7 Dumb Stock Picking Mistakes Even Smart Investors Make

By Damian Davila on 12 May 2015 0 comments

Everybody loves a winner.

That explains why America seems to be obsessed with stories of amazing stock pickers, such as the New Jersey teen wonder who allegedly turned $10,000 into $300,000 by trading penny stocks from his smartphone

However, even some of the smartest (and luckiest!) investors make mistakes sometimes. Here are seven dumb mistakes to watch out for the next time you're picking investment options.

1. Having No Investment Goals

If you don't know where you're going, you'll never know when you get there.

However deeply people may agree with this statement, there are still those who lack clear investment goals. Your first step in investing is defining these goals.

Here are three examples of good ones:

  • In order to avoid the extra cost of private mortgage insurance, you would like to save for a down payment that is at least 20% of a $300,000 apartment in your city within the next 10 years.
     
  • You first child is just born and you would like to have $35,000 available for his or her college tuition by their 18th birthday.
     
  • Planning to retire 33 years from today, you and your spouse calculated you'd need $3,000 every month to cover your expenses during retirement.

Notice the two things that these goals have in common: a specific dollar amount and a target date. These two elements are the starting point for any discussion about investing. They allow you to establish a timeline and select benchmarks to evaluate your performance.

Before you even think about stock picking, establish your investment goals. (See also: 5 Dumb 401(k) Mistakes Smart People Make)

2. Ignoring Your Risk Tolerance

There are two key elements to determining your risk tolerance.

First, there is your time horizon. A rule of thumb is that the longer your time horizon, the riskier your investments may be. Since you don't need the funds for quite a while, you can better sustain the ups and downs of the market and chase higher returns. On the other hand, if you need the funds a year from now, you're better off taking more conservative investments.

Second is your available "play money." A person with a net worth of $1 million is more likely to better stomach the price fluctuations of a $25,000 investment than a person with a net worth of $75,000. Also, don't forget about potential liquidity issues. The second individual would be in a really tough situation if he were to suddenly need those $25,000 to pay damages from a lawsuit or meet another type of big financial obligation.

Pick investments according to your time horizon and bankroll.

3. Spending Instead of Investing

While some people are very eager to start stock picking, others think they can't even afford it.

Or it could be that those others may be listening to their "lizard brain" a bit too much. The idea of the "lizard brain" refers to the instincts that helped our ancestors to survive back in the stone age. Given scarce resources and the ever-present possibility of death, our ancestors prefered to enjoy things right away instead of waiting.

Old habits die hard. Given the choice of enjoying $500 right now or receiving $3,000 in five years, most of us would chose the first option. However, this is a bad idea.

By refusing to invest even just a little bit, you're incurring a huge opportunity cost. For example, let's imagine that you make an initial investment to your 401(k) of $100. Assuming your 401(k) has a return rate of 5% compounded annually and you contribute $100 every month for 20 years, you would end up with $40,845.78.

Start investing today. Right now. Even a little bit! 20 years from now, you'll be glad that you did.

4. Paying Too Much in Fees

This is one of Warren Buffett's top three investing mistakes to avoid. (See also: 5 Investors With Better Returns Than Warren Buffett)

While you can't be 100% sure about the return of your stock picks, you can be 100% sure of how much money you're paying in management and trade fees. For example, if you were to invest $10,000 in the average actively managed U.S. mutual fund, you would pay $132 in fees. On the other, you would pay just $17 by investing the same $10,000 in the Vanguard Total Stock Market Index (VTSMX), the largest index mutual fund.

5. Trying to Beat the Market

Here's another reason to choose index mutual funds.

Most actively managed funds fail to achieve returns above their respective benchmark. Only about 20%–35% of fund managers are able to "beat the market." These are the pros that do this for a living. Are you sure that you can do better than them on your spare time while juggling your job and family life?

Over the long-term, index funds are typically top performers and do better than 65%–75% of actively managed funds. And index funds cost you less than a fund manager, too.

6. Betting on a Single Stock

There are too many stories about people getting filthy rich by putting all their money on Apple stock.

Before you decide to put all your eggs in one basket, consider the performances of these two other past media darlings.

Groupon

Launched in November 2008, Groupon quickly became the leader of the deal-of-the-day movement. Groupon became one of the fastest companies to reach a $1 billion valuation. Heck, Groupon was doing so well that it turned down a $6 billion buyout offer from Google. However, an original investment of $10,000 in Groupon on November 7, 2011 would only be worth about $2,554.66 today.

Enron

It's hard to believe that Enron was once a media darling. Back in 2001, Enron's stock was priced at 70 times earnings and 6 times book value. Out of the 22 analysts covering Enron, 19 of them rated the stock a "buy." The maximum stock price of $90 in August 2000 convinced several people to put all their nest eggs on Enron. A little over two years later, the stock was trading below $1.

The lesson is that history tends to repeat itself, so don't bet all your money on a single stock. (See also: 10 Investing Lessons You Must Teach Your Kids)

7. Not Rebalancing Your Portfolio

Last but not least, remember that asset prices vary over time.

Your investment plan sets a target allocation of your monies in different types of investments. For example, you may have 50% in domestic stocks, 30% in foreign stocks, 20% in bonds, and 10% in T-bills.

Let's imagine that your foreign stock holdings had a nice upward ride for the last five years. So, now they represent 50% of your total investment portfolio's value. It's a good idea to rebalance your portfolio to set back your allocation of funds to the target 30% so that you're not taking more risk than you're comfortable with.

It's shocking how simple it can be to avoid these six investing mistakes.There's no secret to stock picking — it just requires planning and sticking to that plan. It may not sound exciting, but it's more likely to make you a profit. And isn't that why you really invest?

What steps have you taken to fix your investment decisions?

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