11 Biggest Mistakes To Avoid When Making Capital Investment

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 the errors private investors

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).

Behavioral errors

Behavioural Finance Mistakes

The above-mentioned mistakes of understanding often have consequences which lead to different behavioural mistakes by private investors. These behavioral mistakes and other factors are briefly described in the following section.

#7: Deviations From The Inherent Risk Spreading

It is now well known that, it is important for a long term investment strategies to be able to spread risk. This means that different geographical, geopolitical segments, sectors and asset classes should be appropriately mixed in order to achieve a reasonable risk or reward.

The whole thing is problematic if at the beginning, this diversification and structure behaves differently from what one actually expected. So it can happen that one's own diversified portfolio brings a worse return than the references, such as the DAX in the same period.

The mistake results from the deviation from one's own strategy, possibly due to the short-term losses that one experiences, due to stress, though the possible chances remain underrepresented. Thus, it is usually better to stick to one's own diversification, if no fundamental weaknesses that need to be eradicated were identified (R. Gibbson).

#8: Exaggerated Confidence and Linear Extrapolation

Actually, the mistake of excessive self-confidence from private investors in Germany does not necessarily refer to the investors trust in themselves, but on their trust in others, such as the independent financial advisor, as well as the asset managers of different types of investment funds.

These days, a private investor always assumes that, having these supposed experts of financial markets will automatically guarantee the best for him and his capital; forgetting to know that, these trusted third parties track their own economic interests on the one hand, and there is no evidence on the other hand that they can actually beat the financial markets in the long run.To beat in this case means, to achieve a rate of return which exceeds the average return, for example the DAX, (B. Barber, T. Odean,M. Glaser, M. Weber).

The mistake of linear extrapolation is based on the faulty assumption that the returns generated in the past can be transferred directly to the present and the future. Therefore, private investors usually like to buy assets, funds or stocks, which have performed particularly well in the recent past.

However, from evidences in economic studies, this relationship does not hold. Thus, the returns of funds which have featured amongst the best in recent years will not necessarily have higher returns than others in the long term (M. Statmann,J. Zweig).

#9: Blind Belief and Incorrect Use of Financial InstitutionsYield Forecasts

Financial analyst, economist and various financial institutions more or less regularly publish forecasts for the future development. This does not only concerns the general economic situation, but also share prices, commodity prices, inflation rates, labour market indicators, interest rates and much more.

Entire books, journals and online articles are filled with these figures and many private investors take these predictions at face value. However, these predictions in a wide variety of cases have been shown again and again, not to apply, but to only have a very poor prediction quality, (j. Zweig,P. Tetlock).

Small investors can be tempted by these financial experts opinions and consequently make wrong money investment decisionsfor themselves. This too is related to the above described "excessive confidence".

It can also be rationally explained why we have to regularly deny these forecasts. This is partly because, the underlying information is also available to financial markets and is therefore already considered in setting the price.

Still, the accuracy of the forecasts is limited because; an accurate forecast is only possible if the event has already occurred. Furthermore, the predictions from a multiplicity of people's believe, do affect the actual prediction (E.g).

The complexity of the markets and systems impedes good forecasts and if there was someone who could make accurate predictions, then this publication would explicitly go against his own interests (N. Taleb).

#10: Application of Investment Fund Ratings as a Selection Criterion

Private investors desire the simplest possible systems, in order to determine the quality, performance and credibility of a particular fund. Through the media system, you will get the so-called investment funds rating. However, such a system can equally be easily used by anyone.

These ratings are available in Germany in almost twenty different institutions. Examples of these groups are Stiftung Warentest, Standard & Poor's (S&P), Morning Star and Feri rating and research.The classifications of individual funds through these organizations demonstrably affect the flow of money into these funds, regardless of their actual performances (D. del Guerico, P. A. Tkac).

Unfortunately however, it shows that these ratings only have a very low predictive power, and it is only slightly distinguishable from the random prediction (J. Jordan, A. Loviscek). Thus, the reliance on fund ratings may lead to erroneous investment decisions.

#11: Intelligent Investment Products as Means for Low Risk High Return

Also, this sales point is often used by the commission consultants "to market certain assets to private investors". Besides, you can argue that certain products are designed in such a way as to minimize the risk of investors and at the same time maximize the expected yield.

As we have already made it clear however, there is a direct correlation between the returns and the risk taken. Thus, a financial product can never have a high return while having a lower risk, as this would conflict with the fundamental rules of modern financial markets; therefore it's almost impossible to find high yield low risk investments.

However, products which offer a so-called capital guarantee or minimum return extremely well because the investor thinks that with these products, there are no risk. The problem with these systems however is that, they are only partially involved in possible profits and as a result, its actual yield is significantly lower than the standard funds.

This is therefore the kind of price that the investors have to pay for this security. In addition, there is a considerable risk for the private investors, if the guarantor (usually a Bank), is unable to financially meet up to this warranty at the end of the term (E. Dimson, P. Marsh, M. Staunon).

understanding the errors in passive investments

The Vision of Small Investor about Passive Investments

Passive investments are often confused with inaction. Honest private investors therefore like to believe that passive investment strategy must inevitably be inferior to an active management.

