Succumbing to emotions
Emotional decision-making is a common mistake investors make. Cognitive biases such as herd mentality, loss aversion, anchoring bias and hindsight bias can diminish your ability to make good investment decisions.
Experienced professionals aren’t immune either. We can’t know the exact reasons behind it, but in early 2023, Michael "Big Short" Burry, Bill Ackman and Ray Dalio made several pessimistic statements about the market and placed bets against stocks and bonds. These bets failed as the S&P 500 surged 24% in 2023.
To avoid these pitfalls, Buffett recommends being a “no-emotion person” in matters of business and investing.
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Get StartedUnder- or over-diversifying
Diversification is an important but often misunderstood tool. Passive investors in index funds may fail to recognize the level of concentration within their portfolio. They may own multiple funds with similar holdings not realizing there’s overlap. Experts recommend limiting any asset in a portfolio to 5-10%.
Investors also overlook their home bias, according to AllianceBernstein. American investors stick to U.S. stocks and overlook the benefits of diversifying with foreign equities. They cited Morningstar data from 2023, which said international equities accounted for just 15% of total U.S. investor assets through April.
Meanwhile, some investors may be too diversified. “Most research suggests the right number of stocks to hold in a diversified portfolio is 25 to 30 companies,” Jonathan Thomas, private wealth advisor at LVW Advisors, told Time. “Owning significantly fewer is considered speculation and any more is over-diversification. At some point after continuing to add individual stocks to your portfolio, you may ‘own the market’ and be better served in purchasing an index fund that’s able to trim positions and rebalance in a tax-efficient manner.”
Analysis published by Enterprising Investor showed that the difference in volatility between a portfolio with 10 large-cap stocks and another one with 40 large-cap stocks was just 3%. “For large-cap portfolios, there’s little to be gained by diversifying beyond 15 stock or so,” wrote the authors. “For small-cap portfolios, peak diversification is achieved with around 26 stocks. The same applies for non-dividend portfolios, while growth and value portfolios need a roughly equal number of stocks to optimally reduce volatility.”
Trying to time the market
Countless studies, including one by Morningstar, have proven that uninterrupted time in the market is better than timing the market. A buy and hold investment strategy outperformed a strategy where investors tried to time the market based on fair value estimates over a three year period ending in 2023, according to this study.
By moving to the sidelines, you risk missing some of the strongest days of gains for the market. Analysis by Capital Group found that the chances of a positive return from the S&P 500 was 94% if the index was held for a period of 10 years.
So, avoid the temptation to jump in and out of the market based on what your gut is telling you and stay invested for the long term.
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Get StartedNot managing expectations
Investors overestimate their ability to predict the future. For instance, many investors were “excessively optimistic” about a cut in interest rates by the Federal Reserve this year, according to Oxford Economics. Optimistic or pessimistic investor sentiment often pushes asset prices to extremes. Managing your expectations could help you remain disciplined throughout your investment journey.
Misusing leverage
“My partner Charlie says there is only three ways a smart person can go broke: liquor, ladies and leverage,” Buffett once said. The Oracle of Omaha is famous for his conservative approach to debt. That’s because borrowed capital is a double-edged sword that can expand gains or losses during market swings. Adopting Buffett’s cautious approach to leverage could be prudent for most investors.
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