These five misconceptions can get investors into big trouble

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As much as I like investing, and finding great companies to invest in or recommend, it is not easy. At times, it seems like decades of experience means nothing, and the exact opposite of what you expect to occur happens. This of course adds to the challenge.

Many investors make mistakes, and we have discussed some of these common investor mistakes in prior columns. Today, we will look into a similar theme. Not specific mistakes,per se, but overall thought processes that get in the way of investment success. Let’s look at a few. These issues impact both individual investors and professional fund managers alike.

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These five misconceptions can get investors into big trouble Back to video

The pressure to ‘do something’

This applies more to professional fund managers, who feel they have to justify their high investment management fees. But individual investors also feel pressure. This can occur in both good and bad markets. When markets decline, investors always think they need to do something to “protect” their portfolio. In good markets, investors are always fighting the “fear of missing out” and can sometimes adjust their portfolio (like selling bonds to buy tech stocks) which is not the right move for them. Doing nothing is often the best move in times of market stress. When I was a fund manager, though, if the market was down 10 per cent and a worried investor called me and asked what I was doing with my fund, the answer of “nothing” would basically ensure that investor would take their money out of the fund.

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Reducing your time horizon

Think back to those dark market days of March this year. Were you a long-term investor then? Did you view the coronavirus as a horrible — but short-term — event? Or, like most investors, did you panic and suddenly start to make big portfolio changes (such as going to cash) in order to ‘make it through’ 2020? We saw investors with 20-year time horizons suddenly start to worry about what was going to happen in the market the next day. Sure, panic is a tough emotion to fight. Still, if you have an investment plan — and you should — don’t let daily, weekly or even monthly events change your plan. Now, if you have a three-year time frame, that’s different, and maybe in that case you shouldn’t be in the market at all. But if your time frame is appropriate, don’t let short-term events, be it a virus or a weak earnings report, throw you off your game.

Overestimating your knowledge of a company

This happens to everyone, but more so to professional fund managers. Managers read reports, analyze spreadsheets, talk to company executives and listen to conference calls. They have worked hard, and believe this hard work has given them ‘an edge’ over other investors, and thus they have strong convictions in their stock picks. But other investors do this too. Companies have to be very tight with information these days because of regulation, and really can’t say much. What’s more, companies are extremely careful in only saying the same things to all investors. So a fund manager may think they know more than others when they decide to buy, but they really don’t. In fact, many of the sellers of a particular stock on any particular day have the exact same information, and they have decided to sell instead. We think information is of course important for stock-picking success, but it should not lead to overconfidence. Every time you buy a stock, remember this: someone (the seller) surely does not like that stock as much as you do.

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Confusing a good company with a good stock

We have mixed views on this one. We believe that a good or great company, in the long term, is going to get you solid investment returns, eventually, even if you pay a lot for that company. Great companies have a beautiful way of growing into their valuations. However, in the short term, things are very different. If you pay too much for a good company, you might not make any money from that stock for a very long time. Conversely, you might find you are able to buy a lousy company very cheaply. Again, in the short term, you might make way more money from a bad company priced cheaply than a good company priced expensively. In the market bounce since March, this has been exemplified. Some investors have made small fortunes buying stocks of highly indebted companies that might not even make it to the end of the COVID crisis. But in the short term, they are making bank from buying bad companies at highly discounted valuations.

Restricting your investment criteria

This one may also apply more to fund managers. Most individual investors can do whatever they wish. But fund managers often have restrictions, be it market cap limits, sector, geography, investment style, and so on. Any restriction on investment criteria will, of course, reduce the size of your investable universe and potential returns. If you are a value manager right now, you know all about this, as growth stocks are running hard, leaving your value fund in the dust. We like mid-cap growth companies, but that doesn’t mean we ignore other possible investments. It is better to look at everything — with no restrictions — and then decide. This is going to take more time and effort, naturally, but your investment returns will be better for it.

Peter Hodson, CFA, is Founder and Head of Research at 5i Research Inc., an independent investment research network helping do-it-yourself investors reach their investment goals.