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Common mistakes that investors make

Written by Leonardo Hadi
· 9 min read >
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Disclaimer

Investing is a tough job; even Warren Buffett made billion-dollar mistakes. Learn about the mistakes that investors should avoid.

Finding a good investment is not an easy job for anyone, including the legendary investor Warren Buffett. Even though it seems simple, stock picking is a difficult skill set to master, and many people have failed. Warren Buffett has spent over seven decades of trials and errors in making stock purchases and acquisitions. Some of them resulted in billion-dollar losses.

Read more: Warren Buffett’s top stock holdings in 2021, valued at $271 billion.

Buffett’s $20 billion-dollar mistakes

In 2016 shareholder letters, Warren Buffett admitted to making a $10 billion mistake in buying Precision Castparts [1]. The company makes aircraft parts, but the business went south after the decline in air travel. It had to write down $10 billion from its book, while Buffett spent $32 billion to purchase the company.

Moreover, Buffett bought a shoe company for $433 million in 1993 called Dexter Shoe Co., and the company went bankrupt as soon as the bank check cleared [2]. The worst part about the deal was that Buffett bought Dexter Shoe’s stocks with Berkshire Hathaway Class A stocks. The value was equal to 1.6% of the overall Berkshire Hathaway value at that time. The mistake cost $9.7 billion based on Berkshire’s market capitalization on April 9, 2021.

In summary, the most significant aspect of a profitable investment venture is how to manage risks and losses successfully. Anyone will make mistakes, including the most successful investor of all time. Still, one thing that differentiates winners and losers is the skill and experience to manage risks.

Every investor wants to be Warren Buffet, but do you have the stomach to bear the massive losses? Do you have a risk management plan? Do you have an investment strategy to minimize risk and optimize return in good and bad economic conditions?

Risk comes from not knowing what you’re doing. – Warren Buffett.

Top 6 common mistakes investors made

However, there are top six mistakes that many investors can easily do, but difficult to escape. These bad habits can be “too light to be felt until they are too heavy to be broken.” – Warren Buffett. Any successful investor will make mistakes, learn from them, and do better. But, some of them can be damaging with a slight chance for recovery.

Therefore, investors must recognize them early and put together a long-term investment plan. It will take years for good investments to gain a sizeable return.

The followings are the top six common mistakes that investors should avoid:

1. Buying Hype Stocks

Only buying hype stocks without sound research and quantitative analysis will likely cause investors a loss in the long term. The situation is also worsened by the lack of credibility in social media to encourage first-time traders to engage in risky trading.

Based on the asset bubble chart, most investors will end up buying high and selling low. In most cases, average investors will not hear the news until the stock price hits an all-time high.

GME and r/wallstreetbets
GameStop (NYSE:GME) stock performance in 1 year. How late buyers will likely lose money in a hype stock.

The recent hype about GameStop (NYSE: GME) stock is a perfect example of how late investors will lose money by buying high and selling low in both the short and long term. The early buyers purchased the stock long before the stock rallied, while the late buyers did not hear the news from mainstream media until the price peaked.

At that point, the early buyers sold for profits, while the late buyers just got excited, bought the stocks at their peak. However, the price soon collapsed when the Robinhood trading app prevented investors from buying the stock. The situation forced investors to sell the stock at a loss when the price hit rock bottom.

Only the early buyers gained profit on hype stock, but it is not a sustainable and precarious investment practice. Many of them will not sleep well at night.

Read more: Reddit trading guru Keith Gill looks to have made over $25 million on his GameStop bet.

Social Media Influence

Selecting good stocks to buy (for a long position) or bad stocks to sell (or short) requires many research and analysis hours. On top of it, the financial markets are dynamic and volatile, driven by macroeconomic events and disruptions.

It is a nearly impossible task for retail investors with full-time jobs and families to spend hours researching, calculating the discounted cash flow and net present value, and creating a model to evaluate the alpha (return) and beta (risk) investment portfolio.

Most people look at Twitter, Facebook, R/WallStreetBets, Discord Chat, and YouTube to see what stocks are trending. They start buying the stocks or cryptocurrency as soon as seeing someone post, “I just gained 100% on GME, it will go to the moon tomorrow”, “Bitcoin will hit $100,000,” and “How I made $1.15 million in the stock market in a single month during the pandemic.”

The posts come with catchy memes and funny GIFs, making average retail investors never look at 20 pages of 10 years of future cash flow evaluation, the net present value of the discounted cash flow, and the intrinsic value analysis. The most common mistake is buying into hype stocks or cryptocurrencies without understanding the asset’s underlying value.

