Avoid These Five Archetypal Investing Mistakes
By Norton Reamer and Jesse Downing
For thousands of years, investors have been making the same mistakes over and over. True financial literacy should include understanding the history of investment successes and also investing failures. Unfortunately, the recent history of the financial crisis and Great Recession indicate that many investors—even professionals—have not learned those lessons.
Decade after decade, we see markets collapse and fortunes vanish for the same basic reasons. Most of the time the root cause is not some complex technical error. It’s just some new flavor of an archetypal mistake.
Mistake #1: Not diversifying enough
In plain language, diversification means not putting all your eggs in one basket. One of the biggest advances of the last few hundred years has been the ability to truly diversify one’s investments. Diversification is what makes modern investment portfolios tick.
In fourteenth-century Italy, before there was such a concept as “too big to fail.” Two major Florentine banking houses, the Bardi and the Peruzzi, poured a great deal of their capital into the wartime exploits of England’s King Edward III. When Edward defaulted, both banks failed.
The goal of diversification is to ensure that even if one asset in the portfolio is underperforming, other assets are still potentially delivering gains. Both the Bible and Shakespeare reference diversification, and despite how ancient the wisdom may be, it can be hard to follow. Many homeowners have a significant portion of their wealth tied up in a single asset, such as a home or company-granted stock, or in a single asset class. To weather the inevitable vagaries of the market, one must diversify.
Mistake #2: Buying into asset bubbles
As a largely cooperative species, we are primed to seek consensus. That impulse is perilous to investing. The Dutch ‘Tulip Craze” in the 1630s is the quintessential example of an asset bubble, but in the past two decades we have seen asset bubbles in technology stocks and U.S. housing. Bubbles happen when investor enthusiasm outpaces the fundamental value of an asset. Prices are bid up to unsustainable heights. Investors can use basic investment principles, like focusing on fundamental value and being wary of consensus to avoid being swept up into investment bubbles.
Mistake #3: Inappropriate use of leverage
Most of the world’s major fortunes have been made with an intelligent use of leverage. But the emphasis here is on the word intelligent. Leverage can magnify profits, but also losses. So it demands care, both in how much and where it is applied.
Cautionary tales include the highly leveraged investment funds that invested in the housing bubble and whose failures were the first economic dominoes to fall in the Great Recession. But smart investors, like Warren Buffett, have benefited from inexpensive sources of investible capital sometimes at rates even lower than those available to the U.S. federal government by using insurance float. That kind of smart use of leverage has fueled the growth of businesses and the personal wealth of a great many investors.
Mistake #4: Conflicts of interest
As long as people have been managing resources on behalf of others, there have been conflicts of interest. Take the East India Company in the seventeenth century. Superintendents in Japan traded for their own accounts while supposedly representing the Company. They lived in luxury despite receiving minimal salaries. Almost comically, the Company often mitigated the practice only by granting an exemption to the person in charge in return for an agreement to enforce the policy against personal trading on his subordinates. Today, we have devised better mechanisms to promote investor alignment, but such principal-agent conflicts still do manifest themselves again and again, and can affect even the largest and most sophisticated investors.
Mistake #5: Emotional biases
People need to take the emotion out of investing. When you let yourself be guided by emotion, you tend to invest based on unfounded biases, and you can make mistakes.
Modern investment theory, and the discipline of behavioral finance specifically, has identified a wide range of biases. For example, “recency bias” means that people make dangerous generalizations based on the immediate past. “Herd behavior” is the tendency for people to invest with the crowd. “Confirmation bias” suggests that people look for information to support existing opinions and discount information that contradicts their opinions.
In all these examples, emotion clouds the investor’s judgment. Removing emotion as much as possible from investing decisions, large and small, can only benefit the investor in the long run.