How To Avoid The Biggest Mistakes During Financial & Capital Investments
Banks and Big Financial Institutions are always in the financial markets to provide capital or to invest their own capital. But for many years these opportunities are also increasingly being used by individual investors, who wish to generate either a passive income or who are looking for an investment or a hedge for the future.
The investments in share values has made developments such as, the publication of the so-called people's stocks of the former state-owned telecommunications giant telecom to look presentable.
After this, many people could start making high profits at the beginning by purchasing these shares, a part of you had to get to know the downside of the financial marketsin order to accept bitter losses. This impressively demonstrates that investing in a single stock can never give an acceptable risk reward ratio for private investors.
In the following article we would like to explain some of the mistakes committed by many individuals as they tried to optimally invest their money. Please note that we will rely on some basics from the article "Introduction to Financial Investments", because, the advantages and disadvantages, as well as the problems the investors face, are clearly outlined in the article.
The mistakes of private investors in financial markets, which we will in details discuss below, belong to the categories of understanding errors as well as behavioral errors"Understanding Mistakes" and "Behavioural Finance Mistakes".At the end, we also want to get the opinions of small investors on the so-called passive investment strategy.
Understanding Mistakes of Private Investors While Investing Money
Private investors have comparatively little time to deal with their investments in detail as opposed to institutional investors, such as banks or any other financial institution. Unfortunately, for a very long time, only little practical knowledge on the stock market is being provided in Germany, even in the schools of general education (G. Hobein).
This is frequently due to the unavailability of willing investors, as well as the lack of the incentive to deal with this matter. There's a little wonder as to how the simple mistake of understanding, often represents the biggest problems in the investment strategies of private investors.
Resourceful financial intermediaries, who receive commissions but are not paid by the investors, usually take advantage of this ignorance and make the small investor's sub-optimal products to look attractive and to persuade the customer.
11 Biggest Mistakes To Avoid When Making Capital Investment
#1: Incorrect Assessment of "Risk and Return" Relationship
Every investor should be constantly aware that, in any forms of investment the risk and return are directly connected to each other. As an investor you should know, for investments how are risk and return related and what is the relationship between risk and return. The term "return" is obtained from the derivation of the compensation for a real risk. Therefore it is very important to calculate risk reward ratio.
An investor is thus rewarded by the return for which he took a risk for. This therefore means that, for an investment to bring a high return, a high risk must have automatically been taken. However, this risk is not often assumed, it is virtually never applied, but must and will regularly lead to losses for the investors.
In contrast, most private investors unfortunately think that risk and return do not grow together, but rather have it in mind that, a higher risk will lead to a lower yield (H. Shefrin). However, the correct understanding of the connection between risk and return is an indispensable prerequisite for effective investment decisions.
#2: The Mistake of Understanding "Flight"
In addition to the lack of understanding of the relationship between risk and return, small investors often have other understanding mistakes: "The Flight From an Investment". It often happens that, certain assets suffer severe losses and hence we frequently read on financial newspapers headlines about the "Flight of Investors". This scenario however does not apply on the modern market, because, the "Flight of All Investors" is virtually impossible.
To understand this, one has to recall how the price of an asset is determined: The price of a stock, a commodity etc. is determined from the supply and demand, which are each dependent on the price. According to the law of supply and demand, if the demand is higher and supply is lower, then the prices will be higher and if the supply is higher and demand is lower, then the prices will be lower.
The rate in financial markets is the price at which the supply and demand are equal. This therefore means that, there will never be an instant where all the investors will reject an asset at the same time, because there will always be an optimist, who will buy the stock in return, since the number of shares always remains the same (E. Fama, k. French).
The false perception of these facts unfortunately means that, small investors are always trying to follow the non-existent majority of other investors and sell a stock before it is "too late". However, this prevents the targeted learning progress from private investors, thereby limiting their rational thoughts on Capital accumulation (G. Hobein).
#3: Changes inthe Prices of Assets and Returns
As explained in the previous section, an increasing price of an asset occurs due to an increase of in demand or a fall in supply. However, private investors tend to disregard this principle. So, private investors generally expect that a stock with a sharp increase in price will have another sharp increase in price in the future.
This was the exact mistake that led to the doom of many of the Telecom stocks investors. They bought the shares at a time when the demand was high and the demands increase further. Although this led to a further increase in the prices for a short period of time, the price fell again in the long term, since an increase in demand cannot be permanent.
Therefore high prices should cause investors to dump a share and not to acquire more of the share in question. What is particularly ironical is that, private individuals tend to buy more of a material asset, when its price drops, but tend to reverse this behaviour when trading in the stock market. (Bernstein).
#4:Successful Companies Also Have Successful Shares
Nokia was a successful company in 1996, a Nokia bonds cost 4 000 DM and the Nokia share was a hot stock exchange tip in 1996. BlackBerry (or RIM) was a successful company in 2006, a BlackBerry premium series cost 2,000 chf, and the shares were flying high.
BlackBerry and Nokia are trading today at a small fraction of their former value. Apple is a successful company in 2016, an upper-class iPhone costs 2 000 chf and nobody can say at what price the Apple share will be traded in 2026. But there is evidence that the iPhone success story shall not continue eternally.
Private investors, who try to deal more with their own investments, also generally try to find "good" stocks/shares. Unfortunately they often do this by equating the success of a particular company to the success of its shares.
However, contrary to above assumption, successful and solid companies generally have less successful shares (with respect to their returns) (S. Thorley). This mistake of understanding can be traced back to the misunderstood relationship between risk and return.
Whoever accepts that a higher risk is associated with higher returns, will soon realize that a solid company (low risk) cannot provide a high return on investment, i.e. for high return, high risk should be taken.
One could summarize this as: Bad companies have good shares and good companies have bad shares (Bernstein). Through this mistake of understanding, private investors again tend to behave incorrectly.
#5: The Wrong Perception of Future-Oriented Industries and Emerging Markets
Emerging Markets, as well as future-oriented industries are what private investors prefer in their own portfolios. This is because they believe that this category of assets promises a particularly high future growth in assets.
However, the economic research was able to repeatedly show in recent decades that there is no sector of the economy that will yield higher returns in the long run than other sectors of that same economy during the same period.
Also a strong focus on the investment strategy known as metropolitan (agglomeration) risks must be avoided, especially for the private investors. Also, technology companies are exposed to a further yield-reducing effect, although they often develop innovations, since these only have a short-term growth effects. The actual beneficiaries are usually the companies from other sectors who earn significantly more (L. Swedroe).
#6: Inflation Risk
Another problem is that the assets are exposed to, is the risk of inflation, i.e. the possible loss of real purchasing power. The goal for a long term investments will be to achieve a gain in the purchasing power.
This risk is particularly high, especially in the forms of investment that promise only a low return, such as Government Bonds from countries with extremely good credit. If we retrospectively look at the returns on this investment minus the inflation, we could frequently find negative returns. (j. Siegel).