August 27, 2008

10 Mistakes Every Investor Makes & How To Avoid Them Part 1

By IdeaMan21

Welcome back! Great to See You Again!

Throughout my years of investing I have had the opportunity to be a part of many different experiences – some good and some bad. What I have learned by being trained and working with investors in all different markets is that the discipline to follow the fundamental rules to investing can make or break someone’s bank account.

While even amateur investors know these basic rules to investing, it is much easier said than done. Maybe this is because most investors have a competitive edge, and we think we can out-perform or outsmart the next guy. But the bottom line is it is pretty tough to outsmart the market.

Investing is a zero sum game. For every winner there is a loser, which is what keeps the market efficient. Knowing this, it is possible to develop an edge in order to win more than you lose. This is why some of the best trading systems make people so much money. These systems have found a way to analyze trading opportunities and automate the process so you can get in and out of trades quickly and profitably.

However, many investors and professional traders still manage to end up in the red. These investors are unsuccessful because they let emotions get in the way, are too stubborn to be successful, or they think they know something other people don’t. They can literally have their trading system screaming at them to get in or out of a trade, and yet they ignore all the signs.

What these losers fail to realize is that the market is irrational because it is driven by emotion and institutional houses throwing their weight around. For that reason, it is nearly impossible to predict short-term directions and win every time. If you avoid the common mistakes that every investor makes, you can develop an edge and build an unlimited amount of wealth.

Nothing in this article should come as a surprise. These are basic investing mistakes that every investor should avoid. But for those who like to make money, sticking to the basics may not be an easy task. It involves leaving your ego behind, some planning and sticking to the rules or trading system you have in place.

Mistake #1 – Playing Without Rules

No matter what you invest in you must create and stick to personal investing rules. It doesn’t matter if you invest in real estate, currency, stocks or options, before you begin you must create strict strategic rules that you will hold yourself accountable to.

The rules should provide a checklist for the investor when considering opportunities. By creating strict criteria, it places limitations on the investor and takes the emotion out of the decision. There could be multiple opportunities that the investor finds that he knows will create great returns if Action A happened followed by Action B, but gambling simply does not fit into his rules for investing. Therefore, he would pass on such an opportunity.

Secondly, these rules provide a clear exit strategy with deadlines. The investor knows going in that he can potentially make a certain amount of money, say $20,000, but more importantly he also knows the potential that he can lose by not selling the opportunity in a certain amount of time. By having a backup plan, and a backup plan for that plan, the investor minimizes the downside and eliminates the need to make an important decision that is influenced by emotion or hope.

Mistake #2 – Ignoring Taxes and Fees

Investors often get excited about the potential income an investment can make and forget to consider fees and tax implications that can diminish their profits. When trading stocks, for example, a single stock purchase can cost you $10 or more, even with a low-cost, online brokerage account. If you are buying 10 shares of a $10 stock, that value of the stock will have to increase 10% before you can break even.

Add capital gains tax you now owe on the appreciation of this asset, and you have actually lost money on your prudent stock purchase. How much you are paying in taxes depends on the type of investment and how long you hold the asset. MoneyChimp.com has a free Capital Gains Tax calculator. Click Here to See It.

Mistake #3 – Confusing Investing with Trading

People who are not investors often think investors are the high strung, fast-paced people in the New York Stock Exchange pits, or those that stare at stock charts all day long to catch a quick profit. These people are not investors. They are day traders who play markets for a living.

Investors are much different. They are interested in the certainty the stock market returns as a means to produce wealth, as opposed to the possible income it can produce. For that reason they are less concerned with the day-to-day activity in the market and are not depending on how the day goes in order to produce immediate income.

They know that over time the stock market has historically trended up and they take advantage of the slow and steady profits the market will return. With those profits, they reinvest their earnings in order to take advantage of compound interest and accelerate their net worth.

Mistake #4 – Letting the Media Influence Decisions

The stock market is partially driven by emotion. Many investors would say in the short-term the market is entirely driven by investor psychology. People hear a stock tip about an upcoming earnings report, and they race to get in before everyone else does. An earnings report disappoints Wall Street and the stock drops 10% in after-hours trading, which keeps investors up all night in a panic and they immediately sell first thing in the morning.

While psychology ends up being the primary driver for decisions for individual investors, the assets you buy should not be an emotional decision. This is why it is imperative for investors to create a strategy with specific rules that they can stick to. However, the media loves to drive this emotion. There are television stations dedicated to the up-to-the-minute movements in the market, rumors and other current events. This coverage keeps viewers glued to the television, which drives advertising revenue.

The media may provide relevant information to the short-term day trader who is trying to capitalize on investor psychology, but for the most part very little should cause a long term investor to act today. Therefore, to avoid letting the news influence your investing decision, ignore media influence as much as possible, remind yourself why you purchased the equity in the first place and ask if those same reasons still exist.

Mistake #5 – Taking Too Much Risk

Losing money is the only thing keeping investors from creating wealth. Sounds obvious, but many investors don’t pay attention to this mistake. As Warren Buffet so eloquently put, “The first rule of investing is don’t lose money. The second rule is don’t forget rule number one.” When you lose money, it takes twice as much money just to get back to break even. For example, if an equity loses 50% in value it will require a 100% increase just to get back to break even.

When you take substantial risks, it’s not unusual for your asset to decrease 50% in value, but gaining 100% is far more unusual. While the dividends and earnings from your winning stocks can be reinvested in order to take advantage of compound interest, your losers also compound and quickly eat away any gains you achieve in other investments.

This is the end of Part 1. I will post Part 2 and the Other 5 Mistakes tomorrow.

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