Topic: Value Stocks

How to make investment decisions that won’t ruin your returns

how to make investment decisions

It’s important to know how to make investment decisions for maximum safety

All too often, investors search for certainty on how to make investment decisions. This can lead them to zero in on a single fact or indicator. This focus can pay off—for a while—if you are fortunate enough to zero in on the right fact or indicator.

In investing, however, “facts” can turn out to be based on mistaken assumptions. Indicators based on these assumptions can seem to work for a while, then shift abruptly from useful to harmful. The markets of the 1990s produced some outstanding examples.

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How to make investment decisions based on what we learned from the 1990s

In the early days of the 1990s Internet stock boom, many investors assumed that Internet pioneers were sure to produce huge gains for those who got in early. These investors figured that an early start would give pioneers an unbeatable competitive position. They overlooked the enormous capital investment that Internet growth attracted. This capital influx sped up the rate of technological advances. More important, it spurred the development of new business concepts. This stopped many pioneers from achieving profitability or building a strong competitive position.

Later in the Internet boom, stock promoters and brokers seized on the idea that it didn’t matter if Internet pioneers lost money. The important thing was that they attract enough “eyeballs”—website viewers and visitors. This also proved mistaken. Web viewers and visitors are only loyal until something better appears, usually only a click or two away.

In web browsers, Netscape lost out to Yahoo, which in turn lost out to Google. The same thing happened in most other pioneering Internet businesses.

Something like this has been going on as long as people have invested. Some investors routinely shift from one misleading focus to another. The only way to prosper consistently is to look at a variety of facts. That’s what we do when we analyze investments. It helps us avoid putting too much emphasis on any mistaken assumptions.

How to make investment decisions: Stay away from short-term market forecasts

When investors base buy and sell decisions on short-term market forecasts, they often experience notably poor investment results, or even lose money. This may come as a shock to them. In hindsight, it may seem that past market trends, up or down, should have been easy to foresee. But in fact, nobody consistently foresees these trends. That’s why most investors hurt their returns if they let short-term market forecasts have much impact on their investment decisions.

Investors may feel tempted to follow the long-time saying that you should, “Sell in May and go away.” This saying is based on the observation that, over the years, stock prices have often gone sideways or dropped between May and October.

The problem with this kind of analysis is that it fails to distinguish between causation and correlation. The pattern of falling stock prices between May and October may simply be a coincidence.

Many investors have guessed right about a coming trend at one time or another. Maybe they bought just prior to a big upswing, or sold in advance of a major stump. In the long run, however, these experiences may wind up costing them money. They may bet twice as heavily on the next trend they foresee, with more volatile stocks, only to discover their forecast was 100% wrong.

How to make investment decisions: Avoid broker jargon

Stock broker jargon can slant your investment decisions. Some of this stock broker jargon is simply shorthand that brokers use amongst themselves, to refer to familiar situations without having to explain the underlying concept. However, the concepts that these “broker-ese” words and phrases represent are just naturally conducive to furthering the goals of the brokerage business.

If you find yourself thinking in broker-ese, you’ll naturally make assumptions that are in tune with the goals of your stock broker, and may be out of tune with yours.

How to make investment decisions: Risk and reward potential exists in all investments—but you must drill down into the details

You have to learn a lot of things to become a successful investor, and few people learn them all in any logical progression. Instead, most of us move from one subject of interest to another, with a lot of zigs and zags in between.

That’s why some investors go through a phase when they know just enough about a particular investment to be a danger to themselves and others.

All investments come with a mix of risk and potential reward. The greatest danger comes when you understand the mechanics of an investment, but you’re missing some of the details. Your understanding of the potential reward can make you greedy, while the gaps in your knowledge limit your natural, healthy sense of skepticism.

What are the most important factors you look at when considering an investment decision? Share your thoughts with us in the comments.


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