Recently, it occurred to me that it would be instructive to challenge our Sound Mind Investing readers to step forward and admit to the group, "This was my biggest mistake." In looking back over the past 10 or so years, they were to explain what they did, or didn't do, that they now regard as a major error. I was interested in learning if a few common themes would emerge.
In the interest of fair play, I went first by sharing the story of one of my biggest blunders. In 1999, I watched with amazement as some of the dot.com stocks rose to breathtaking price levels when many of the companies who issued the stock had no earnings and no hope of having any earnings for several years. The ones that did have minuscule earnings had P/E ratios that went to 200 times earnings, then 300, then 400 and more. It was insane.
I decided to cash in on the insanity by "selling short" two of the high flyers, profiting when the inevitable bursting of the bubble took place. (If an investor thinks the price of a stock is going down, the investor can borrow the stock from a broker and sell it. Eventually, the investor must buy the stock back on the open market at what he hopes will be a lower price.)
But I didn't put a plan in place. I was so sure that "they just couldn't keep going higher" that I didn't bother with stop losses or any of the other aspects of a plan that I regularly apply elsewhere.
I was way wrong. They did keep going higher. I was overly confident, not knowing at the time that the limits of the mania were far more elastic than I had ever imagined. I finally couldn't take it anymore and got out.
The losses weren't devastating, but they were painful, embarrassing, and much more than they would have been if I had followed my usual guidelines. To add insult to injury, the mania ended the very next week after I got out! (It almost seems as if the market taunts you sometimes, doesn't it?)
My analysis was correct; my timing — driven by my emotions — was terrible. If I had had the courage of my convictions and hung in there, I would have cleaned up over the next year as the tech crash unfolded.
Lesson: When you enter an investment, always have a specific plan in place that will trigger your exit. No exceptions. Even when you know you're right. Especially when you know you're right.
Our Sound Mind Investing readers accepted the "biggest mistake" challenge and came forward with their stories. Though varied in details, the stories had much in common when it came to the basic underlying problems. Here are the four most common themes:
• No plan for when to sell. Tales abounded of buying stocks, happily watching them rise, and then passively standing by and watching them crater to single digit lows (or even bankruptcy). Some admitted to compounding the problem by optimistically buying even more shares as they dropped in value (a practice known as "averaging down").
• Overly concentrated in a "hot" sector. When an industry moves into the media spotlight (as technology did in the 1998-2000 mania), investors often respond by investing more and more of their portfolio in that one industry. When the inevitable selloff occurs, their losses are much larger than if they had maintained a prudent level of diversification.
• Underinvested in stocks. Out of either fear or ignorance, many investors failed to invest 80 percent-100 percent of their portfolios in stocks in their younger days, when time was on their side and they could afford to take the additional risk. This cost them tens of thousands of dollars.
• Following the wrong advice. Many investors told of turning their portfolios over to market professionals and trusting them to get the job done. In some cases, that trust was betrayed due to conflicts of interest — usually when a broker placed a greater value on earning commissions than on what was best for the client. In others, the broker was well intentioned but was either inept or used a flawed strategy.
Happily, we already offer an antidote to these problems. SMI's strategies have built-in safeguards that help investors avoid repeating common mistakes. They offer specifics on what to buy and when to sell, broad diversification, age-appropriate stock percentage guidelines, and a proven record of effectiveness.
Austin Pryor is the founder of Sound Mind Investing, America's best-selling investment newsletter written from a biblical perspective. SMI helps people manage money well so they can truly live well and give generously.
© Sound Mind Investing