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.