Almost every investor is kind of familiar with the general rules for investing wisely and building wealth.
But when it comes to putting things into practice, a lot of people inadvertently make common investing mistakes that seriously undermine their goals and take them off track.
A sound investing strategy is key in supporting your life goals and your financial wellbeing. Being a successful market participant over the years is easy, but not simple.
In fact, while lots of great investors, authors, and financial planners have laid down the strategies (some of them incredibly simple and almost effortless) to generate long-term wealth, many investors don’t plan, don’t research, and generally allow their emotions to take control when making investing decisions.
This article wants to give you evidence on why people lose money on the stock market by making common (and avoidable) mistakes and how you can plan your investment strategy in order to protect yourself from poor returns, making things work for you.
Stock Market Performance vs. Individual Investor Performance
Let’s start with a really sad fact: the majority of investors lose money on the stock market. And they do that consistently over the long run.
It’s almost surprising that so many investors end up with such poor outcomes despite all the efforts in financial education and all the information freely available out there.
Although the stock market is a great long-term wealth-generating machine, many investors actually have really poor returns or even lose money through investing.
The J.P. Morgan guide to markets, a quarterly publication that contains a lot of interesting information on markets and the economy, provides an idea of how big that phenomenon is:
Over a period of 20 years on financial markets, the average annualized performance of the individual investors has been 2.5% compared to the 6.1% of the S&P 500.
In other words, the average investor made only one third of the returns offered by the market, slightly above inflation.
That should give you the first hint on the fact that behaviors matter more than the market in generating returns.
In this case (and in many other cases), buying a low-cost index fund and doing absolutely nothing would have paid roughly three times more.
Although it might sound overly simple now that we are looking at the data, the “doing nothing” part is actually one of the most important and most difficult to stick with.
As financial markets behave the way they are supposed to behave, that is with dynamic prices that move up and down, investors repeatedly make the same investing mistakes over and over again. Let’s take a closer look.
Why People Lose Money in the Stock Market
Even if investing in financial markets over the long-term is an excellent journey to wealth, the path is dotted with volatility and prices can move significantly over short periods of time.
Not only they can, but they also will.
That’s actually one of the reasons why we have a market that matches supply and demand among its participants.
Volatility is natural and recurring, therefore experiencing occasional losses along the way as stock prices move up and down is just the rule.
While in this article we are going to cover a large number of pitfalls and common investing mistakes that result in poor performance, we can safely say that the number one reason why investors lose money on the stock market has to do with the behavior and the poor ability to manage one’s emotions.
People lose money in the markets because they let their emotions, mainly fear and greed, drive their investing decisions.
Think about that.
Most of the time investors are their worst enemy. Despite the theory says that investors behave rationally to maximize their outcomes, a quick look at empirical evidence suggests that the opposite is true: in the real world, we are all subject to emotions and irrational behavior.
Couple that with the unceasing flow of (dis)information about daily news, stock prices movements, things that can go wrong and thousands of warning bells, and what you get is something similar to an investing behavior that is perfectly described by this illustration by Carl Richards:
While many people have great intelligence, when it comes to investing it is not rare to repeatedly make dumb decisions due to emotions.
The emotional part is natural. You naturally tend to feel disappointed when you see the value of your positions going down and the gut instinct is screaming “Hey! You must do something now!”.
The same is true when the market goes up, except that this time the feeling is one of euphoria that suggest from inside “I can’t miss that!”.
Well, 99% of the time “doing something now” is the worst thing at the worst time possible and typically leads to investing mistakes that slash the legs of your portfolio and make it impossible to grow in the years to come.
The way you deal with the ups and downs of the market is the major driver of investing results.
The real good news here is that you have 100% control over that and there’s no need for any kind of particular set of circumstances for you to be a successful investor.
Recognize this and you are light years ahead.
Bad Investing Behavior That Holds You Back
There is a number of psychological traps and misconceptions, well described by studies of behavioral finance, that lead to bad investing behavior.
