Classic investment mistakes and how to avoid them

By Frederik Vanhaverbeke, Bond Manager at KBC Asset Management and author of Excess Returns: A
Comparative Study of the Methods of the World’s Greatest Investors.

A country of security analysts would still overreact. In short, even the best-trained investors would
make the same mistakes that investors have been making forever, and for the same immutable
reason – that they cannot help it.
---Seth Klarman

There is nothing new on Wall Street or in stock speculation. What has happened in the past will
happen again and again and again. This is because human nature does not change, and it is human
emotion that always gets in the way of human intelligence.
---Jesse Livermore

These quotations from Seth Klarman, one of today's most respected hedge fund investors, and Jesse
Livermore, one of the biggest momentum traders of the 20th century, leave nothing to the
imagination. Investors – whether private individuals or professionals – repeatedly make mistakes on
the stock market. And these mistakes are generally caused by unconscious psychological forces that
impel investors to take action that makes no sense. There is an ever stronger realisation of this
nowadays. A new academic discipline has even come into being, focusing entirely on analysing the
many psychological forces (or 'psychological biases') that prompt investors to make investment
mistakes. It's called 'behavioural finance'. Oddly enough, this is an area of research that has made a
fairly late appearance on the scene. Decades ago, countless top investors had discovered the
destructive power of the human psyche, and learned how they had to deal with it.
In my book Excess Returns: A Comparative Study of the Methods of the World’s Greatest Investors,
I explain all the ins and outs of how the world's most successful investors go about beating the stock
market. In that respect, it's remarkable how they systematically avoid a number of mistakes that
other investors do make, by being properly aware of the factors that are essential for making
successful investments. They emphasise that successful investors (i) invest using a superior
investment method, (ii) implement that investment method consistently and with great discipline and
(iii) know how to cope with all sorts of (unconscious) psychological forces that steer them repeatedly
onto the wrong course. Let's look in more detail at a number of classic mistakes.

Classic mistakes across the investment chain

In figure 1, I illustrate the various steps in the investment chain, and the points at which everything
can go wrong:

Step 1: Selecting shares for further analysis

First of all, investors have to use their time efficiently. There are thousands of shares on the stock
market, and time is limited for everyone. Intelligent investors, therefore, concentrate in the first place
on shares that have a greater chance of being undervalued, rather than the market in general. Thus,
they realise that it's a waste of time to analyse shares that are probably not undervalued. As you can
see in figure 1, however, there are a number of (psychological) forces that steer people to precisely
the wrong shares. For instance, many people seem to find it more logical to put their money in shares
that figure prominently in the media, that are 'in', that do something spectacular or are 'hip'. The
problem is that these sorts of shares are often expensive or over-hyped. The most interesting shares
are often precisely those that people aren't looking at, that aren't popular or that people have an
aversion to.

Figure 1: The challenge facing investors.

Step 2: Analysing the idea

Once a share has been selected for further examination, the investor has to look and see whether it
really is an interesting investment. To do this, serious investors look at financial information in the
annual reports, assess the business's competitive position, try and form a view of the management
and estimate the company's intrinsic value. However, in this step, too, there lurk a number of
psychological forces which can jeopardise the value of such an analysis. Two examples doing the
rounds are:
 It is not unusual for an investor to form a certain (positive or negative) view even before doing an
analysis of this kind. You can, for instance, have a positive bias towards a company whose name
appeals to you or that sells the type of products you appreciate, etc. It goes without saying that
such preconceptions make it harder to make a neutral evaluation of the company. For example, it's
not unusual to then go looking for precisely the factors that confirm this view and to dismiss
counter-arguments.
 Another typical example is that some people tend to buy shares in the company they work for,
without thinking twice, since many consider themselves insiders who know a good deal more than
the average person about what exactly is going on in the company. Unfortunately, that's often an
illusion. Not doing your homework because you think you know a company inside out, whereas you
 don't even have the most fundamental financial information on it (the position of most employees)
can be a serious error.

