Common errors in Investment Management

Investors appear to be prone to the following errors in managing their investments.

1. Inadequate comprehensive of return and risk
2. Vaguely formulated investment policy
3. Naïve extrapolation of the past
4. Cursory decision making
5. Simultaneous switching
6. Misplaced love for cheap stocks
7. Over diversification and under diversification
8. Buying shares of familiar companies
9. Wrong attitude toward losses and profits
10. Tendency to speculate

Inadequate Comprehension of Return and Risk:

What returns can one expect from different investments? What are the risks associated with these investments? Answers to these questions crucial before you invest. Yet investors often have nebulous ideas about risk and return. Many investors have unrealistic and exaggerated expectations from investments, in particular from equity shares and convertible debentures. One often comes across investors who say that they hope to earn a return of 25 to 30 percent per year with virtually no risk exposure or even double their investment in a year or so. They have apparently been misled by one or more of the following; (1) tall and unjustified claims made by people with vested interests; (2) exceptional performance of some portfolio they have been or managed, which may be attributable mostly to fortuitous factors; and (3) promises made by tipsters, operators and others. In most of the cases such expectations reflect investor naiveté and gullibility.

By setting unrealistic goals, investors may do precisely the things that give poor result. They may churn their portfolio too frequently; they may buy dubious ‘stories’ from Stock Exchange; they may pay huge premiums for speculative, fashionable stocks they may discard sound companies because of temporary stagnation in earnings; they may try to outguess short term market swings.

Vaguely Formulated Investment Policy:

Often investors do not clearly spell out their risk disposition and investment policy. This tends to create confusion and impairs the quality of investment decisions. Ironically, conservative investors turn aggressive when the bull market is near its peak in the hope of reaping a bonanza; like wise in the wake of sharp losses inflicted by a bear market, aggressive investors turn unduly cautions and overlook opportunities before them. The fear of losing capital when prices are low and declining, and the greed for more capital gains when prices are rising, are probably more than any other factors responsible for poor performance. If you know what your risk attitude is and why you are investing, you will learn how to invest well. A well articulated investment policy, adhered to consistently over a period of time, saves a great deal of disappointment.

Naïve extrapolation of the past:

Investors generally believe in a simple extrapolation of past trends and events and do not effectively incorporate changes into expectations.

People generally and investors particularly, fail to appreciate the working of countervailing forces; change and momentum are largely misunderstood concepts. Most investors tend to cling to the course to which they are currently committed, especially at turning points.

Cursory Decision Making:

Investment decision making is characterized by a great deal of cursoriness. Investors tend to:

1. Base their decisions on partial evidence, unreliable hearsay, or casual tips given by brokers, friends, and others.
2. Cavalierly brush aside various kinds of investment risk (market risk, business risk, and interest rate risk) as greed overpowers them.
3. Uncritically follow others because of the temptation to ride the bandwagon or lack of confidence in their own judgment.

Simultaneous Switching:

When investors switch over from one stock to another, they often buy and sell more or less simultaneously. For example, an investor may sell stock A and simultaneously buy stock B. Such action assumes that the right time for selling stock A is also the right time for buying stock B. This may not often be so. While it may be the right time to sell stock A, it may to necessarily be the right time to buy stock B. Alternatively, while it may be the right time to buy stock B, it may necessarily be the right time to sell stock A. Hence, when you contemplate switching, you should first sell if you feel it is the right time to do so or buy if you feel it is the right time to do so and make the other deal at an appropriate time.