Social media, memes, and free-commission trading App have changed the way people invest and trade stocks. The stock market becomes a casino to make a quick buck for the day traders who pump certain stocks with tweets, social media posts like r/wallstreetbets and dump the stocks to cash in the profit. The early buyers always benefit from the trade, and remember, the late buyers always lose.

2. Fear of Missing Out (FOMO)
Fear of Missing Out (FOMO) trading has caused price bubbles over the centuries that made people went broke from the boom and bust cycles. Source: TheStreet.

The second common mistake is to base the trading decision on the emotional trap of “the fear of missing out” or “FOMO” trading. Fear of missing out happens when investors notice a sharp jump or drop in a stock or other marketable assets such as cryptocurrencies, gold, or real estate.

The desire to jump into the trade on either buying and selling clouds the logical sense and other analyses like the asset’s intrinsic value. The “natural bias” of believing that what happened in the past will continue has driven the FOMO trader’s decision to buy or sell the assets [3]. The same bias also drives the momentum trading.

The FOMO has driven the creation of asset “bubbles” and “crashes” over centuries, including Tulip mania in 1634-1638, the South Sea bubble in 1720, the dot-com bubble in 2000, the subprime real restates bubble in 2008, and now the cryptocurrency [4]. However, FOMO trading’s main flaw is that often the cognitive bias does not always hold in the real world, especially in a volatile market.

The market keeps changing direction due to disruption and macro events like a pandemic. Besides, the envy and desire to perform better than their peers also drive the FOMO trading, especially after seeing other investors’ chats and social media posts making a significant gain in bitcoin and other trades.

Unfortunately, the considerable price movement will eventually reverse back, just like what happened during Tulipmania.

3. Losing Patience
The illustration of impatience asset holding causes a big opportunity miss in the price gain in the future.

Even though successful investment managers and investors understand the importance of patience, it is one of the most difficult skills to learn and master. The arrival of the commission-free trading app on your mobile phone, 24/7 news alert, and real-time tweets often get investors confused, lost, and emotional, even the experienced ones.

At worst, the news media actively report the trade wars, pandemic, and poor job reports, which fear the market and promote investors to sell too early, which mostly ended up losing big gain in the future.

Amazon
The stock of Amazon had a long period of stagnation between 1997 and 2009 before it jumped nearly 200,000%.

The best example is Amazon (NASDAQ: AMZN). The stock price has been stagnant for a very long time after surviving the dot-com bubble. If an investor invested $1000 in 1997 in Amazon stock and patiently held the stock for 24 years until today, the $1000 investment is worth $3.3 million.

During the stagnation period, Amazon was losing money on online book sales, but its valuation was higher than Sears, a department store conglomerate, at that time. It was difficult for average investors to justify the valuation as Amazon had to sell every book in the world to defend the market capitalization.

However, Amazon was reinvesting all the earnings to grow the business, especially in cloud computing infrastructure, which became the turning point to become a profitable company. Major streaming media like Netflix uses Amazon’s cloud services which creates a sustainable competitive advantage for Amazon and makes it the largest cloud provider.

It was not easy to predict Amazon’s future success from an online bookstore into a giant cloud and e-commerce platform. But, patience for investing in a good business will pay a massive dividend in the future.

4. Complicated Strategy
37 Predefined Options Strategies, Volatility Smile (Skew), and OCO orders. Source: QuantTower.

Complicated trading strategies often attract many investors with a promise for significant returns in a short period. It seems “good to be true,” but most of them become “get rich quick” schemes and cause substantial loss if the investors don’t know what they are doing.

Interestingly, the more complex they are, the more people are attracted and pour big dollars into them. Many investors are interested in complicated strategies; sometimes, it is just because it sounds sophisticated, and many of them have no clue how they work.

Big words and exotic terms like “Long Call Butterfly Spread,” “Bear Put Spread,” and “Momentum Divergence” are more attractive than a simple strategy that works like “Buy Low and Hold Forever.”

Robinhood Casualty

Unfortunately, trading with complicated strategies had taken the life of a 20-years old student at the University of Nebraska who committed suicide after seeing a $730,165 negative balance in his Robinhood trading account. He utilized an options trading strategy called “Bull Put Spread” and started with only a few thousand dollars in the account.

The method allows a trader to buy put options at a specific strike price and sell the same number of puts at a higher strike price with the same expiry date. The trader will profit from the strike price difference when the stock price is going up. However, the strategy can go ugly in a hurry if the stock price goes in the opposite direction.

Derivatives: “Financial Weapon of Mass Destruction”

Derivative instruments and other complicated trading strategies can be a “financial weapon of mass destruction” if the traders don’t know what they are doing, which is the true definition of risk, according to Warren Buffett [5]. It will come back to individual investors to access their risk and exposure to such instruments before making any trading decision.

