Pitfalls You Should Avoid While Investing
The S&P 500 was created in 1957 and before that was the S&P 90 created in 1926 and the annualized return for the S&P over that entire time period has been about 10.08% (using 2013 as the last year). In the world of investing a 10% return per year is pretty good. It has been said there are only two ways to beat the market. The first way is to have superior information that the market and the second way is to get lucky.
There is the Strong Form Efficient Market Hypothesis which states that stocks always trade at their fair value on stock exchanges which makes it impossible for an investor to purchase an undervalued stock or sell stocks for inflated prices. The strong form theory assumes the only way to beat the market is by purchasing investments that are riskier than the market. This theory is up for debate however because Warren Buffett has beaten the market consistently and theories such as sector rotation, market timing, and technical analysis (where you invest based on stock chart patterns) exist.
The second form of EMH is the semi-strong form efficiency which implies that all public information is calculated into a stock’s price so fundamental or technical analysis cannot be used to achieve superior gains.
The final form of the EMH is the weak-form which implies that the market is efficient reflecting all market information. The hypothesis here is that the rates of return on the market should be independent of past returns. Past returns have no impact on future returns. This theory basically states that technical analysis and historical analysis will not earn excess returns.
What does all this mean? It means that it is really hard to beat the market. If the market is actually weak form efficient then historical and technical analysis will not get you a better return than the market. Certain types of fundamental analysis for a weak-from market is the only type of analysis that will earn you a better than market return. Strong form suggests that the market is omniscient and the only way to beat it is by taking on more risk. The EMH is up for debate but from my education tests indicate that the stock market is somewhere between semi strong and strong form efficiency.
Remember a market is any place that there is a supply and demand for anything. Even you are a market your friends for instance can demand you to be two places at once.
Now that you know how smart the stock market is..
-Market Timing – When do you normally hear about a great investment? It’s usually from your friend who has already a significant return or the media when it says how well an asset class has been doing. Usually by the time it has been reported the people who invested are ready to sell for a quick gain. Sometimes however the asset class could appreciate for years. Look at the dotcom boom that started in 1997. If you invested in 1997 and sold before late 1999 you could have gotten a great return. However if you invested in late 1999 then you were really late to the party and there wasn’t much room left to run. Not only do you have to decide when the right time to buy is but you also have to decide when the right time to sale is. As a rule of thumb I once read that when you lose 8% on an investment then it is definitely time to sale.
Emotion – This relates to greed, what drives up the market, and fear, what causes selling in the market. Giving into greed or fear is emotionally satisfying. The human brain is incapable of creating new information, it doesn’t know what it doesn’t know. To compensate for the lack of information our brains attempt to piece together the best possible story based on what we do know. So when we are right about choosing the right time to buy or sale we think we are smart and when we are wrong we blame it on a lack of information.
The hot sector and valuations – there are some sectors that get really hot like dot com bubble in 2000 or the housing bubble in 2007. The hot sector combined with the market timing can lead to a complete disaster for your investment. When buying a stock for a long term investment you need to think about the valuation of the stock. The returns you get are a product of the difference between your entry and exit evaluation whether your valuation is based on earnings, cash flow, sales, book value, etc. Warren Buffett is so good at investing because he has mastered the concept of buying a company for really cheap where he sees growth for that company and then selling it really high.
Investing is not a business – this couldn’t be further from the truth! Investing is a business you are spending your hard earned cash on purchasing part ownership of a company. You need to understand if a company is being managed properly, if a company is over or under valued, if the industry a company is in is growing or declining, etc. There are financial ratios to help you quickly evaluate a company.
Hopefully knowing these four pitfalls will help you become a better investor. It’s up to you to decide how to invest your money and become rich. Remember there are only two ways to beat the market by either having more information or just being lucky. A study was done by Farma and French using a bootstrapping technique where they created thousands of portfolios by selecting stocks at random. The bootstrap portfolios were compared with that of mutual fund returns and the statistical overlay was very close which meant that most fund returns were a result of random stock selection and not skill.
About Shaun Archer Tatum Shaun works in corporate finance in New York City. He has done financial consulting for several start-ups and has worked at several Fortune 500 companies. He has contributed several finance/investing articles on Seeking Alpha which have been published on Yahoo! Finance.