6 Investment Mistakes To Avoid In A Frothy Market

Sep. 13, 2020 9:39 PM ETAAPL, AMZN, BRK.A, BRK.B, CRM, CRWD, DOCU, ETSY, FSLY, JD, NFLX, NVDA, QQQ, SHOP, SPY, SQ, TDOC, TSLA, TWLO, ZM, SHOP:CA219 Comments

Summary

  • The market has been particularly volatile in 2020, making it treacherous for all types of investors.
  • The pandemic has created tailwinds and headwinds across all industries, and analysts of all kinds are insisting a crash is upon us every day.
  • In this context, it can be extremely difficult to know what to do, keep your emotions in check, and avoid common investing pitfalls.
  • That's why today, I want to cover six investment mistakes to avoid, particularly in a frothy market like the current one.
  • You may have made some or all of these mistakes in the recent months, without realizing it.
  • Looking for a portfolio of ideas like this one? Members of App Economy Portfolio get exclusive access to our model portfolio. Get started today »

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Great investing is not simply about selecting the right investment ideas. The main factor in the success of your investing journey is about avoiding common behavioral mistakes that we all make at one point or another in our lives.

Morgan Housel just released his book The Psychology Of Money, in which I particularly enjoyed a quote that borrows from Napoleon and his definition of a military genius:

"A good definition of an investing genius is the man or woman who can do the average thing when all those around them are going crazy."

The average investor has underperformed almost all investable asset class returns over time, as illustrated below by the data from Richard Bernstein Advisors.

Why is the Average InvestorSource

The main cause behind this is behavior and temperament. Most investors are hardwired to get in the way of their portfolio's success over time.

The S&P 500 (SPY) and the Nasdaq (QQQ) both fell around 30% earlier this year before rebounding to new highs in a record time. The volatile time we are all going through since the beginning of the COVID-19 pandemic has a particularly pernicious effect on investor behavior. Volatility has its ways to compel the most counter-intuitive decisions when it comes to portfolio management.

Today, I want to discuss six common investment mistakes you are most likely to make (or have already made) in a frothy market like this year.

Let's review!

1) Trading too much

Great long-term investing is 1% buying, 99% waiting. But most investors feel that they're lazy if they don't tinker with their portfolio regularly one way or another.

A disciplined investor should look beyond the short-term concerns and focus on the long-term growth potential of the market. Looking at the performance of the MSCI World Index in the past 50 years can help gain some perspective. One dollar invested in 1970 would have grown to $68 by 2018. And the journey to get there was filled with financial crisis, wars, terrorist attacks and bear markets of all kinds. None of these disasters have changed the fact that the best course of action over the years was to remain invested through thick and thin and to stay the course.

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Despite history telling us that trading in and out of stocks is a weapon of alpha destruction, some investors can't help themselves.

Attempting market timing is the favorite pastime of many unsophisticated investors. Anyone who has been exposed to enough financial literature understands that it's a hazardous hobby, and one that can eat away at your long-term returns very fast. In concept, it's easy to sell stocks when they have gone up a lot. But when do you get back in? What if they go higher for months and you have most of your assets in cash? At what point do you admit you were wrong and get back in? You'll find many commentators bragging online, claiming they have sold their stocks "at the top." But how many times have they been wrong before they were right? What are their annual returns over a lifetime of investing? Over the very long term, stocks are going to appreciate and follow GDP growth. If you are out of the market long enough, you are virtually guaranteed to lose.

The futility of timing the stock market is illustrated by the fact that its best and worst days happen close together. Those who claimed they have avoided the worst days will omit that they missed the best ones as well.

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Investment turnover is another symptom that is similar. Many investors can't help but cash in on their gains as soon as a stock is up 20%, 50% or 100%. They might buy back the shares at the same price or higher several months later when they realize their mistake. But the damage has already been done if they are trading in a taxable account. Or worse, they refuse to invest again in great companies they have previously sold at lower prices and leave a long-term compounder such as Amazon (AMZN), Netflix (NFLX), or Salesforce (CRM) out of their portfolio forever.

We are constantly surrounded by market forecasts and financial news that push heavily a narrative that suggests you should tinker with your portfolio. According to most sell side analysts, a stock can turn from "overvalued" to "undervalued" or the other way around just based on a 10% move or one piece of news.

If you spend too much time listening to talking heads on CNBC or reading the perma-bears on Seeking Alpha predicting that a crash is upon us every other week, you will think the world is constantly about to collapse. And I'm not just talking about these past few weeks. The so-called market pundits that are warning you about the next stock market crash today are often the same ones who were telling you to sell stocks in March 2020, when the S&P 500 was trading below $2,500. It's essential to look at the past articles of any author you read and see for yourself who you are dealing with.

