How to Avoid the Three Biggest Mistakes Stock-Market Investors Make

I’m not an expert in stocks, but I have been involved with stock-market publications and stock-market gurus for more than 25 years. During that time, I’ve met a lot of characters – some brilliant men without a trace of honesty and some honest men without a trace of intelligence.

I’ve seen investors swindled, bamboozled, conned, and just plain charmed. And I’ve been conned and swindled myself.

I have seen bright young men come into the market with brilliant new ideas and shine like stars – until their stars imploded. I’ve seen crotchety old men who had been predicting a market change be proven right – after 20 years of being wrong.

I’ve known two-bit hustlers who would bully and scream at clients who even thought of asking for a refund and quietly confident brokers who spent most of their time trying to dissuade people from investing with them.

I’ve seen a lot – and though I have never attempted to figure out the stock market or how to get the better of it, I have developed an instinct for it. That may be too strong a way to put it. What I mean to say is that I now have a sense of what works and what doesn’t, which stories are true and which are not, and who can be trusted and who cannot – and, in a new book that I’m writing, I’ve been trying to assemble all this unarticulated sensitivity into some useful instruction.

Since I’ve had only meager success in predicting the profitability of the businesses I’ve been in charge of all these years, it seems impossible to imagine that I (or anyone else) could possibly predict the future profits (not to mention share prices) of companies that are remote.

That said, there is a very big market out there for just that kind of thing. There is a huge demand for expertise and an equally huge supply of experts. Of the many things you hear these experts say, three caveats in particular make sense to me:

1. Don’t put too much money in any one recommendation – because you never know, despite what you may think, the outcome of any particular stock or the market in general. By limiting each investment, you’ll never get hurt so badly that you won’t be able to keep going.

2. Never invest in something just because you like the story behind it – because a story, by its very nature, is meant to dramatize, not to inform.

3. Don’t leave money in an investment after it turns south. I have many good investment-expert friends who will tell me I’m wrong about this one, but my feeling is that when businesses start to fail, most of them, most of the time, continue in that direction. When it comes to investing in your own business, however, you can ignore this rule, because you can do something extraordinary to turn things around. But when it comes to other people’s businesses . . . well, you never know.

As I write this, it occurs to me that each of these three mistakes is related to one or more emotional tendencies that are dangerous and destructive to long-term investing. Let’s take a look at them by asking a few questions.

1. Why would you put too much money in one recommendation?

*Laziness. (You want to make a big hit – and you don’t want to spend the time to research other possibilities.)

*Weakness. (The broker intimidates you into buying more than you want.)

2. Why would you abandon a sensible investment strategy to buy into a hot story?

*Greed. (You know it violates everything you have learned about investing, but you’re willing to take a flier because the money sounds too good to pass up.)

*Inexperience. (It’s the first time you’ve fallen for a good story, so you don’t understand that good investments don’t always have good stories and good stories are usually just that – stories.)

3. Why would you keep your money in an investment that goes down instead of up?

* Pride. (You don’t want to admit you made a mistake. So long as you leave the money in the investment, you don’t have to admit you were wrong.)

* Foolishness. (The facts proved your theory wrong, but the broker tells you another story that promises a recovery and more profits. You’ve fallen for one story, and now you fall for another.)

Think about your experience as an investor. Has it been less than satisfying? If so, what are you going to do about it? Blame your broker/adviser/fate – or take responsibility? If you are willing to take responsibility, you are going to have to make some changes in your behavior.

* Admit that you are not smart enough to always have the right stock. When the market proves you wrong by moving substantially against you (i.e., when you hit your stop-loss point), sell your position.

* Recognize that you don’t always have the right idea – and the same is true of your adviser(s). Stock pickers blow hot and cold. Even the best ones will be very wrong on a regular basis. If your investment system is sensible – with no more than 4 percent invested in any one security and a strict 25 percent trailing-stop – you won’t have to worry about believing the next good story.

* Train yourself to be reasonable in your expectations. The stock market returned, more or less, about 12 percent during the 20th century. If you’re happy with that, forget the whole system thing. Just buy an index fund with ultra-low expenses, and you should come within 0.3 percent of the return of the market. But if you want to put yourself in the best possible position to do a little better than the market, limit your risk by following these three simple Early to Rise guidelines:

1. Make yourself a promise that you will never abandon your basic investing scheme to take advantage of a hot tip or an exciting story.

2. Set trailing stop-losses (I recommend 25 percent) – and follow them.

3. Limit each particular investment to 4 percent of your invested wealth. (I’d really like to say 1 percent, but it’s hard enough to find 25 good investments, let alone 100. And, anyway, a 25 percent trailing-stop at 4 percent limits your total risk to 1 percent.)

(Keep in mind that even a 2 percent advantage, with compound interest, can mean up to double the wealth over time.)

Yes, you will lose money, sometimes, but it will never be so much or so often that you’ll have to worry about it.

As the years go by, you’ll get wealthier and wealthier. Not by a huge amount – that kind of growth will come only from your primary business – but by a percentage big enough to make you happy and comfortable when it comes time to slow down and rely more on your passive income.

[Ed. Note.  Mark Morgan Ford was the creator of Early To Rise. In 2011, Mark retired from ETR and now writes the Palm Beach Letter. His advice, in our opinion, continues to get better and better with every essay, particularly in the controversial ones we have shared today. We encourage you to read everything you can that has been written by Mark.]