I think you would agree with me that
If You Always Do What You’ve Always Done, You Always Get What You’ve Always Gotten
That sounds straightforward. However, many investors are often blind to their own bad habits.
The first thing to overcome bad habits is being able to see them and shed some light on the risks and mistakes that they may bring about.
As we saw, bad behavior can lead to repeatedly and consistently buying and selling at the wrong time, which can prevent investors from reaching their full financial potential.
To frame that differently, you are riskier than the stock market!
Investing success is a direct function of the decisions you make along the way. Despite the financial market (broadly speaking) being the same for everyone, different investors have astoundingly different results.
The other side of the coin is that you matter more that the stock market!
At the end of the day, your behavior can have a greater impact on your portfolio’s performance than the market itself.
The overall portfolio return over the long-term will not be determined just by the average returns of your holdings, it will also depend on the investment decisions and their timing over the years.
Here are the most common pitfalls and investing mistakes that can lead to poor investing decisions. If you know them, you can train yourself to avoid them and you can pinpoint the important things to keep in mind during your investing journey in order to make the most out of it.
Avoid These Common Investing Mistakes
1. Not Having an Investment Goal
While many investors hold a vague idea in their mind about what they want as financial results, it is shocking how the majority haven’t defined exactly what the result is and consequently have no plan to actually achieve it.
Setting a clearly defined investing goal represents the intersection between your life and your finances.
Take some time to quietly think about it because it’s where everything starts.
Investing is extremely personal and must be tailored to your needs, your attitude, your income, your age, your time horizon, and your risk tolerance.
The reason why having a strong goal is a necessity is simple: without a clear understanding of the “why” behind your investments, it’s hard to develop that disciplined approach that will ultimately lead to success.
I guess that a lot of people dream about a nice retirement, a dream home, their financial freedom, or sending their kids to college without debt.
The problem is that if those things don’t become a written and defined goal, chances are that they will only remain a wish.
By setting a goal you take control.
Having a goal allows investors to be 100 times more clear about what to do and not to do, especially during tough volatile markets.
Defining a clear goal allows you to shape your behavior accordingly so that your thinking and your actions are in line with what you want to achieve.
2. Failing to Plan Your Investment Strategy
Have you ever heard that “a goal without a plan is simply a wish” or “failing to plan is planning to fail”?
Both are right because once you know “what”, to make it a reality one has to figure out “how”.
Figuring out the right investing strategy that suits you as a person is the second step that will actually transform your goal into reality.
A lot of investors simply don’t plan or adopt a set of rules to follow. This results into buying and selling without any knowledge of the investments, mainly depending on their mood or what is hot at the moment.
It is no surprise that this behavior will ultimately lead to poor performance and will not create anything relevant over the long-term.
To make this very clear:
Things don’t happen by chance and investing is not about buying and hoping.
Your investment strategy is a set of behaviors and actions that, if followed, will produce the result and through time will keep you away from doing the thousands of little wrong moves that undermine your achievements.
For example, if your goal is for the long-term, your thinking and actions must be for the long-term, which implies things like not being overly concerned about market volatility, having patience, and develop consistency.
By focusing on your long-term goals and defining an investment strategy you may find it easier to look beyond the short-term volatility without exposing yourself to a much bigger risk than a stock market crash, the only risk that you should care about: not reaching your goal.
Investing (and money in general) is a part of your financial life. Before even bothering about the right investing vehicles, the whole plan should start from your income, from knowing where your money goes, from saving and the consistent allocation of a percentage of your money to investments.
What percentage? It’s up to you depending on your goal, your situation, your commitment and your life plans.
3. Ignoring Your Risk Tolerance
This is something that is often overlooked but at the end of the day is what causes capitulation during market downturns.
If you get on the stock market, it’s guaranteed that you will experience volatility and adverse market movements. This is intrinsic in how the financial markets work and there is nothing to do about it.
If you read the definition or risk tolerance on Investopedia, you find this:
“Personal risk tolerance is the amount of risk that an investor is comfortable taking or the degree of uncertainty that an investor is able to handle”
It is a huge component in investing and it’s important to have an idea of your degree of risk tolerance because underestimating your ability to stomach large ups and downs can have serious impacts on your ability to sleep well at night and consequently on your investing decisions.
