Why we do the things we do: A look at the reasoning behind common investor mistakes
Most of us have made an investment mistake of one type or another.
While you canít avoid all investment errors, you can learn from those youíve made ó and benefit from that knowledge.
One of the most common and costly mistakes involves hanging on to a losing stock or investment. Psychologically, it hurts to recognize youíve lost some of the money you invested. But thereís a cost as well to hope against hope the loser will become a winner. You could be better off selling the losing stock and putting the proceeds into an alternative investment that appears likely to have better returns.
While a lot of investors donít want to realize a paper loss, some do the exact opposite ó they avoid a realized gain because they want to avoid its tax consequences. That disdain for paying taxes can lead to holding onto investments too long. Also, letting taxes drive their investment decisions means that their portfolios can become distorted.
Other times, investors simply maintain a false sense of diversification. For example, investors who hold several different mutual funds may consider themselves fully diversified. However, if those mutual funds have identical investment objectives, theyíre not providing that intended diversification. In that case, the investor could gain diversity by converting one of those funds to a large-cap fund with a focus on value stocks and a mid-cap fund that seeks both growth and value stocks.
Everybody wants a piece of a shining star, and many investors catch a news bite or see a companyís stock highlighted in the media and figure it is the next hot stock. As they hear more and more about it from various sources, investors may feel confident enough to buy. But chances are by then, itís probably too late. A stock thatís a media darling most likely has already had a lot of expectations built into its price.
For investors, the tendency to look for and trade into the next best investment can lead to excessive trading. The churn effect on investing can represent another costly investment mistake and can significantly impact any gains on the investments.
While we canít cover all investment errors here, these are some of the most common and costly and why investors continue to make them. Sometimes knowing where you went wrong keeps you from going wrong again.