15 Mistakes People Make In The Stock Market
“All I Want To Know Is Where I’m Going To Die So I’ll Never Go There”, this is what Charlie Munger said. The meaning of this quote is that he wants to know where he’ll fail so he’ll avoid that.
One of the most important mental model which Munger uses is Inversion. If you flip a problem backwards, the problem becomes simple. Let’s say you are asking the question “How to get rich?”. The simplest thing you can do is answer the question “How not to get rich?” And whatever answers you get from that, you just avoid those.
When people start out in the stock market, they try to do too many things at once. Not knowing what to do and what not to do, they do things that they shouldn’t have and lose their hard earned money. This article will help you avoid such mistakes.
Disc.: I am not a SEBI registered investment advisor. The stocks listed here as recommendations in any way.
#1. Thinking Stock Market Is Too Easy
People who have opened their brokerage accounts over the last 2 years have seen the market go in one direction. All this is making them think that investing in the stock market is too easy. Add to that the rise in number of advertisements that are showing that investing is stocks is easier than doing trivial things.
All this is making people think that they can’t lose money. Beginner’s luck is the worst thing that can happens to an investor. If you lose money initially, you begin to reflect what went wrong. And in that process, you will improve yourself as an investor.
If you look at Warren Buffett, he has been active in the stock markets for over 6 decades. He is still learning. A great characteristic of successful investors is humility. The moment you think you know it all, the market will knock you back down with another lesson to teach.
#2. Chasing Hot Stocks
A lot of people chase stocks that are currently trending. More often than not these stocks are a part of pump and dump narratives. Yes, there might be times when the stock is really rallying due to its fundamentals. But, such cases are too rare.
Many retailers get trapped into such stocks thinking that it can keep on going up. When you feel the urge to buy such stocks always remind yourself of this quote:
Only when the tide goes out do you discover who’s been swimming naked.
— Warren Buffett
As an investor your job is not to engage in the greater fool theory, but to buy great businesses during times of distress. If you still want to get into that hot stock in which your neighbor is up 200%, repeat this multiple times before you press the buy button:
Money is mine.
Profit is mine.
Loss is mine.
I solely take the responsibilty.
If you still feel like buying, then nobody can stop you.
#3. Blindly Following Big Investors
You see the news of a big investor buying a stock and then see that the stock is up. You think, “Successful investor has bought this stock. How can I go wrong?” and buy the stock in bulk. This stock is now 30% of your portfolio. You don’t even have a faintest of an idea that the same stock is not even 1% of that big investor’s portfolio.
When you see a big investor buying, you don’t know their thesis, conviction, allocation, buying price. You also don’t know whether that investment will fail or not. There are cases where successful investors have also lost huge amounts of money in some stocks. After all, they are humans just like us.
It is okay to take ideas from big investors. In fact, some investors look for big investors’ portfolios for new stock ideas (remember, just ideas). But, it is not okay to blindly follow them. Ideas can be borrowed, conviction can’t be borrowed.
#4. “It’s Only ₹5 A Share. What Can I Lose?”
Penny stocks are a great way to build wealth. But, 99% of those are pure trash. Many newbies think that there are high chances for a ₹5 stock to go to ₹10 as compared to a ₹500 stock going to ₹1000. This kind of thinking is wrong.
Rather than looking at stock prices alone, look at market capitalisations. Yes Bank trades at ₹12 while Tasty Bite Eatables trades at ₹15,000. Now you might think that it is easier for Yes Bank to double as compared to Tasty Bite. Go and check the market capitalisations of the two stocks and rethink. Yes Bank has a market cap of ~ ₹35k crore while Tasty Bite has a market cap of just ~₹3.5k crore — 1/10th the size of Yes Bank.
Again, looking at market cap alone won’t show you the growth potential of the stock. You also need to look at other things such as total addressable market, valuations to get a better judgement of the potential of the stock.
#5. Timing The Market
Many people think that they can sell at the top and buy the stock back at the bottom. There’s an extremely small percentage of people who can really do that consistently over time. There are many people that sold out in 2011 dip thinking that the market will tank more. The next big fall came 9 years later. Do you have the ability to stay out of the market for such long periods of time?
All the energy that you put in timing the market will be wasted. It’s better to not try and do that. What should you do then? Buy when you have money and sell when you need it. As simple as that. If you are in your accumulation phase and don’t need that money for at least 10 years, then you will do fine. Go through this blog post on market timing which I had written some time back.
