (2018). “Do investors exhibit behavioral biases in investment decision making? A systematic review.” Department of Management Studies, Rajiv Gandhi Institute of Petroleum Technology, India.
• “Quantitative Analysis of Investor Behavior (QAIB).” Dalbar, Inc.