As explained in my article about 5 Ways To Prepare for The Next Stock Market Crash, recognizing how often market crashes happen can give you a better idea of what you are getting into and the risks you are taking when investing in equities. Here is the historical frequency of pullbacks identified since 1928:

Market drawdown Historical Frequency
10% Every 11 months
15% Every 24 months
20% Every four years
30% Every decade
40% Every few decades
50% 2-3 times per century

According to a research note from Bank of America Securities, the average time for the market to get back to where it was after a drawdown of 20% or more is 4.4 years. This is why most advisors recommend investing in equities only if you intend to hold your investment for the next five years. Even assuming you have terrible timing and invest right before a bear market, you will still have a good chance to be back in the green after five years.

We are surrounded by first level thinkers who are in the business of pushing a narrative as soon as the market moves by a few points. For some analysts, the concept of reversion to the mean is engraved so deeply in their brains that, for them, any performance that appears even remotely extraordinary is bound to normalize soon.

Not only is it not particularly insightful, it is also misguiding if you focus on investing for the long term and narrowing your portfolio allocation to the very best performers the market has to offer.

The problem with the way most analysts provide market commentary is that they seem to imply that you should be 100% in cash or 100% in equities every time the market moves by 10% or 20%. Not only is such a strategy not practical or sustainable, it's a total waste of time. They really have no insights on where stocks may trade in the short term, just like anybody else. Tuning out the noise can be a great way to avoid common investing pitfalls.

2) Relying on your emotions

Many biases are at play when we make an investment decision. I've covered previously the common behavioral biases that can adversely affect your temperament, and I've offered strategies to counter them.

Relying on your emotions is a common investment mistake in a volatile market. And unless you are willing to identify it and address it, chances are your emotions will eventually get in the way. We are influenced by our own fear and greed, often better described as fear of joining in or fear of missing out (another topic I've covered more in depth here).

This brings me to one of my favorite ways to identify when your emotions are getting the best of you. If your decision to buy or sell cannot wait for a few days, you are likely making an emotional decision.

A great long-term investment decision should not require perfect timing. Unless you are in the business of day trading, you should always be able to "sleep on it" and let a day go by before you pull the trigger on your investment decision. Great investment decisions are not made in a rush. They should not be made over a concern that something material could happen within hours or minutes. If bad news comes out and a stock you own is down 50%, you don't have to sell that day either, even if your bullish thesis is broken. You might want to digest the news and make sure you grasp the ins and outs of a new situation. In investing and beyond, before making a strategic decision, you are always better off sleeping on it. If your intentions are intact after a good night's sleep, your decision is more likely to be sensible and grounded as opposed to a knee-jerk reaction.

Journaling is another way to alleviate any investment decision that is simply based on emotions. As someone managing an investment marketplace, I've seen a lot of members come to me and tell me that they had sold a position because they "felt" like there wasn't much upside to a stock. In investing, the less your feelings are involved the better off you are.

Using a systematic investment strategy can be a powerful tool. This can take the form of safeguards such as a maximum amount added to an individual stock (diversification over several positions) or a limit on the funds you can invest in a single month (diversification over time).

3) Chasing returns

Performance chasing refers to selling a poorly performing investment to buy one that has recently delivered strong returns.

Chasing returns is the practice of taking excessive risk by selling what you own in order to concentrate heavily your portfolio into what everyone else is buying.

Many companies have more than doubled so far in 2020. That includes the likes of Zoom Video (ZM), Tesla (TSLA), Fastly (FSLY), DocuSign (DOCU) CrowdStrike (CRWD), Etsy (ETSY), Shopify (SHOP), Twilio (TWLO), Teladoc Health (TDOC), Square (SQ), JD.com (JD), or Nvidia (NVDA).

I'm an investor in almost all of these companies and they're likely to do very well over the years. But that doesn't mean you should suddenly sell all your under-performing holdings and blindly replace them by the top performers of the market at any given time.

ChartData by YCharts

We've learned from legendary investor Peter Lynch that “Selling your winners and holding your losers is like cutting the flowers and watering the weeds.” Assuming you have already internalized this lesson, it might be tempting to sell all your portfolio positions in the red to add to the ones in the green. If anything, that's the right way to think about portfolio management.

While selling your losers and adding to your winners over time is a sound long-term investment strategy, any kind of portfolio re-balancing requires a lot of nuance and precaution. Switching your money from big losers to whatever is "hot" can lead to selling low and buying high. There is nothing wrong with re-allocating some of your portfolio from losing to winning positions, but it must be done with extreme vigilance. If you do so in the middle of a very volatile market, your long-term returns could be permanently damaged. Re-balancing is another form of market timing after all.