If you take on too much risk, it’s very likely to end up panicking and selling at the wrong time.
4. Getting Emotional
Letting your emotions guide your investing decisions is a surefire path to failure and the number one mistake among investors.
Today financial markets are accessible almost to anyone and even in a world of free information the performance of a lot of investors is so poor. Why?
I think it all comes down to the behavior.
Price fluctuations on financial markets are part of the game, however, for many people, it is natural to experience some degree of disappointment when you see the value of your portfolio going down as well as rising enthusiasm as the market goes up.
This is a real cycle of emotions that makes your gut instinct say “you must do something now!”.
Unfortunately, 99% of the time that feeling is really bad investing advice.
On one side of the scale, there is fear and on the other side there is greed, you should never let any of them overtake you.
Instead, focus on the bigger picture and just realize that markets may deviate wildly over short periods of time but over the long-term, they will offer nice returns.
If you rule your emotions, not only you will survive better during periods of high volatility, you might benefit from the irrational decisions of other investors.
5. Forgetting Your Time Horizon
There is a joke that says that “everyone is a long-term investor until the next market crash“.
The time horizon is closely related to the investment goal and it’s a fundamental variable in the definition of the investment strategy.
Once you understand your horizon, you can find investments that match that profile.
Think about the time horizons as the period where investments are held until they are needed.
In general, the longer the time horizon, the more aggressive an investor can be in his portfolio and the longer the power of compounding has to work.
If you are investing for your retirement 30 years from now, what the stock market does this year or next shouldn’t be your biggest concern.
6. Lack of Portfolio Diversification and Rebalancing
Diversification is actually a mantra in the world of investments and there are good reasons for that.
Long story short: diversification allows you to reduce the overall risk of the portfolio and makes it possible to reach a higher return with a lower level of risk.
Having a portfolio made up of investments in different asset classes protects you against volatility and extreme price movements in any single investment.
That’s because when one asset class is underperforming, another asset class may be performing better.
In this way it is possible to achieve a higher return for every unit of risk. It makes a lot of sense because having all your investments in a single stock can be too risky.
While some kind of investors may be able to beat the market and generate alpha returns, or excess returns compared to the marked (measured with a benchmark, like the S&P 500), it takes a lot of work and results are highly uncertain.
The vast majority of investors, unless they are committed to spending a lot of time doing the analysis and taking up higher risks anyway, should not even try to do that and would be better off with diversified ETFs or index funds.
Don’t take my word for it. If you read The Little Book of Common Sense Investing by John Bogle, a book that every individual must read before approaching financial markets, it will be clear to you how simple, effortless and successful that approach could be if you just stick with it.
Warren Buffett, “the Oracle of Omaha”, everyone’s legend and one of the greatest long-term investors out there clearly stated that unless you are willing to think like a business owner and do the analysis, you will have major benefits by investing in board market low-cost index funds.
He believes so much in the advantages of index funds that he’s instructed the trustee of his estate to invest in index funds in the shareholders’ letter of 2013: “My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund”.
I would say that diversification is a must implement factor for everyone that doesn’t devote his entire time (and maybe life) to analyze individual companies.
Diversification, however, is not something that you set once and forget about it. Unless you are committed to staying 100% into a single asset class whatever happens, effective diversification over the years is done by periodically rebalancing the portfolio to your target asset allocation defined in your investment plan.
Rebalancing might be difficult because it brings you to sell a portion of the assets that are performing well and buy more of the ones that are underperforming.
Although it might be difficult, this allows you to systematically buy low and sell high and prevents you from ending up with a portfolio that is overweighted in some asset classes when the market peaks and underweighted in other asset classes during market lows.
The main takeaway here is to rebalance religiously and reap the long-term rewards.
7. Trying to Time the Market
Timing the market is a strategy that rarely works for the individual investor. Buying and selling with the idea of benefit from the ups and downs and the good days on the market can be detrimental to your success.