Step 3: Buying and selling

In the last phase of the investment process, a decision also has to be taken on whether or not to buy
the share that you've analysed. Or you need to take regular decisions on whether to keep, sell or buy
more of the shares already in your portfolio. This may seem easy but can be very difficult in practice
because countless psychological forces often lead to irrational buy and sale transactions. For example,
it's not unusual for investors to refuse to buy stocks in a bear market, even if they're quoted at prices
that they could have only dreamed of in a previous bull market.

I have heard many men talk intelligently, even brilliantly, about something – only to see them
proven powerless when it comes to acting on what they believe. Investors must act in time.
--- Bernard Baruch

In my book Excess Returns: A Comparative Study of the Methods of the World’s Greatest Investors, I
go in great depth into the above steps in the investment process. In so doing, I look at the way in
which a wide selection of very successful investors go to work and how their approach to the
investment process sets them apart from less successful investors. As part of that discussion, I pay a
lot of attention to classic investment mistakes. In the following section, I look at a number of classic
buy and sell mistakes.

Classic buy and sell mistakes

Mistake 1: Trying to sell at a peak or trying to buy at a low point

Many investors think – wrongly – that successful investors buy shares at their low point and sell them
again at their peak. The idea that you can time buys and sells exactly is the product of a number of
psychological biases. Thus, many think that stock markets are easier to predict than they actually are.
On top of that, many people believe they can discern certain patterns in how share prices move,
whereas, in truth, the prices mean nothing. These convictions, coupled with excess confidence, lead to
the idea that it has to be possible to apply some kind of method to time buys and sells perfectly.
In a predictable world, timing would indeed be a matter of logic. However, the problem is that the
stock markets are anything but predictable. Even the world's most successful investors point out that
perfect timing is impossible. And, if they think so, who are we to think that it is still possible, despite
that? Top investors spend their time looking for the perfect way of timing their purchases and sales.
They are very pragmatic in how they take buy and sell decisions. They have no problem with buying a
share that falls further after the purchase, or selling a share that continues to rise after the sale. Their
sole overriding concern is whether the share is expensive or cheap compared to its intrinsic value.
They realise that it makes no sense to keep an overvalued share simply because they might speculate
that the price could go even higher. And they point out that it's silly not to sell a cheap share because
they think the price might go down a little bit more.
To avoid their having to time purchases, a large number of top investors spread their purchases
over time and within a given price range. There's a nice example of this in figure 2. It illustrates how
Prem Watsa – who goes under the nickname of 'the Canadian Warren Buffett' because he's achieved
investment returns similar to Buffett's – bought and sold shares in International Coal between 2006
and 2011. As you can see in the diagram, Watsa bought an initial small position in 2006 at 4.6 dollars,
after which he seriously increased that position in 2007 at a somewhat lower price of 4.4 dollars.
When the share slumped in 2008 in the middle of the credit crisis, he added to his position at a price
of 1.8 dollars. In 2009, too, he took advantage of the low share price and bought an additional
package of shares at 2.9 dollars. As the diagram shows, the share recovered spectacularly in 2010
and 2011, allowing Watsa to sell the position off gradually with high profit at 7.3 dollars (in 2010) and
14.6 dollars (in 2011).

Left hand axis: Cost (buy) or income (sell) in millions of US dollars

Right-hand axis: International Coal share price

Figure 2: Buys and sells of International Coal by Prem Watsa between 2006 and 2011.

Seasoned bargain hunters understand that it is their common plight to sell stocks too soon,
particularly as they find cheaper bargains elsewhere. If you hold on to your stocks as they rise
above their estimated worth, you are joining a game of speculation and have left the sphere of
investing.

