Good decisions sometimes lead to unfavorable outcomes. Even Warren Buffet’s Berkshire Hathaway lost over $4 billion[ii]in late February when Kraft Heinz (KHC) stock lost about 27% of its value in one day after an unfavorable earnings announcement.[iii]After the stock dropped, Buffett said his company paid too much for it.[iv]
However, mistakes – avoidable actions originating from undisciplined or uninformed decisions – compound the risk of loss.
We find it useful to examine here some of the most common investment mistakes in hopes of recognizing and avoiding them.[v]
Emotion might be the greatest among factors leading to mistakes that threaten investment returns. Emotion can erode discipline, and it can contribute to other mistakes. A sensible emotion-control strategy adopts objective decision criteria, a practical discipline.
Another part of that strategy recognizes sources that appeal to emotion; these sources can threaten discipline. The popular media, for example, often seem to appeal to emotion. Consider television programs like CNBC’s “Squawk Box” with an ostensible agenda to inform investors.
Follow the money: Many of the programs’ advertisers sell investment products or benefit from investment transactions. Many of the program’s guests, though their interviews address current investing issues, also benefit from investment transactions. Those incentives can ultimately work against investors.
Emotion often has its way, especially with market timers. Yet let’s assume for a moment an investor casts out all emotion and objectively decides declining market values are imminent and the correct solution reduces all risky assets to cash.
If the investor possesses no skill forecasting the future, then the probability of success equals 50%. That is, the investor really doesn’t know what direction the market will take, and the market gives us only two outcomes, up or down.
Let’s assume now the investor was right and market values collapse.
After that, what should the investor do? Should the investor remain in cash forever? No, the investor would reinvest when they determine rising market values are imminent and the correct solution applies cash to risky assets.
If the investor possesses no skill forecasting the future, then the probability of success equals 50%.
In the beginning, the probability of just two consecutive correct calls equals (0.5 x 0.5 =) 25%. The unskilled investor had a 50% chance of success with the original decision and a 50% chance of success with the second decision, then the investor’s chance of success after both decisions equals ( 0.5 x 0.5 =) 25%. Imagine the probability[vi]for a lifetime of market timing transactions.
But wait! The probabilities assume the investor acted objectively and without emotion. Also, some investors claim to possess skill at deciding whether an investment’s price is high or low. No doubt some possess skill, though it might be ephemeral. Timing works sometimes, but not over a lifetime of investing.
Excessive turnover is market timing’s evil cousin. Although we believe thoughtful active investing trumps a passive approach, excessive transactions impose expense and risk. Some lane-switching drivers in rush hour interstate traffic behave like overly active investors. In their short-sighted way, they see opportunities to get ahead. Sometimes they succeed, but more often heavy traffic finds a way of snuffing out opportunities. Lane-changing is necessary, but all lane changes impose risk.
Waiting to Get Even
Failing to change lanes also threatens investment performance. We’re all guilty of this: We thoughtfully invest, and then soon after the transaction, investment value drops. We acknowledge to ourselves either we made a mistake or things just didn’t work out. None of that matters, we just want to fix the problem. Because we believe in our original assessment of the investment’s potential, we figure it will recover. We tell ourselves we can exit the position when investment value returns to the price we paid. Then sometimes value drops even more. At some point, we often throw in the towel and take our losses.
Purchase price is the wrong criterion for selling because historical price has no bearing on future prices. In our opinion, the best way to make sale decisions relies on an objective criterion.
[i]William Artzberger’s ideas inspire this post: Artzberger, W. (2018 May 19). 8 common investing mistakes to avoid at all costs. Investopedia. Retrieved from https://www.investopedia.com/articles/stocks/07/beat_the_mistakes.asp.
[ii]English, C. (2019 February 22). Shares of Warren Buffett’s Berkshire Hathaway plummet after dismal Kraft Heinz report. New York Post. Retrieved from https://nypost.com/2019/02/22/buffetts-berkshire-hathaway-lost-4b-after-kraft-heinz-earnings-report/.
[iii]The Kraft Heinz Company. (2019 February 21). Kraft Heinz reports fourth quarter and full year 2018 results [Press Release]. Retrieved from https://www.sec.gov/Archives/edgar/data/1637459/000163745919000010/ex991-erq42018.htm.
[iv]Stempel, J. and Ablan, J. (2019 February 25). Warren Buffett says Berkshire overpaid for Kraft Heinz. Reuters. Retrieved from https://www.reuters.com/article/us-berkshire-buffett-kraft-heinz/warren-buffett-says-berkshire-overpaid-for-kraft-heinz-idUSKCN1QE1F0.
[v]The broadcast “It’s a Mistake” addressed what we think are the 10 most common investment mistakes. This post only addresses four mistakes. Readers can get a complete list by sending an email message to email@example.com they can listen to the podcast at https://twincitiesbusinessradio.com/content/all/financial-fortitude-podcasts?apt_credirect=1.
[vi]The prior probability equals 50% to the power of the number of decisions.
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