Mistakes investors make, part 2

Good investors also learn from the mistakes of other investors, as otherwise this hobby can be costly in the long run.

Not understanding the real value of investments 

Investors should always understand where they are investing their money and form an idea of the true value of the company's business. The price of a share doesn’t tell you much, but rather it's important to understand whether the price paid for the share reflects its current value. Here, investors are assisted by analysts whose job is to price the true value of the business so that the investor has an idea of what the value of the company's share should be. 

In particular, a novice investor may buy stocks that have not yet risen at the end of a bull market. At the end of a bull market, even lower-quality companies often rise like a piece of plastic at high tide, but in investor jargon the downside risk is greater than many people expect. 

Relying on historical data without a qualitative understanding

In investment discussions, one often comes across arguments that the stock market has historically been this or that, supported by at least a 100-year price chart. While knowledge of history is useful, educational and can help investors avoid the most epic mistakes, investors should look to the future first and foremost. The biggest risk for an investor comes when you don't know what you are doing.

History never repeats itself in exactly the same way and the stock market is constantly changing. For example, it took the NASDAQ-100 index more than 10 years to return to its peaks of early 2000s. In other words, the average annual return of 7% on the stock market is no guarantee, especially when viewed over different time horizons. Listed companies were very different companies 20 years ago, let alone 50 or 100 years ago. Therefore, claims that rely on the assumption that the stock market is always the same and therefore always deserves the same valuation multiples should be viewed critically and the qualitative factors behind the multiples understood. 

The same applies to companies. For example, it’s important for investors to understand why certain companies have a high return on equity and not to directly assume that a five-year high return on equity automatically guarantees continuity. Finns also tend to get excited about dividends in the spring, and rightly so, as in the long run most of the return on equities is explained by dividends. Still, in many cases high dividend yields are too good to be true and high dividends in past years are not a reason to buy a share. The investor should assess what the dividend growth curve will be in the future. 

Hunting only for profit, ignoring the risks

Many investors, especially in the final stages of a bull market, completely forget about the riskiness of equities. In the short term, the value of shares can fluctuate dramatically and, furthermore, the returns on many companies are actually zero or negative for a very long time. The risk of a stock picker being hit by such mines is always there. Investors should therefore consider the binary nature of stocks, i.e., the possibility of returns in both directions. How much can I realistically lose in this stock in the long run? For example, an expected annual return of 30% is not realistic for a long time, so if you have found such an investment, you should check the downside risks.

 Too low required return

Stocks are a risky asset class and therefore also require a return. If an investment in a stock is made with a low expected return and the investment doesn’t perform as expected, returns can remain negative or at zero for several years. For this reason, investors shouldn’t settle for low required returns in equities. When you buy a stock after careful research with a high expected return but with a controlled risk, you're left with a margin of safety in case of mistakes. So as an investor, don't settle for little!