Mistake 2: Selling a strong share with the aim of buying it back later at a lower price
Closely related to the timing mistake we've just talked about is the attempt made by some investors
to take a share that has performed well and that they don't really want to sell and still sell it, with the
aim of later picking it up after a price correction. Investors who try this on are very overconfident,
since they run a big risk that they'll exit the share for good. In fact, these investors are trying to do
something that is twice as difficult as selling at a peak and buying at a low point.
1. They have to sell the share close to a peak. Indeed, if they sell the share before it's reached a
peak, they will probably refuse to buy the share back at above the sale price because most people
view this as locking in 'missed profit'.
2. Even if the sale turns out well and the share corrects, they still need to buy the share back close
to a floor. However, many investors think that the correction of such shares will be much greater
than it actually is. And so they wait too long to buy the share back. And, once the share starts
climbing again (and rises back above the sale price), they're anything but keen to buy it back.

Mistake 3: No one gets poorer by taking profit

This supposed stock market truth is as old as the stock market itself and follows seamlessly on from
mistake 2. Of course, it sounds logical: if a share has performed well, it makes sense to secure a part
of the profit so that that profit can no longer be lost. In addition, many investors are under the
unconscious impression that strong performing shares have 'used up' their upward potential, and so
it's plain that they should be replaced with shares that do still have such potential.
Top investors consider this stock market truth to be nonsense. If we look at the portfolios of top
investors, we see that their exceptional performance is often attributable to a limited number of
shares that have performed particularly well on the stock market and that they've been holding for
years (if not decades). Warren Buffett, who has achieved an average annual return of 22.3% since
1957 (which is 12% better per annum than the S&P 500) has around 15 shares that he held onto for
many years to thank mainly for his exceptional performance. Shelby Davis, too, who managed to
invest 100 000 dollars and turn it into 900 million dollars over 45 years, could attribute that
exceptional performance to a handful of shares that he kept hold of for a number of decades. It is
furthermore remarkable that even a lot of successful traders say that their outstanding performance is
due to a limited number of shares that they've held onto for a long time.
There's nothing all that wrong with taking profit on shares that have risen sharply. On the contrary,
it makes sense to sell shares that have risen so spectacularly that they are (heavily) overvalued.
However, systematically selling off just any strongly performing share for the sake of it makes no
sense at all. You can but anticipate that the share price of an exceptional company will perform
outstandingly well on the stock market. But this doesn't then mean that the share is overvalued.
Serious investors take changes in the share's intrinsic value into account and compare that with its
price on the stock market. It's only when a discrepancy arises between the two that a sale is
advisable. Thus, it's a far better stock market truth, which top investors stand behind, to: 'hold
strongly performing shares as long as the company continues to perform well and as long as the share
price does not get (too far) ahead of the results.'

Selling winning stocks and hanging on to losing stocks is like cutting the flowers and watering the
weeds.
--- Peter Lynch

Mistake 4: Refusing to sell poorly performing shares below the purchase price
As is stated in the above quote from Peter Lynch, one of the most successful fund managers ever, who
achieved an average annual return of 29.2% between 1977 and 1992, it's wrong not only to sell
winning shares but also to hold on to losing shares. In fact, many investors refuse to sell shares that
are performing very poorly, especially if their price drops way below the purchase price. This is due to
a range of psychological biases. Until such time as a share is sold at a loss, the loss remains virtual. It
is not palpable and the investor can continue to cherish the hope that everything will turn out well in
the end. It's also the case that many investors are transfixed by the purchase price, which seemed so
advantageous to them when they bought the share. They therefore take the view that the share has
to be dirt cheap if it is trading far below that purchase price. Some investors also think that a share
whose price has plummeted can't fall any further and that it's set to recover, just as a depressed
spring will bounce up when it's released.
Although these arguments seem plausible at first sight, they're all ultimately irrational. Common
sense says that it's wrong to stick with a share that's rightly been slashed in value and where any
objective situation leads but to one conclusion: that the company probably won't rebound again very
quickly. It's right and proper that poorly performing companies fall on the stock market. And, even if
the share takes a punishing and then gives the impression of being cheap, if no improvement's in
sight, there's a big chance that the share price could be hit even harder. Those who continue to sit on
a loss position with no clear prospect of improvement run the risk of having to incur even bigger
losses on that position. Obstinately holding on to positions because they don't want to take a loss has
ended up costing countless investors bucketloads of money!

