Knowing how to be an awful investor can help you become a great one.
Are you one of those people frustrated with your inability to beat the stock market? Despite watching Bloomberg TV and Working Lunch religiously, and reading the Financial Times every day, you just can't seem to make it happen. Here are five ways I think that investors shoot themselves in the foot.
1. Do little or no research before buying a share
Would you trust a stranger to take care of your kids or drive your car? Then why would you entrust your portfolio, your hard-earned money, to the hands of management teams and businesses that you hardly know?
If you want to make blind bets, head to the local bookie. You'll find you can lose money just as quickly there than you can in front of your computer. While you're at it, you could do a little research on bookmaking companies, and you'll see that they always make big profits, even if the share prices of William Hill (LSE: WMH) and Ladbrokes (LSE: LAD) have been hammered in this recession.
Remember, every time you buy shares in a company, there's someone on the other side of the trade. Consider these other people the "house." If they know more than you about the shares, you're at a disadvantage.
2. Buy shares based on tips and rumours
In my life, I've gotten two tips that could be construed as insider information, which I declined to act on. Both tips were of the "I have a friend, who knows a guy, whose cousin..." variety. Anyways, I checked out the shares about a year after hearing the tips, and both had plummeted.
3. Be an envious investor
Warren Buffett's sidekick Charlie Munger often states that the worst of the seven deadly sins is envy, because other sins, like lust or gluttony, provide the sinner with pleasure. Envy, on the other hand, has no pleasurable aspect whatsoever.
I blame envy for a lot of things. I think envious investors bid shares like Arm Holdings (LSE: ARM) and BT Group (LSE: BT-A) up to amazing heights during the tech boom, and Marks & Spencer (LSE: MKS) to nearly 750p a share two years ago. I also think envy causes the average investor to get swept up into bull markets and decimated in the subsequent crash.
4. Invest with low conviction
Doing a lot of research doesn't help much if you don't stick around to reap the benefits. I think investing without conviction is like marrying someone you just met a week ago. After the initial honeymoon phase, failure awaits after the first set of speed bumps.
When investing in shares, I can almost guarantee you won't catch the bottom. There are just too many random factors involved in the collective buying and selling activities of millions of people around the globe.
In fact, I think investing without conviction almost guarantees failure. Let's say you were smart enough to figure out that Autonomy (LSE: AU) was a bargain back in early 2004, and bought in the 300p range. The shares had cratered more than 85% from their 2001 peak, so investors could reasonably think that was the bottom of the barrel.
Unfortunately, everyone who invested in Autonomy's shares in 2004 would've seen their investment fall around 40% over the next year. They'd also have to wait over 18 months just to get back to break even. Many investors would not have the conviction to ride out this storm, and would have bailed out at a loss. However, those with conviction who held on would be sitting on a 3-baggers, with the shares currently trading at around 1,200p per share.
5. Fail to separate price from value
Oddly enough, we have no problem distinguishing between price and value at the shopping centre. We don't say, this Gucci handbag is worth £1,000. We say, wow, that handbag costs £1,000. What a rip-off. At the shopping centre, we know that the price people want us to pay, and the value we receive, can be two very different things.
The same rules apply to the stock market. For most companies, share prices move around a lot more than intrinsic value. Sometimes the two move together, sometimes they don't -- but they're two very different things.
The investor who fails to discriminate between price and value fares no better than the tone-deaf contestant in Britain's Got Talent. Both lack vital ingredients for success.
Final thoughts
So there are a couple of examples of what not to do. If you eliminate as many bad investing habits as possible, you might just turn into a great investor.
More on the economy and the markets:
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> A version of this article was originally published on Fool.com. It has been updated by Bruce Jackson, who does not have an interest in any of the companies mentioned in this article.