If you are properly diversified, there will always be a portion of your portfolio that underperforms the market. And that's okay. It should be natural to have a portion of your portfolio that you temporarily hate. If you are properly diversified, chances are that you will hate different parts of your portfolio over the years.

Stocks don't go up in a straight line. And it's not uncommon to see a stock go nowhere for more than three years before it generates outstanding returns. If you need an example, look at the chart of Tesla in the past five years.

ChartData by YCharts

And the same way it wouldn't have been wise to sell Tesla before 2020 just because the stock was performing poorly, it would be a mistake today to triple down or quadruple down on TSLA just because it has performed well.

Chasing returns is essentially making large portfolio re-allocations solely based on recent stock movement. If you are a momentum or swing trader with intentionally short holding periods, it may work. But if you are investing for the long term, chasing returns will likely adversely impact your overall performance over the years, with very sub-optimal entry points.

What compels investors to chase returns is usually their lack of patience. As Charlie Munger explained:

"It's waiting that helps you as an investor, and a lot of people just can't stand to wait. If you didn't get the deferred-gratification gene, you've got to work very hard to overcome that."

So before you re-balance your portfolio, generating tax gains and losses, or before you throw in the towel on what may become a great missed opportunity, you want to ask yourself if you've truly given enough time for your bullish thesis to materialize. Unless my bullish thesis is broken, I personally don't sell until I've held a position for at least five years since my last purchase. It's an effective safeguard to avoid selling my existing investments in order to chase the latest and brightest stocks every single month.

It's perfectly fine to buy some of the hottest stocks on the market if you truly see the long-term potential. But you don't have to do it with your entire portfolio.

4) Staying all in cash

When the market is volatile, it can feel much safer to watch it from the sidelines. And that's generally a mistake.

Cash itself is a depreciating asset, but it's also an essential tool to buy other assets. Finding the right balance of cash in an investment portfolio can be a challenge, particularly for those who are not generating new income or savings to add to their investment portfolio. Warren Buffett has been known for keeping a huge cash allocation in his portfolio at Berkshire Hathaway (BRK.A) (BRK.B). At the end of Q2, Berkshire had $147 billion in cash. But that cash allocation that so many point out to as excessive represents less than 40% of its equity portfolio. And Warren is in the insurance business, which requires large cash allocations for unforeseen events. If you have more than 50% of your liquid assets in cash, you are likely permanently damaging your long-term returns.

If you are a new investor, waiting too long to start is one of the most crucial mistakes a young investor can make. Albert Einstein famously called compound interest the eighth wonder of the world. Thomas Phelps, author of the book 100 to 1 in the Stock Market has provided valuable lessons to better understand the power of compounding.

A 100-bagger is a stock that returns 100 times your initial investment. That means a $10,000 investment would turn into $1 million. You wouldn't need to find a lot of investments like this to achieve your investing goals. If you ever hope to have a 100-bagger in your portfolio, you might wonder how long it would take to get there. The higher the compound annual growth rate, the fewer number of years you would need to get there. It's simple math. Phelps has a table in his book that lists the annual returns and how many years it would take before you get a 100-bagger:

If you hold a stock that is compounding at 20% annually for 25 years, you returned 100 times your money. But if you hold it for 10 years, you only returned 5 times your money. Every year you are not invested, you are missing out on the benefit of the most powerful tool you have on your hands: time.

Most individuals don't have the luxury to have capital available to invest. But if you are lucky enough to be in a position to allocate capital to the markets, not investing enough when you have the resources is one of the most damaging decisions you can make.

Staying in cash gives the illusion of control and security, but only for a moment. In fact, your cash position is losing to inflation every year. It's simply another form of market timing. Make no mistake, if you ever find yourself tempted to "raise cash" by selling a lot of your best-performing positions during a market rally, all you are doing is another form of panic-selling. You are effectively actively trying to time the market.

Only with the discipline of staying invested through thick and thin will you truly benefit from the power of compounding over the years. If you get in the way of your portfolio and try to stay in cash to outsmart the market and wait for the next market crash, chances are you are doing a lot more damage to your long-term returns than if you were sticking to a long-term focused investment plan, with a mix of both good and bad times eventually moving your portfolio onward and upward.

5) Concentrating too much in risky bets

Seeking alpha is a noble cause (and a great name for a crowd-sourced content service for financial markets), but that doesn't mean you should be actively trying to beat the market.

Beating the market should be a result of your investing habits, not a goal.

If you invest thinking the market averages are not enough, you are likely to go over-board and heavily concentrate into risky investments.

There is always room for risky companies in a portfolio. But your appetite for market-beating returns should never overshadow the importance of position sizing and proper portfolio allocation based on your risk profile.

Failing to diversify is far more common than a failure to concentrate. I wrote about this extensively in my previous article about The Delicate Art Of Balancing Diversification And Concentration.