Mistake 5: Stock market trading with a mixed strategy

Beating the market isn't that easy. It can nevertheless be done in a number of ways. Some traders
have raked in astronomical returns by momentum trading. For instance, top trader Richard Dennis
managed to turn 400 dollars into 200 million over 15 years by trading in futures. Others proved their
mettle in macro investing. Macro investors generally buy all kinds of assets (shares, bonds,
currencies, derivatives, etc.) across the whole world based on fundamental analysis and economic and
political considerations. George Soros is probably the most famous macro investor. And rightly so,
given how he's achieved a phenomenal annual return of more than 26% over a period of 40 years.
Another way to beat the stock market is to invest. Investors try and determine the intrinsic value of
shares with the aim of buying shares that are trading (far) below their intrinsic value and selling them
again once they've risen to their intrinsic value. Warren Buffett, Peter Lynch and Shelby Davis (all
mentioned above) are just a few examples of successful investors.
The fact that there's no single way of beating the market doesn't mean, however, that various
methods can be jumbled together. As was revealed by my survey of investors and traders, each of
those highly successful market players is backed by a certain philosophy that explains how the stock
market works and where attractive shares are to be found. Each of them has developed his own
method, which he uses to try and profit from opportunities in the market. And, ultimately, they pursue
that method in a rigorous, disciplined manner.
To this, I would like to add that some investment methods and philosophies are usually incompatible
with one another. For instance, investors use a share's intrinsic value as a guiding principle for their
investment decisions and thus exploit price fluctuations. If a share falls in price (without good reason),
then the share becomes more attractive to them because it can be bought at a lower price.
Momentum traders, on the other hand, are not interested in the intrinsic value of shares. They look
only to price fluctuations and try to follow price trends. Momentum traders generally buy shares that
perform well, whereas they short or sell shares that do badly. In other words, to a trader, a share
whose price falls is an opportunity to short, whereas an investor might see this as an opportunity to
buy.
That said, investors have to realise that it's wrong to use instruments from the traders' arsenal to
base their buy and sell decisions on. One classic mistake, for example, is the use of stop losses. A stop
loss is an instruction to sell a share automatically and without further ado if it drops below a certain
price. This is a very useful instrument for momentum traders because they allow themselves to be led
by price movements, so that it's logical if they want to exit positions that are shifting in the wrong
direction. However, for investors, stop losses make no sense. If a share falls whilst the intrinsic value
stays the same, the share becomes more attractive to the investor. Falls of this kind present more of
an opportunity to buy (more of) the share than to sell it. Therefore, stop loss is anathema to the basic
philosophy of investing and those who use it have to realise that they're not investing. If they think
they are, then they haven't grasped exactly what investing is all about.

Putting in a stop-loss order is like buying a house for 1 million dollars and then instructing the
real estate broker to accept the first bid for the property that comes in below 800 000 dollars.
--- Warren Buffet

So, there we have it, our brief discussion of a number of common investment mistakes. In my book
Excess Returns: A Comparative Study of the Methods of the World’s Greatest Investors, I look at
many more investment mistakes. In all of this, the general conclusion is that most investment
mistakes are caused by psychological biases, a lack of clear strategy (that does not produce any
advantage in the market), a lack of discipline, senseless conventional wisdoms that people believe in,
a lack of insight into the drivers behind the market, and so on. For more information, I refer the
reader to my book, which is on sale on Amazon and on the website of the publisher,
Harriman House (http://www.harriman-house.com/book/view/627/investing/frederik-vanhaverbeke/
excess-returns/).