Investing always carries an element of risk. But even the smartest investors can greatly reduce their exposure to unnecessary losses by avoiding some of the most common investment mistakes.
They're not difficult to understand nor are they hard to fix. But it is crucial that investors be aware of these issues right now -- before they end up costing them dearly.
After all, there is enough risk in the market. As investors, the last thing we need to do is introduce more by making one of these avoidable errors.
1. Raise cash when you need it the least
The most common mistake smart investors tend to make is to run out of cash at the wrong time.
As investors, we've been made to believe that to maximize our returns we need to have every penny of our portfolio actively working for us. If we're not fully invested, we equate that with being inefficient or overly cautious.
It's easy to find an investment professional who will sell you on just about anything -- stocks, bonds, real estate, gold, structured products and annuities. But you won't find many who talk about the advantages of cash. It's probably because they don't make a commission on cash.
Gold performed well during the recent market downturn. But guess what? So did cash. I made money on my cash. I increased my cash position near the top of the market in 2007. Was I a genius? No. I've just been riding in this rodeo a long time.
Cash allowed me to sleep through the night. It also allowed me to pick up bargains at the bottom of the market without having to sell off my other positions at a loss.
Cash is not the enemy. It is your friend. And the time to think about cash is when things are going well -- not after the bottom falls out. The better things get, the more you want to be thinking about cash.
2. Stop protecting your downside risk by limiting your upside potential
Mark Twain once said, 'The cat, having sat upon a hot stove lid, will not sit upon a hot stove lid again. But he won't sit upon a cold stove lid, either.'
Almost everyone who was in the market in the last five years got burned. The silver lining is that if we didn't know what our tolerance for risk was, we do now.
But this revelation jarred some investors. They withdrew from the market. And unfortunately, they missed out on much of the recovery.
If you got burned, it doesn't mean you have to stay away from the stove. You just have to develop ways to measure your tolerance for heat and the temperature of the stove. I didn't make big changes in my investments. I did, however, make a change in how I manage those investments.
Just because I was more sensitive to risk than I thought I was, I didn't move all of my money into bonds or CDs (although I do own both). I did, however, start using more tools to protect my gains and limit my losses on riskier assets.
For instance, I bought shares of Olin Corporation (NYSE: OLN) for $12.92 a share for my Stock of the Month portfolio. At the time, about two-thirds of Olin's revenue came from chemicals, making it a very volatile holding. But the remaining third of Olin's revenue was coming from ammunition sales. At the time, ammunition was in tight supply -- most stores resorted to rationing just to keep a small inventory on the shelves.
I was down 11.4% on OLN in July of 2009 and set a stop loss to protect against a potential 17% loss. The stock rebounded and I reset my stop loss to protect a 20% gain. As the stock continued to climb, I continued to bump up my stop.
I was finally stopped out of my Olin position at $19.62 per share in May 2010. Including dividends, I had a total return of 58.0%.
Even though you might be more sensitive to risk than you once thought, you don't have to sacrifice upside potential. Learn to manage the risks involved in riskier assets with simple tools offered by almost every brokerage service.
3. Don't invest in what you know best
Peter Lynch became a superstar managing Fidelity Investment's Magellan Fund. From 1977 to 1990, the fund returned an average of 29.2% annually under his watch. One of his famous investment principles was to 'invest in what you know.' But this can lead to another common, but costly, error.
Research has concluded that investing in what you know best isn't such a great idea.
A recent study looked at 10 years of stock transaction data, comparing it with investors' jobs. The expectation was that individuals' investments in the industries they worked in should outperform the market. After all, they had better access to information and could better understand the significance of that information.
But that's not what the data showed.
Instead, all of the study's estimates showed that in cases where investors put money into stocks within their own industries, they underperformed the market.
It's hard to be objective about our own area of expertise. A software developer may get really pumped up about a new application he or she is working on. But maybe a competitor has a better product waiting in the wings. Or even if the new application is successful, the rest of the company's product line might be under pressure.
Sometimes even knowing your company is trumping the competition isn't enough. Industries are cyclical, and even the top dog can languish on a down cycle.
The last thing you want to do is invest solely in what you know or where you work. As a worst-case example, many Enron employees had all of their investment eggs in the energy company's basket when the company went bankrupt in 2001.
Be sure to know everything you can about any investment before you make it, even if it's in the company you work for.
The Investing Answer: In my Stock of the Month newsletter, I spend all month researching a single opportunity that I believe will outperform the market.
But that's not all I do. I also make sure I have an appropriate cash balance in my portfolio. I use trading tools to manage my riskiest assets. And I try to be especially skeptical of the industries I know well.
This way, I never spend a sleepless night worrying about an investment.