The size of an investment should be proportional to your probability of success. An educated investment decision should be like a game of Texas Hold'em poker where you would be able to see everyone's cards and make your decision accordingly before seeing the flop, the turn and the river unfold. You must recognize when you have a good hand with odds in your favor. As explained by Annie Duke in her book Thinking In Bets:

"What makes a decision great is not that it has a great outcome. A great decision is the result of a good process, and that process must include an attempt to accurately represent our own state of knowledge. That state of knowledge, in turn, is some variation of "I’m not sure."

While it makes sense for Warren Buffett to let Apple (AAPL) represent more than half of its portfolio at Berkshire Hathaway over time, a small biotech that has less than 50% chance of receiving an FDA approval should not represent a significant part of your portfolio.

I've covered before the idea that you should invest like a VC and let your portfolio concentrate for you. Your portfolio concentration should be the result of its sheer performance over time, not your intimate conviction.

6) Not understanding what you're doing

As explained by Adam Smith in The Money Game:

"If you don't know who you are, [the stock market] is an expensive place to find out."

Having a clear strategy is probably the most essential aspect of investing, in both bull and bear markets. If you haven't spent the time to think about your goals, time horizon, risk appetite and understanding what you are trying to achieve, you probably need a little bit of soul-searching.

Understanding why you invest is the very first step, one that comes before learning how you want to invest or in what specific opportunities.

Most of your core financial decisions should be automated, organized around safeguards and clear boundaries. Trying to simply replicate what other investors are doing can lead to terrible decisions if you don't have a clear understanding of where their strategy fits in your life.

If you have gone through all the steps required to build an investment strategy with the safeguards that protect your portfolio from yourself, you won't be able to get in the way of your own success. That's usually when good things can start happening.

When the market is volatile like it has been since March, it's easy to get overwhelmed. That's why you need something to hold on to that guides you through uncertainty. It can be a mentor, other investors you follow and respect, or simply reviewing the notes you have written down in a moment you were calm and collected.

Your next question should not be "should I buy this stock now?" Instead, you should ask yourself if you have built a system that makes room for mistakes, unforeseen failures, or simply bad luck. When the tide turns, you'll be prepared to face the consequences and will be far more likely to stay in the game. Investing should be a rewarding and enjoyable journey, not a source of stress and sleepless nights.

Hierarchy Of Financial Needs Pyramid, HD Png Download - kindpng

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  • Have you made any of these common mistakes in the past few months?
  • What advice would you give to investors who are trading too much, chasing returns, and staying all in cash?
  • Would you add any other pitfalls you wish you had learned earlier in your investing journey?
  • Fill in the blank: "If I could go back in time, I would tell my younger self ____________."

Let me know in the comments!

If you are looking for a portfolio of actionable ideas like this one, please consider joining the App Economy Portfolio. Start your free trial today!

The rise of the App Economy is disrupting many industries: retail, entertainment, financials, media, social platforms, healthcare, enterprise software and more.

This article was written by

App Economy Insights profile picture
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My name is Bertrand Seguin. I'm a former PwC consultant and veteran financial executive in the video game industry. I've spent 12 years at Bandai Namco Entertainment, leading the Financial Planning and Analysis team in the transition to Digital, Mobile, and Game-as-a-Service. I hold a Master of Science in Management and Finance.

My portfolio is built to disproportionately benefit from the rise of the app economy, the range of economic activity surrounding mobile applications. My investment plan and asset allocation are a result of secular trends I have identified (macro) and in which I take individual bets (micro). I invest with a very long time horizon (ideally 10+ years).

I am fortunate enough to have seen my strategy deliver outstanding results throughout the years.


Discipline and consistency win the game over time. Unfortunately, many investors violate their own model or strategy when their portfolio performance is temporarily disappointing. I would rather sell too late than too early, so I tend to never sell. I let my winners compound to a significant portion of my portfolio and let my losers become insignificant over time.



Disclaimer:

All App Economy Insights contributions to Seeking Alpha, or elsewhere on the web, are personal opinions only and do not constitute investment advice. All articles, blog posts, comments, emails, and chatroom contributions by App Economy Insights - even those including the word "recommendation" - should never be construed as official business recommendations or advice. In an effort to maintain full transparency, related positions will be disclosed at the end of each article to the maximum extent practicable. The premium service App Economy Portfolio is a research and opinion subscription. I am not registered as an investment adviser. The majority of trades are reported live, but this cannot be guaranteed due to technical constraints. Investors should always do their own due diligence and fact-check all research prior to making any investment decisions. Liability of all investment decisions reside with the individual investor.


Disclosure: I am/we are long AAPL AMZN CRM CRWD ETSY FSLY JD NFLX SHOP SQ TDOC TWLO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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