April 16, 2013 -- Many view successful investing as knowing how to do things right. This is undeniably true, but a big part of knowing how to do things right involves not doing things that are wrong.
Most investors, including professionals, routinely make blunders that cut deeply into their total stock market returns. Here are seven common, highly damaging investing errors and ways to avoid them:
• Failing to limit risk in their trading process by using stop-loss limits. This is a set of standing instructions to brokers to sell a stock if its price falls below a set value -- or, in the case of professional traders, an alert from their trading platform that the stock has crossed the established loss limit. Many professionals set their stop losses at 8 to 10 percent of the purchase price. Stop-loss orders are helpful for individual investors who don't want to watch the market every day or don't want to come back from vacation to find their gains in a given stock wiped out. You shouldn't be afraid to sell when losses reach this point.
• Letting emotions interfere with judgment. The two primary emotions that derail rational decision-making are greed and fear. Greed can prompt you to buy high by chasing past performance. People tend to say they're buying a stock because it's "doing great," but that's not accurate. The accurate statement is, "This stock has been doing great." Just because a stock has been rising sharply recently doesn't mean it will continue to do so. Greed can blind you to this rational analysis.
Fear can cause you to sell in a panic when a stock starts to fall. This doesn't mean you should never sell when a stock declines, but this decision, like a decision to buy, is best based on rational judgment, preferably involving technical analysis -- the assessment of market activity and trading patterns surrounding the stock or your stop-loss limit.
• Under-diversifying a stock portfolio by over-investing in one or two companies. This can stem from the fallacy that just because you know some good things about a company (perhaps you used to work there) or for some reason have developed a fondness for it, it's necessarily a good investment. Behavioral finance experts call this "familiarity bias." People who receive stock as part of their compensation are typically over-invested in their companies. They should take a tip from their CEOs, who sell company stock at regular intervals, within allowable limits, to diversify their holdings.
• Over-diversifying a stock portfolio. Ironically, by buying too many different stocks to limit risk, you can sometimes decrease your chances of getting good returns. Many investors' portfolios contain too many stocks, usually because they own too many mutual funds. Many of these funds own shares in all or most of the major players in different industries. Yet, all companies in a given industry cannot come out on top. A mutual fund might own shares of Macy's, Sears, and J.C. Penney, but as an individual investor buying individual stocks, you're free to choose the company you believe will do better.
• Using mutual funds, which have various drawbacks. A good reason not to own mutual funds involves taxes — one of the most significant factors determining net returns in any investment. The exasperating thing about mutual funds in taxable accounts is that even when you lose money, you can be taxed on gains that the fund made previously. So sometimes, when you lose, you lose some more. Another problem with mutual funds is that you can't get out of them until the end of the trading day. So when the market is in rough water, you just have to sit there and take it. If you have enough money to diversify across 20-30 stocks, you might be better off building your own portfolio.
• Always playing the market in one direction — up. Most investors buy in anticipation of rising prices. Yet many professionals and astute amateurs also invest in downward movement by shorting stocks -- essentially, betting on their decline – or buying Exchange Traded Funds (ETF's) that short the market. For example, the ETF issued by ProShares, the Short Dow30 (DOG), seeks results that correspond to the inverse daily performance of the Dow Jones Industrial Average. Professional traders use these techniques, called hedging, to hedge or protect their stock investments. If the market falls, these techniques provide protection. Too many individual investors don't use such strategies to reduce risk.
• Failing to enhance their stock portfolios by using options. One type of option, a covered call, is a contract that gives you cash (called a premium) in return for your obligation to sell a stock at an agreed-upon price within a set time period. If the stock reaches the agreed-upon price, you must sell – but you get to keep the premium. If the stock doesn't reach the agreed-on price, you get to keep both the premium and the stock. If you have stocks in your portfolio that you're thinking of selling anyway, why not collect a premium by selling a covered call? You'll eventually sell the stock, but you can collect premiums in the meantime.
Successful investing is a complex endeavor involving myriad factors. These errors and omissions are related to only a few of these factors, yet the principles they entail are among the most critical affecting investing success. By avoiding these blunders – and taking the right proactive measures instead -- you can go a long way toward increasing your returns.
Byron Studdard is founder and president of Studdard Financial a firm in Sarasota, Fla., dedicated to helping clients build wealth, protect it and pass it on to future generations. A Certified Financial Planner®, Studdard is listed in the Guide to America's Best Financial Planners (published by the Consumers' Research Council of America, an independent research company).