#6. Waiting To Get Even
You buy a stock and that has now tanked 50%. You later realise that it is a poor quality company. Many retail investors wait till the stock comes back to purchase price. And this is where they go wrong.
“Selling your winners and holding your losers is like cutting the flowers and watering the weeds.”
– Peter Lynch
Most retail investors do this. If you think the business is not a good quality one, then sell the stock. Your purchase price of a stock doesn’t matter. What matters is what the stock will do from the current price.
#7. Investing Without Research
If you buy a stock without studying the underlying business, you are not investing. You are speculating. The worst reason to buy a stock is by thinking that it will go up. Yes, that is the reason why we invest, but it is the outcome. You must understand that over the long run, it is the earnings that drive the stock.
To understand how the trajectory of earnings might be in the future, you must understand the company. That means the company must be within your circle of competence. To know that, you must first define your circle of competence. If you don’t have any idea, this thread will help you.
The most common mistake retail investors make is thinking that good products mean good companies. This is not necessarily true. There are various products which are loved by the customers, but the underlying businesses are struggling. This is why you must also look at the financial and future prospects of the business and the industry.
#8. Using Borrowed Money To Invest
Boosting your returns using leverage might sound fun. But when the tide turns, it will hurt you badly. You might feel like investing with a 5x leverage if you are “confident’. But, a 20% fall will wipe your capital out. Nowadays, there are many HNIs who borrow in huge amounts just to apply for IPOs. All this is done just for listing gains. But, just a single poor listing can wipe out all the profits that one might have earned.
The lending business is very much dependent on leverage. If you look at the history of lending business, it is not the risk taking banks that have created significant wealth. It is the conservative banks that have generated enormous wealth. It is the survivability that matters. Same is the case with stock market. Know what to avoid, don’t take unnecessary risks, focus on surviving over the long term.
#9. Panic Selling
Investing and emotions are two things that do not mix together. You might do everything right — find a quality business, with a high pedigree managment, and buy when it is cheap — but you won’t make a single rupee until and unless the market agrees with you. Always remember, that an undervalued stock might become even more undervalued.
As an investor, it is important to control your emotions. Volatility is a part of the stock market. You must embrace it. Actually, it is volatility that makes long term investors like us profit. You’ll be able to control your emotions if you invest in a company within your circle of competence. If a stock you own is down 50% you should ask —
- Is the business really worth 50% less?
- Has the earnings potential deteriorated?
- Has there really been a fundamental change in the business that might deplete the earnings?
#10. Investing Money That You Need In Near Term
You have invested in a quality stock and the stock is down 50%. You have studied this business very well and know that it has solid growth potential. Now that it has fallen 50%, it is now at a very attractive level. But you don’t have any more funds to invest, so you turn to your emergency fund.
Thinking that the stock will rebound quickly, you invest your emergency fund. Now, the stock tanks even more. During the same time, you are faced with a medical emergency. Due to this, you are now forced to sell that stock at a loss. This is the reason why you should never deploy your emergency fund into the stock market — no exceptions to this rule.
#11. Chasing Turnaround Stories
How many times have you put your hard earned money into companies that you think will turn around? The problem with turnarounds is that they seldom turn. There are a few companies like Suzlon, JP Associates that are turning around since a decade. A company’s management have might project that they have a plan to turn their business around, but it all boils down to execution.
Yes, there might be a few companies that could manage to turn around — and those are the ones that give exceptional multibagger returns. But, to be able to find such companies is more difficult than finding a needle in a haystack. To be able to understand whether a company has a significant chance of turning around, you must properly understand the business (circle of competence). Also, you should be able to judge whether what the management is planning to do is realistic to achieve.
As a value investor, your goal should be to bet on high probability events. Ask yourself these questions:
- What if I’m wrong?
- How do I know that I’m wrong?
- What are the consequences / downsides if I go wrong?
Aim for survival in the markets, and you’ll be definitely rewarded for your time in the markets.
#12. Relying on EPS alone
Everyone on the street has made one metric the holy grail of analysis — the P/E ratio. The metric required to calculate the P/E ratio is Earnings Per Share (EPS). If you look at brokerage and analyst reports, the metric they all focus on is EPS. You must understand that profits (indirectly EPS) are something that can be manipulated. On the other hand, cash flow can’t be manipulated.