When you try to time the market, instead of gradually building wealth over a lifetime you engage in trading for instant gratification.
By the way, when you do that, you are no longer an investor, you are a speculator.
Nothing wrong with being a speculator, speculation is important because it makes the market liquid, however, is a totally different job, a riskier one, and it’s simply not the way ordinary people with a job and other life interests create wealth.
Successfully timing the market is extremely difficult to do, highly uncertain and even institutional investors often fail. If not even professionals succeed, why do you think you will be able to do better? That’s an interesting question.
If you are willing to speculate and think you can do better, just remember that you are competing with supercomputers and billion dollars firms engaged in the same activity.
Instead, if you are looking to reach long-term investment goals, just remember that most of a portfolio return comes from the asset allocation, not from market timing.
8. Lack of Patience and Too Much Investment Turnover
By not being patient, you increase the chance of messing things up.
We are all different in our ability to be patient and today we are getting used to having everything with fast delivery. When it comes to investing, however, for companies to grow and increase their earnings and dividends it takes time.
In order to be patient in the markets, one has to learn to manage his own emotions in different market scenarios.
That’s where having a strong and clear goal helps because you are able to connect your actions to the end result that is probably some years in the future.
Keeping realistic expectations about the time and growth that your portfolio can provide and sticking to your strategy will enable you to reap the long-term benefits.
Expecting your portfolio to do something other than what it is designed to do is a recipe for disaster.
If you jump in and out of positions, a high portfolio turnover results in banking losses and missing opportunities, higher transaction costs, and taxes, things that literally eat away your returns and reduce the long-term gains of a good investment discipline.
9. Following the Herd and Chasing the Winners
Another common mistake among investors of all ages is the tendency to chase the best performers while dumping the other part of their portfolio.
This is a typical example of following the heard. If out of control, it will lead to paying too much for stocks that already appreciated and might be on the verge of turning around.
Many investors select asset classes, strategies, and funds based on a current strong performance. The fear of missing out is often a big driver of bad investment decisions.
Chasing the winners and doing what “the heard” is doing can easily result in buying high and selling low. Also, by selling today’s losers you are depriving yourself of tomorrow winners.
If you think for a moment, it makes no sense. If a particular asset class, strategy, or fund has done extremely well for three or four years, the only thing you know for sure is that you should have invested back then.
Past performance tells you nothing about what’s going to come next. That’s also what you see on the prospect of every financial instrument, believe it!
Remember the chart of the investor emotions? If you always run behind what’s hot at the moment you increase your risk of disappointment.
What led to a particular stock or sector’s “recent amazing performance” may be nearing its end. It happens again and again that as the “smart money” is moving out, the “dumb money” pours in. And once it happens, the dumb money gets burned and people soon look for a newer fad to get into.
Don’t be part of the so-called “dumb money” that ends to buy and sell securities at the worst possible time. If you must do something wild, set aside some fun money that you are fully prepared to lose.
10. Listening to Financial Noise and Getting Stuck with Information Overload
Some decades ago, the problem was to access information. In today’s world, one of the issues for savvy investors is to get rid of useless information. And most of the financial information is just that to a real investor: useless.
The ability to filter out everything that is not useful to make a good decision is a game-changer. Most of the stuff is just noise.
Take financial media. They are in the business of attention, their goal is not to provide you useful information for your investment.
They get a lot of attention by selling fear and concerns, while what you are interested in if you are investing for decades is the long-term ability of the economy and companies to do well, that is exactly what generally happens.
There is virtually nothing on financial news that can help you achieve your investing goals.
That’s “financial entertainment”. The risk here is that if you focus on the attention-grabbing headlines you might end up acting based on how you feel today instead of how you planned (or should have planned) to act in order to reach your investment goal.
During an interview in 1985, when asked if he didn’t find Omaha a little bit off the beaten track for the investment world (far away from Wall Street), Warren Buffett replied that he was getting all the facts needed to make decisions.
