INVESTING EDUCATIONAL02/10/2020

Common mistakes made by investors: how to avoid them

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Common mistakes made by investors: how to avoid themCommon mistakes made by investors: how to avoid themCommon mistakes made by investors: how to avoid them

The success of a financial investment depends on making more right choices for your portfolio than wrong ones. It's important to define a well-structured and planned investment strategy.

IN A FEW WORDS

Neglecting your investments Performance expectations Risk capacity v. risk appetite


4 min reading

Some ot the most common mistakes made by investors:

  • Neglecting your investments
  • Focusing too much on short-term results
  • Changing investments often (or never)
  • Buying products you don't understand
  • Investing based on suggestions and rumours
  • Buying at a high price
  • Selling at a low price
  • Not knowing your actual risk tolerance
  • Lack of effective diversification
  • Basing decisions on past results
  • Having unrealistic performance expectations
  • Lack of strategy

In finance just as in any other area, right choices are made and wrong decisions are taken. The success of investments depends on the prevalence of the former over the latter. By knowing the most common mistakes of investors, you can avoid doing the things that diminish the performance of your portfolio.

Avoid excesses

Neglecting your investments is a first bad habit that involves an undervalued risk: investing is serious since it concerns your savings and the planning of your future pension.

At the same time, you should not focus too much on short-term results. If you have a medium/long-term objective it's good to keep an eye on your investments, but you should avoid focusing only on the short term. If you make portfolio decisions based on a momentary change of mind, you risk making sub-optimal choices that often lead to losses that keep you from achieving your goals.

The solution is to buy and hold investments for the appropriate amount of time so that your portfolio choices can pay off. Too frequent buying and selling can significantly reduce returns due to transaction costs, but it's also wrong to insist on never making changes to your portfolio mix even when your assets have changed because of the markets or personal situations.

Emotional ups and downs

For this reason it's advisable to carefully check what your maximum bearable loss is (in absolute value) based on your assets, and make the necessary adjustments in your investment components to respect the correct risk/return ratio. This is not an easy exercise, as financial information can often be contradictory, causing excessive reactions from investors in one direction or another.

It is precisely these "emotional" responses that constitute one of the most frequent and dangerous mistakes made by investors. A good investment is buying low and selling high. Too bad that, in practice, the exact opposite often happens: many investors buy at the highs, tempted by the idea of an easy profit, and then rush to liquidate positions on the lows, in a panic.

One solution is to base the mix of your financial portfolio on a precise long-term expected risk/return ratio, bearing in mind that in considering the past performance or characteristics of a product or management it is essential to resist the natural tendency to dwell only on the positive aspects.

Avoiding the fashions of the moment

Many investment products can be particularly complex, especially when they have underlying leverage mechanisms or derivatives: the recommendation is to only invest in products that you understand. Similarly, it is often wrong to act on suggestions and rumours: if you get information (for example from friends or acquaintances) it is likely that it has already been discounted from the market price.

In any case, it's a mistake to make decisions on individual financial instruments without taking the entire portfolio into consideration. The risk of the portfolio as a whole is more easily managed, focusing on a good diversification that combines with the right dose of risk based on one's objectives and needs. In fact, portfolios are often poorly diversified, with risks of being too concentrated in individual securities, sectors or markets. Other times there is a lack of further diversification, which can be achieved through the implementation of different investment strategies.

Psychological impact and risk appetite

However, it should always be borne in mind that there is no risk-free investment. Determining your risk appetite means measuring the potential impact of a loss, both on your portfolio and psychologically. Risk perception and risk appetite are in fact very subjective and are influenced by multiple factors, some of the most important being socio-demographic characteristics (gender, age, level of education, family status, etc.) and some personal traits of the investor (optimism, confidence in their ability to make good investment choices, etc.). Moreover, risk appetite can increase after making a profit, or become more conservative after suffering a loss. Bear in mind, however, that the emotional reaction to a loss is systematically stronger than the reaction to a gain of the same amount.

Risk capacity v. risk appetite

An incorrect but widespread approach is to think that if a financial instrument has performed well in the past it is likely to continue to do so in the future. In reality, financial markets are unpredictable and active management does not always perform better than the market average. It is therefore necessary to invest in the main asset classes (equities, bonds, commodities, currencies, real estate, liquidity and alternative instruments) according to one's financial objectives, tolerance and appetite for financial risk.

Unfortunately, investors often expect returns that are inconsistent with their investments. Based on data collected by Schroders's Global Investor Study 2019, investors expect an average return of 10.7% per year over the next five years, and one in six even expects a return of at least 20% per year overall for their investment portfolio. Those who consider themselves experienced/advanced have higher return expectations (12.2%) than novice/inexperienced investors (8.2%).

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