1. Thinking that Stocks are a Better Investment Because the Market has Recovered
“Risk is always relative to the price paid.” – Seth Klarman
Stocks are no less risky because the S&P 500 has recovered from its lows. The stock market’s past performance is in no way indicative of the risk of investing in it.
When determining the risk of an investment, investors need to understand its underlying value. The difference between price and value determine an investment’s risk. This difference is also known as the margin of safety of an investment.
If a stock’s price is lower than its value, it has a margin of safety thereby lowering its risk. For comparison, a stock whose price is higher than its value has no margin of safety and is therefore higher risk.
2. Investing Without a Compass
Many investors buy stocks without knowing the underlying value of the security they’re investing in.
It’s dangerous because they’re not “investing”. They’re speculating. They might as well put their money on black and hope the roulette gods will be kind to them.
Speculators risk buying overvalued stocks and selling undervalued stocks. It’s a recipe for financial disaster.
The solution is investing with a compass.
They can do this by either learning how to do valuations (Resource) or use a tool like ours (Shameless Plug). It’s the only realistic way to buy low and sell high, and grow your money.
3. Being Impatient
“Investing is where you find a few great companies and then sit on your ass.” – Charlie Munger
It’s a rite of passage for every investor, and we’re sure many professionals make this same mistake: They pay attention to the day-to-day fluctuations of the market.
This often causes investors to be impatient and sell too early. This could be after the stock has dropped 5% or it’s suddenly run up 15% over the course of a week. Seasoned investors ignore these fluctuations and are patient.
Patience in investing has two ingredients: 1. Discipline; and 2. Understanding the Intrinsic Value of Stocks.
When you’re able to combine those two, it’s easier to ignore the day-to-day fluctuations and focus on the long-term horizon.
For a detailed look at the benefits of buy and hold, see this extensive PDF from Legg Mason Capital Management (Link).
4. Valuing Wall St.’s Opinion
The press usually treats the words of Wall Street analysts as the words of God, reporting each day which firms have upgraded or downgraded particular stocks.
This often causes individual investors to pay attention to Wall Street’s opinion. However, this can be detrimental to their financial health.
First, over 60% of active fund managers underperform the market (SPIVA). That’s 60% of active fund managers who are at risk of being replaced by an S&P 500 ETF.
Second, the opinions of Wall Street analysts can often be contrarian indicators.
Since March 2009, analysts’ favourite stocks have underperformed the market. Whereas, stocks they liked least outperformed the market by 88%. (Bloomberg)
Lastly, analysts have their firms’ interest at heart, not yours. Their recommendations are often driven by business relationships between their employer and the target company (Harvard Faculty Research).
5. Trying to Time the Market
“We have a lot of fun as the bubble blows up, and we all think we are going to get out five minutes before midnight [like Cinderella], but there are no clocks on the wall.”
– Warren Buffett
The idea that investors can time the market is certainly seductive. We’ve all tried it at least once, but because “there are no clocks on the wall,” it’s virtually impossible to do with any level of precision.
The only variant that works is being, “fearful when others are greedy and greedy when others are fearful.” (Warren Buffett)
When everyone’s shouting, “This time it’s different,” and acting like the world as we know it is going to end, that’s probably a good time to start buying.
When authors start writing books about the Dow Jones going to the moon, that’s probably time to start selling.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.