“I like the lack of stimulation. We get facts, not stimulation here. If I were on Wall Street, I’d probably be a lot poorer. You get overstimulated on Wall Street. And you hear lots of things. And you may shorten your focus and a short focus is not conducive to long profits.”
Are you getting useful information or dangerous overstimulation?
You might want to spend less time reading and watching financial news and spend more time on reading books, doing research, and work on your investment plan or just spend more time enjoying your life!
11. Not Doing The Research and Not Understanding The Investment
Earlier in this article we talked about the long-term investing advantages owning broad markets low-cost index funds.
Despite progressively and consistently buying shares of index funds and just holding them is an almost certain strategy to create wealths, buying individual stocks can add up to your portfolio of investments.
While I honestly think that buying shares on individual companies is more rewarding at a personal level than just buying the ETF, what matters the most here is that you really need to know that you are owning.
Buying what you don’t understand is another pitfall of investors that go out to buy individual companies but don’t actually know what they are buying and why.
Not only. Many people don’t even bother reading company reports or studying the business of the company.
For some strange reason, when people have to buy a new TV or new car they perform hours of research, but when it comes to buying a stock it’s already a lot if they read the company profile.
If you want to buy shares in a company you have to think like the business owner. You’ve got to know what you own!
To say that with Peter Lynch words:
If you can’t explain to a 10-year-old in two minutes or less why you own a stock, you shouldn’t own it.
Investing in individual companies requires being really honest and transparent about yourself, your level of knowledge, and your commitment to do a lot of research.
12. Overlooking Investment Fees and Taxes
If there is one thing that kills the magic of compound interest that’s compounding commissions.
Every single percentage point of commission that you pay matters, and over time the differences are huge.
Many people don’t even know how much they are paying for their investment activity, some people even believe that they pay no fees on their accounts.
Every single cent of commission reduces your returns. The same applies to taxes.
That’s one of the reasons why buying low-cost index funds and holding them for the long-term is a really effective strategy: you pay little commissions and if you don’t get dividends you don’t even pay taxes until you sell. Meanwhile, you get to benefit from the returns offered by the market.
If you hold a mutual fund that charges you 2% yearly commission to manage your capital, it would have to generate additional 2% of return above the market return just to cover its costs.
The idea of active management is that with skills and experience, a fund manager can consistently outperform the market.
Mutual funds as a whole can’t beat the market because they are the market, and those who beat it one year have really little chance of doing that consistently, and you as a person have an even smaller chance of selecting the successful ones.
There is no room for assumptions here, data speak clearly.
Furthermore, institutional have a lot of constraints that you as a single investor don’t have, and remember that they need to make money to survive, therefore your investing interests might not be in the very first place.
As for taxes, those depend on the country you live in.
If you have the ability to access tax-deferred accounts in your country, you should definitely check if they are a viable strategy for you because taxes, like cost, compound over time, and the ability to pay less will make a huge difference over time.
In conclusion, taking part in financial markets in order to create wealth over the long-term is simple but not easy.
We covered a lot of common investing mistakes that may prevent you from reaching your investing goals. Now that you know them, you are better equipped to avoid them.
If you have to remember only one thing from this long article remember this:
Your behavior matters much more than the stock market for investment returns.
Investing is 90% about the mindset and the ability to manage one’s emotions.
One of the things that I’m enjoying the most on my investing journey is that investing teaches you a lot about yourself.
The way to be a successful investor is no secret.
Lots of valuable books talk about that from different angles and, although they might present different strategies to reach the results, they all agree on the fact that you’ve got to know where you are going and you’ve got to know what you are doing.
Many people don’t know what they are doing, and that’s why they fail as investors.
Mistakes are part of the investing process, if you know what they are, you can limit them or avoid the biggest risk of all: not reaching your goals.
The ability to focus on the long-term is a luxury that many professionals simply don’t have.
Financial markets will always be volatile and volatility will always challenge us emotionally. The best way to manage our emotions is through knowledge and by developing a thoughtful and systematic plan and stick with it.
At the end, it’s all about developing good habits.