There are many companies that have posted consistently rising profits, but they haven’t returned a single rupee back to the shareholders. No, I’m not talking about dividends. I’m talking about free cash flow. Focus on companies generating free cash flow, because that is what will matter over the long run.
#13. Thinking Short Term
Many people who entered the stock market after the COVID crash in March 2020, haven’t yet seen even a minor correction in the markets. Add to that, the various advertisements which has made people think that the stock market is easy. I’m sure that most of these people will quit the stock markets even if we see a 10-15% correction.
Warren Buffett has been managing Berkshire Hathaway for almost 6 decades. During that time, there have been 4 instances when Bershire’s stock was down 50% or more. Yes, Buffett’s net-worth was also cut in half. But did he sell? The obvious answer is no. Despite the fact that Berkshire’s stock was down 50% or more for 4 times, it has compounded at almost 20% over the years.
Let’s take the example of Amazon. Over its journey, Amazon fell 90% once, and more than 50% multiple times. It has still given over 2000x in 25 years. If you also look at some of the top companies in India, and bought them at the peak of 2008 financial crisis, or even just before the March 2020 crash, you would still have made money. Everyone know that they are great companies today, everyone know they were great companies a decade ago, and the same can be said about them a couple of decades ago. If you had stuck with them through the ups and down, you would have generated significant wealth.
#14. Too Much Trading
Trading might sound cool, and you could also get into the trap of thinking that the trading is easy money, but beware, the market might take back your profits someday if you aren’t disciplined enough. I’m not saying that trading is bad, but very few people are able to master it. Let me ask you this: Who is the most successful trader of all time?
His name is Jesse Livermore. He earned a lot of money by trading during The Great Depression, and later committed suicide because he went bankrupt 4 times. On the other hand, if someone might be the stupidest person ever, and he would have just invested every month in the index, not look at the prices, he would have become very wealthy within 15-20 years — by doing nothing! The great thing about investing for the long term is that you are rewarded for doing nothing. And anyone can do that. Same is not the case with trading.
Another thing which many people try to do is picking the bottom and the top of the market. You have generated great returns, and thinking that the market has become “overvalued”, you sell off your portfolio. And the market continues rising. Same is the case with picking bottoms. As an investor, just accept the fact that you can’t time the market — in fact you don’t even need to. So, what do you need to do? Just stay in the game.
Let me give you another example. Fidelity conducted a study of the investors which have received the best returns between 2003 and 2013. The people that came at the top of this list were dead. Second on the list were people who had forgotten that they had an account with Fidelity. In investing, less is more.
#15. Ignoring Compounding
Everyone has studied compound interest in fifth grade math, but very few people truly know its power. We saw that Buffett has compounded at almost 20% over the last 56 years at Bershire. Now 20% might not seem much, but let’s say you invested $100 with Warren Buffett in 1965, just make a guess how much that amount might be? It would have been almost $3 million in 2022 — a staggering 30,000 times!
Now this might be an extreme example. Let’s take another one. Two friends Abu and Babu have got a job together at the age of 25. Abu, being smart, decides to invest ₹10,000 every month in index funds. He does that till 35 and doesn’t put any more money. On the other hand, Babu says that it is too early to think about investments, let’s start at 35. So, he begins investing at the age of 35 and continues till 65. Abu has invested a total of ₹12 lakh, while Babu has invested ₹36 lakh. At the age of 65, who would have more money if both have invested in index funds (at 12% CAGR)?
Babu will have ₹3.5 crore with him — almost 10 times his investment. Abu, on the other hand will have, hold your breath…., ₹6.9 crore with him — almost twice as that of Babu by investing one third the amount. How is that even possible? That, my friend, is the power of compounding. To match the corpus that Abu has generated, Babu has to invest ₹20,000 per month for 30 years. To make up for the 10 years, Babu has to invest 12 times the amount!
This is why it important that you start investing as early as possible and look to get your initial corpus set up as quickly as possible.
If you strictly avoid these 15 mistakes, half your job is done. Now you should focus on hunting good businesses. This is the blueprint for the same:
- Know what you don’t know
- Understand what is a good business
- High quality management
- Don’t overpay
This is the process which Warren Buffett follows. If you stick to these rules, and avoid the 15 mistakes, you should do fine over the long term.
If you want just one takeaway from this article, it should be this:
Survival is the only road to riches. Let me say that again: Survival is the only road to riches.
— Peter Bernstein
Till next time.