Topic: How To Invest

Avoid these 4 investment errors for better stock market returns

Here are four classic, profit-killing errors that all investors make from time to time. All can seriously hinder your stock market returns.

1. “Averaging down” without reconsidering whether you should have bought in the first place.

Many investors have made lots of money by “averaging in” to the stock of a well-established, well-managed company — that is, buying more as funds became available over a period of years.

“Averaging down” is different. When you systematically average down (that is, you buy more of a stock you own that has gone down in order to lower your average cost per share), you are zeroing in on your losers and running the risk of hurting your stock market returns.

Mind you, good stocks can drop and stay down for lengthy periods, just like bad ones. But the bad stocks are more likely to go down and stay down. If you routinely buy more of any stock you own that goes down, you increase the risk of loading up on junk (see mistake #4, below). That costs you money and lowers your stock market returns because it keeps you from buying good stocks, since your funds will be tied up in bad ones.

2. Failing to recognize subtle signs of high risk, such as an unusually high dividend yield or an unusually low p/e (the ratio of a stock’s price to its per-share earnings).

High yields and low p/e’s are good, but only within limits.

If a stock’s yield is extraordinarily high, it usually means there is some risk that the company will have to cut its dividend, or quit paying it altogether. If the p/e is extraordinarily low, it usually means there is some risk that the company’s earnings are about to fall. Or worse, that the company is using “creative” or deceptive accounting to seem more profitable than it really is.

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Instead of seeking out the top yields and lowest p/e’s, look for investments that have appeal on a wide variety of measures, rather than just one or two financial ratios.

3. Buying too many “stocks that everybody likes.”

Some stocks stay popular for years, if not decades. They can be very profitable during those periods. But if you buy too many, you’ll wind up getting aboard some just as they reach their peak. When these stocks fall out of favour, the drop in your returns can be breathtaking. It can also take years for such stocks to recover.

4. Stuffing your portfolio with low-quality investments.

To increase your stock market returns, we feel you should invest mainly in high-quality, dividend-paying companies like the ones we recommend in The Successful Investor. We also feel you should diversify by spreading your money out across the five main economic sectors (Resources & Commodities, Finance, Manufacturing & Industry, Utilities and Consumer).

However, diversification only adds value if you apply it to well-established companies. Diversifying a penny stock portfolio is like diversifying a portfolio of lottery tickets. If you buy a lot of speculative stocks, your occasional winner may not be enough to offset your many losses.

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