Investors make mistakes every day. If they didn't we'd all be as rich as Warren Buffett and we're not.
Here's a list of six such mistakes:
- Follow hot tips. As a blogger on AOL's BloggingStocks, I know that some of the most popular posts are the ones that repeat what Jim Cramer said on his TV show five minutes before the post appears on the blog. The reason these posts are so popular is because lots of people are Cramer Ditto Heads (CDHs). He tells them what to do and they do it. While some use Cramer as a starting point for further research, many are too willing to be led and are not inclined to do their own research.
- Don't know how to research fundamentals. One of the reasons people don't do their own research is because they don't know how. Specifically, one kind of research many people don't know how to do is understanding how a company -- whose stock someone wants to buy -- fits within its industry. Many people would not know how to begin answering fundamental questions such as: Is the industry profitable? Why? How is that profitability likely to evolve? What is the company's market share? If it's a leader, can it sustain that leadership? If it's behind can it catch up? What kind of cash flow does the business generate? How much cash flow is it likely to sustain in the future? Does the market recognize these future cash flows in its price?
- Don't know how to analyze technicals. Many times fundamentals have nothing to do with how a stock performs. For example, in December 2003, Martha Stewart Omnimedia Inc. (NYSE: MSO) stock started going up from $9 when its Home & Garden Television (HGTV) show was taken off the air to $36 in February 2005 when Martha Stewart got out of jail. During that time the company saw its revenues shrink 20% a year and its losses skyrocket. The reason the stock went up is a mystery. But I thought people who were loyal Martha Stewart Ditto Heads (MSDHs) bought MSO as a show of support. Many investors do not know how to analyze money flows that would provide clues to what is driving a stock up or down. This can cause them to buy when they should be selling, or sell when they should be buying.
- Don't set stop losses. Many investors buy a stock and assume that they must own it for years because Warren Buffett is a buy-and-hold investor or for some other reason. This despite the fact that sometimes when a stock goes below the price at which an investor purchased it, it will never return to that initial price. Since nobody can predict where a stock will go, it makes sense to set a stop loss, at a price that is 2% or 5% below the price that the investor bought in. While such as stop loss can certainly stop investors from gaining if the stock recovers, it will definitely keep them from losing more than the stop loss percentage once the stock has been sold.
- Don't set target sell prices. Similarly, many investors hold on to their gains too long because they keep hoping that the stock will go higher. This reminds me of the phrase that bulls make money and bears make money, but pigs get slaughtered. While it is hard to let go of a stock that has made money, it is definitely profitable. The biggest challenge is overcoming the emotional barrier associated with giving up on the possible lost opportunity of making even more money by holding on.
- Ignore reality due to confirmation bias. Confirmation bias is a decision-maker's tendency to embrace information consistent with his or her expectations and to reject inconsistent information. Confirmation bias is quite common among investors. In mid-September 2001, I commented in a newspaper that an unprofitable fiber optic network carrier, Williams Communications Group, was likely to go bankrupt. This prompted an e-mail from a holder of the stock suggesting that I take my family on an airplane and hoping that the plane would crash. When I e-mailed this person the evidence on which I based my conclusion, he replied -- sans apology -- that my argument was compelling. His initial response was evidence of confirmation bias and his second response showed he was capable of rational thought -- and extremely impolite.
Do you agree or disagree? What investment mistakes have I missed?
Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in the securities mentioned in this post.