Passive and active portfolio management strategies have huge difference in them and out of these two different investment strategies small investors attract towardsactive investment strategy. In the past, but also in the recent future however, growing evidences show that, even an active asset management, which aims to hit the market, usually achieves a lower return on average.

Passive Investment Strategy Can Only Be Successful in Stable and Secure Markets

One hears over and over again that a passive investment strategy is particularly suitable for less volatile and stable markets, these include the markets of all major industrial countries including their Government Bonds. These markets follow the concepts that passive index funds generally show a better performance.

It is however better to apply an active investment strategy in emerging markets or other high risk markets, though recent studies cannot prove this connection. On the other hand, a passive investment strategy could be applied in the stable large-cap, as well as on emerging markets (Standard & Poor"s Indices).

helplessness of passive investors

The Helplessness of Passive Investors at Market Slumps

Also, small investors believe that during period of huge fall in prices or even when market slumps, a passive investment strategy is virtually doomed to helplessness. This is tantamount to saying that, such an investment must accept a much larger deficit than the actively managed funds over the same period.

After all, with the active asset management, there is the possibility of preventing the worst, by the sale of assets. Also, this has probably been intensively investigated by any intuitively enabled thesis within the economic research.

Historical data could not confirm the accuracy of this assumption, which is why this assumption can be considered to be incorrect.Consider for example, the poor stock market in 2008, when the market in the United States lost an average of 37% of their values, with the actively managed funds losing almost 40% of their value over the same period.

Among other considerations, it shows that actively managed funds also regularly losses higher than the indices in times of crisis (D. Phillips). The cause for this is also that, an early forecast of these downturns would be necessary, but it is not sufficiently possible to reduce the impact of these downturns by actively managing the assets.

professionally managed assets

In Spite of the Expenses, Professionally Managed Assets Do Better As a Private Investor

It's not for nothing that Swiss Asset Managers have an outstanding reputation all over the world. Unlike the sales through insurance agents or financial intermediaries, which are usually influenced by unmanageable commissions, the Swiss Asset Managers (or more specifically financial portfolio managers), are classically paid on percentages basis of the invested asset. The money of the investors are not joined as a "pooled investment" but are applied in "segregated accounts".

This security measure of segregation or separation of the assets of individual investors usually results in additional expenses. By separating all processes such as account statements, tax reporting, trading activities, money laundering etc. individual files must be made for each investor.

Just 10 years ago, all these processes had to be mainly made manually, thus, the Swiss Asset Manager were only called up for assets from 500 000 Swiss francs. Such assets simply needed to cover the cost of separate management of assets.

SAMT AG derived new ways, by consistent digital processes, thereby providing the opportunities for significantly lower assets to afford for a genuine Swiss Asset Management.Scientific studies in which a larger number of real private accounts could be examined are relatively hard to find.

However, there are some extensive studies in which data on the accounts of private investors were made available by large brokers in an anonymous way to the respective scientific study. A lower return on investment realized by private investors was therefore brought out by a number of scientific studies, as scientific evidence.

For example L. Schneider, who over 12 years from 1992 to 2003examined the development of 266 funds in the UK and found that the passive investment amounted to 9% of returns on average per year, while classic active investments funds reached 6.9% of return per annum and real private investors only 4.9% of returns. Thus the real private investors achieved about 43% less yield than the market.

Or G. C. Friesen and T. Sapp, in a study of over 14 years and 7125 funds at a market which had a return of 12.2%, with 7.7% of the return on investment funds and only 6.1% average return on investment from private investors. These are 47% less return for private investors, compared to the market return rate.

Historical analysis shows, that the return of a SAMT AG managed passive investment portfolio was closes to the market rate of return, depending on the risk profile.

Summary and Conclusion

When compared to other industrial countries, the lack of knowledge and understanding from small and private investors in Germany causes them to rarely enjoy an optimal investment strategy. Frequently, insurance agents are paid commissions for the completion of contracts, something that initially seen by the private investors to be cost-saving.

However, it becomes common that these consultants become more driven by their own financial interests rather than those of the customers. Also, these small investors rarely receive a full and proper financial advice and thus, through the exaggerated confidence in their investment consultant, as well as the lack of understanding on the relationship between risk and return, these small investors are bound to systematically make wrong investment decisions.

A passive investment strategy over the illustration of the so-called indices is generally superior to the actively managed fund in relation to the rate of return. This may not correspond to the intuition of the investors, though it is nonetheless true.A corresponding simple buy and hold strategy also prevents a small investor from buying assets at a high price and selling them at a low price, because this is mostly associated with losses.

A passive investment strategy over the illustration of the so-called indices is generally superior to the actively managed fund in relation to the rate of return. This may not correspond to the intuition of the investors, though it is nonetheless true.A corresponding simple buy and hold strategy also prevents a small investor from buying assets at a high price and selling them at a low price, because this is mostly associated with losses.


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