However, social pressure and hearing others utilizing such exotic terms to win big profit draw others without enough experience and thorough research to do such a thing and mostly ended up with a massive loss.

Warren Buffett and Charlie Munger often describe their investment strategy as too simple and incredibly easy, like invest in what you understand, keep it super simple (KISS) [6], stick with the long-term value, patience, and gain return through compounding interest.

A successful investment strategy is similar to watching grasses grow and waiting for paint to dry. It can be tedious and boring. That’s maybe why so many investors ignore them and choose the complicated strategies, which are more exciting, like a casino and roller-coaster ride.

5. High Tax and Fees
Source: social media (unknown).

When an investor sells stocks at a profit, it is subject to a capital gain tax. Many investors don’t realize that the tax investors pay dependent on how long they held the stocks before selling them. Based on the US tax code, there is a different tax rate for long-term and short-term holdings [7].

Long-term capital gain is typically 15% or lower, depending on the investor’s tax bracket, for assets owned for more than one year. However, short-term capital gains are taxed just like your typical income, which can be up to 37% or more, depending on your total taxable income that year.

Although every country, state, and province have their tax rate and regulation, the tax rule is typically similar to the IRS tax code.

Tax Shelter

However, a country like Canada has a Tax Free Savings Account (TFSA) that allows any individual to trade in any marketable securities in most exchanges globally and will not charge any taxes for any capital gain or dividend income. Though, the investor cannot write off any capital loss in the account [8].

The 401(k) account has similar tax benefits in the US, but it is more tax deferral than tax savings [9].

Hidden Trading Cost: “No such thing as a free lunch”

So, active investors who day trade or engage in high-frequency trading should look at the overall net income after tax annually to properly evaluate the investment strategy. In the short term, taking quick profit by day trading seems pretty lucrative.

Still, in the end, all the gains usually go to paying high taxes and expensive hidden trading costs despite the increasing trend of commission-free trading apps. The hidden trading cost can be expensive at high volume as the commission-free trading app typically makes money from the spread.

It gives investors higher pricing for buying and lower pricing for selling.

6. Buying on Margin
Margin call debacle causing Wall Street Investment Banks to lose billions and firing their key executives. Source: Market Insider.

In a 2018 interview with CNBC, Warren Buffett famously said,

“It is crazy to borrow money to buy stocks. My partner Charlie says there are only three ways a smart person can go broke: liquor, ladies, and leverage. Now the truth is – the first two he just added because they started with L – it’s leverage.”

Warren Buffett, 2018 CNBC interview.
How does a margin account work?

When investors register for a margin account, it allows them to borrow stocks from the brokerage. The broker will earn revenue by charging an interest rate during the borrowed period while the equity in the margin account becomes the collateral for the loan. When the strategy goes well, the investors can multiply the profits using the borrowed stocks as leverage.

However, if the margin account’s equity drops below the “maintenance margin” level or equal to 25% of the total equity, the broker will initiate a “margin call” to investors with a specific time limit. The margin call requires investors to deposit more cash or sell some stocks to offset the loss to meet the maintenance margin requirement. If investors fail to comply, the broker has the right to force the sale of the securities in the account.

When the investors have billions of dollars in a margin call and cannot comply, it will trigger a “fire sale” when the brokerage sells the margin account’s stocks to meet the margin requirement. It will cause a massive drop in price for the broker-liquidated stocks.

Archego’s margin call

It is precisely what happened to Bill Hwang’s Archegos fund’s margin call resulting in $20 billion lost in 2 days. Archego’s highly leverage bet started to go sideways and dropped below the maintenance margin requirement. However, the firm could not deposit more cash nor sell some stocks to offset the loss to meet the maintenance margin requirement.

This situation forced Archego’s prime broker and related investment banks to engage in fire sales of around $35 billion. The fire sale caused a massive drop in US media and Chinese technology stocks in a day. Credit Suisse lost $4.7 billion in the transaction and fired its key executives involved in the scandal.

Nomura lost $2 billion, while Morgan Stanley had to sell $5 billion of Archego’s related stock at a discount. However, Goldman Sachs had sold nearly $10.5 billion of Archegos’ related stocks before the meltdown [10].

So, What’s Next?

After learning from all the common mistakes, what can investors do to be successful in the long term? Before going into the best investment strategy, ask yourself the following questions:

  • Have you experienced the same mistakes?
  • How would you do differently?
  • What is your risk tolerance?
  • How much time would you spend in investment research?
  • Are you interested in the excitement or the long-term return?

Please comment below to share your insight and help the audience to be a better investor.

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Written by Leonardo Hadi
MBA from the University of Illinois at Urbana-Champaign. Quantitative Fund Investor. Professional Engineer. Operations Professional. Profile

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