Most investors could dramatically improve their returns by eliminating five common mistakes from their portfolio management toolboxes. One of these common mistakes is so deadly it could wipe you out, while the others can cost you big time.
The most dangerous mistake you can make is betting everything on one investment. This is akin to putting all of your chips on one number at roulette. You might win big but the odds are much greater that you will lose everything. A look at market history should convince an investor that no security is immune. Total loss is not limited to small stocks. Blue chips that appear invulnerable one day can disappear the next. Remember what happened in recent years to Enron, WorldCom, and Countrywide Financial. Investors were nearly wiped out by Bear Stearns. A thousand bucks invested in Citibank a year ago was recently worth only $409. By diversifying as widely as possible you can reduce the risk of loss due to a decline in one security or one market sector.
If your grocer put your favorite cereal on a two-for-one sale, you’d stock up, right? Conversely, you would buy only a box at a time if the price was at a premium level. It stands to reason that any investor would jump at the chance to pump money into the stock market when it is down. The more it is down from recent highs, the more eager they should be to buy. Yet the average investor often holds back when the market is falling, afraid to commit more money just to see prices fall further. The problem with that strategy is that no one can accurately predict the market’s bottom: it often turns up at a point when the news is blackest and investors aren’t convinced that a turnaround has begun. They will continue to hold money back and then miss out on the best part of the recovery.
Conversely, wouldn’t it be better to hold back a little on investing when stocks are expensive? Yet this is not what many investors do: they get swept up in a mania to make money in the stock market well after it has soared. The famous cover of Money magazine in the late 1990s that said “Everyone is getting rich but me!” exemplifies the mindset that sends investors chasing returns that are no longer available.
Fourth, “hanging onto losers” is another common mistake. This applies to an individual stock or security that has fallen sharply from its high. Many investors hang on, reasoning that they “want to see it come back” before selling it. Unfortunately, a past price is not a good predictor of a future price: just because a stock hit $60 a share last year and has fallen since does not mean it ever has to hit $60 again. Again, consider Countrywide or Bear Stearns. Neither recovered to their former highs. They kept falling until the companies were merged into other companies at extremely low prices.
Finally, investors should avoid letting their portfolio drift too far from its target allocation. Instead, they should set a portfolio mix appropriate to their needs and risk propensities and stick with it. When the markets push it out of whack, they should rebalance by selling investments that have gone up and buying those that have dropped, an exercise that forces them to buy low and sell high.