Start trading eToro

Friday, September 14, 2012

Investing mistakes learned from crisis

A lot of time has passed since the 2008 crisis and now we can look back to the period and summarize what mistakes investors did and what lesson have to learn those who want to invest in the nearest future. What have we learned and what mistakes we should not want to repeat anymore? 

If you read books on investing written decades ago you will see that people of the past made the very same mistakes that we do today. Markets do change somewhat, but the mistakes that are made are always the same. And they are being made by both private investors and corporate investment fund managers. We do give in to crowd mentality, emotions, fail to assess risk and recklessly invest with borrowed resources. Even the best trading strategy can fail us if we do not learn to reverse the above mentioned things. 

Some of the best principles such as: “buy and hold” may not be working anymore. Especially if one is ‘smart enough’ to buy at the top. Following this principle can destroy all of your capital and leave you disappointed with investing. 

So, let us look at those fundamental things we have to know while investing our money in financial markets.

History repeats itself

People tend to forget history. There are things that will always repeat. Stocks will go up and they will go down. They will be uptrends and downtrends. Markets will experience booms and collapses. It is only natural that after a long ride upwards you will surely have to experience a similar ride downwards. Go back hundreds of years ago and you will see that the bigger the move upward you have the bigger the correction or the move downwards. The bigger the inertia, the more severe the reversal will be when it finally occurs.

I remember talking to one of my relatives just at the time the first signs of 2008 crisis started to appear. As I studied market booms and collapses for a long time I told him this one will be pretty dramatic and we are going to see very serious troubles. He would not listen. He said there will be a minor correction in economy and then it will continue growing, salaries rising and prices growing. He sounded as if we will have a never ending boom. We know what happened.

And it will happen. Bubbles will always be. So will crises! My relative had a triple cut of his salary. Then he lost his job. With a loan on a house and two new cars it was a pretty severe blow. His wife had to do double work. Parents helped. After many months he got another job and managed to sail through the troubles. His thinking changed though. 

Remember, history will always repeat itself. It may do it in a bit different way, but it will. So, if you see a boom you can be sure that you will also see a collapse. People forget all crises. They forget that there are cycles everywhere. And they continue being bullish for too long. They continue being bearish for too long too. Be ready for repetitions!

Imagine the worst scenario

We often do the other way round. We tend to imagine the best as the only possible way. We tend to think only about how much profit we can make and how many opportunities we can miss. This often leads to borrowing truckloads of money at unfavorable interest rates and rash purchases of assets or securities that we believe should rise soon and make us millions in profits. If we risk a lot we may find ourselves in a situation when we lose everything and in some cases we may not be able to repay what we owe (bank or somebody else) in a lifetime. 

I recently visited an acquaintance of mine who used to be a director in a construction company. He would get there a good salary and have some smaller businesses of his own. Somehow in the middle of the boom he started purchasing land. He got into deep debt. When markets collapsed he lost his house, cars and he still owes to the banks truckloads of money. His wife travels to work in London in order for the family to survive. Had he thought not only about possible opportunities, but losses he would have never had to live the way he lives right now. 

Ask yourself what happens if the market goes against you. How much are you willing and ready to lose? This will help to balance your expectations. Do not be driven either by greed, or by fear. Let your mind and analytical skills guide you in making investment decisions. 

Emotions or a sound plan

Mistakes that are emotionally grounded are bountiful. Investors constantly break the soundest investing principles just because they are ruled by their emotions. Multitudes of investors made psychological mistakes during the last crisis. They bought at the top and sold at the bottom. They jumped from one investment fund to another. They sold risky stocks at the bottom and bought conservative stocks. It is clear that you cannot go far with this type of behavior. 

Fund managers give statistics showing that most investors were willing to sell their securities at the time when market actually found its’ bottom. It also confirms that those securities were bought when markets peaked, just year or half before the collapse. What a smart way to trade!

Mostly sell offs started when “Lehman Brothers” bankruptcy was announced. It is ok, when a speculator behaves in such a way. It is not good when a person who saves up for his/her retirement does so. I have a few friends who bought houses and flats at the time when markets peak. They did this with borrowed money, of course. Now they tell me how lucky I am for not doing that. I would not say I was lucky. I have been studying markets and various technical as well as psychological patterns for years and my findings discouraged me from buying real estate at such prices. Ya, I was lucky.

One sometimes has to wait patiently through such periods, because market cannot stay too long irrational. Sanity does come back. Many wake up to unpleasant reality. Inertia can last for some time, so can irrationality, but sanity does come back and stays in the markets. Wait for bottoming processes to start buying and topping processes to start selling. Not vice versa!

Do not try to recoup losses

This is another mistake that 99 percent of traders make. When a trader loses ten or twenty percent of his capital he naturally tries to recoup the experienced losses. This, in 99 cases out of 100 leads to even bigger losses. When markets start going down they would prefer to close their long term positions and start searching for fast profits. They work hard to figure out how to win back what they had lost. And they lose more and more till they stop this futile occupation. 

You cannot expect to quickly recoup your losses. It will take some time to find good securities and more time for those securities to start rising. Patience is a remedy for this disease of ‘trying to recoup losses’. 

I told you a few times how a friend of mine and me split up from trading together. At some point he decided to follow some bogus Forex signal service. I do not want to go into details, but I would watch how he opened ten trades at the same time with small stop losses and those would be hit the same day. This continued for a few weeks or a month till all account was wiped out. Trying to recoup losses after a bad day will inevitably end this way. Forget your losses. Continue analyzing markets and after you have noticed some developing tendency trade with confidence and with stop loss orders.   

Make your own decisions

This is particularly important for those who enjoy hunting for tips. If you go to investment unit in a bank or an investment fund they would likely give you optimistic predictions for these or those securities. You see, they make money selling their services and they have to behave like that. A lot of their predictions never come true. Just have this in mind when you are tempted to ask your broker what are upcoming golden securities to invest in. Yes, he will tell you. I doubt if you are happy with the final result. 

Learn to do your own analysis and make your own decisions. Take this responsibility on your shoulders. This will be a big step forward for you to maturity as an investor. If, however, you decide to follow some investment advisor be sure to check if the person who consults you invests himself. If he does not buy securities that he offers you to buy why listen to him? It is useless. Better use your own head. 

Invest into securities you understand

A lot of people invested into derivatives during the boom that preceded the crisis. Most of them did not have a clue where they invested. Most experts could not explain that either. If majority people do what they do not understand they are sure on the road to ruin. A lot of financial instruments are created for one single purpose – to make more money. However, the general rule remains the same – only very small percentage of people make money in these special instruments. Majority loses. Why? Because they do not have the slightest idea what risks these instruments involve. Remember the bigger potential to make money you have the bigger risks are involved. You’d better understand what you are doing. You have to understand securities you invest in. If you don’t, it is better not invest into those. Find something you understand. 

Analyze more

We know that too much analysis leads to ‘paralysis’. However, a thorough analysis of conditions a given market is in will help you to understand what time it is: buy, sell or stay away from the market. We would make fewer mistakes if we spent more time for analysis. Having done your own analysis of a company and seeing its’ share falling you should not immediately run away from the market. You should see whether the fall is justified. Maybe it’s just some profit taking or small players getting scared of losing their profit and selling the shares. It is quite possible that after the fall the stock will make even higher highs. You will hardly ever be able to predict exact top in the market, so when you see a fall and a rise you have to ask yourself whether something has changed about the conditions of a given security you own. If not, stay where you are.  

Diversification does not work well during bear markets

This crisis clearly shows us that diversification during bear markets does not work well. If you studied charts of various securities you would see that almost all markets collapsed. So, if you simply moved your money from one industry to another you would still have lost your money. Of course, if you know how and when to ‘sell short’ and be participant of bear market (play from the short side) you will probably make more money than in bull market. Unfortunately, very few people know how to do it. So, in a downward market you either continue selling or you stay out and wait for the market to bottom. 

Look through your investment portfolio more often

Speculators watch markets on daily basis trying to see any changes that might influence prices. Investors tend to look at that less often. Some even buy stocks and hold them for life. Others, let’s say George Soros made his famous pound breaking trade in one day and made a profit of one billion dollars. In one day! Does not sound like investing! Markets are becoming more volatile and you cannot just sit for a decade without looking what happens in the securities you have bought. It may cost you a lot. So, be sure to check from time to time whether market conditions have not changed and it is still ok to own the securities you have in your portfolio. 

Final thoughts

Modern times have brought a lot of various ways and places to invest in. A lot of instruments have been created for an Average Joe to take advantage of. Unfortunately, most Joes lose their money in the markets. Booms and crises come and go. The reasons for those can be different, but the principles that are there always remain the same: greed and fear, buying and selling at the wrong time and etc. One has to sit down and start analyzing one’s mistakes and then go on to perfect one’s trading patterns, style, methods and strategies. Next time a boom or a crisis comes one will do much better. 

Good luck trading.

If you liked the post I would also be happy if you gave a plus on Google+, tweeted, liked it on Facebook and other social platforms. Have a nice day. 


See also:

Trading financial markets carries a high level of risk, and may not be suitable for all investors. All information on the blog is of educational nature and cannot be considered as advice, recommendation or signals to trade in any financial markets.