7 mistakes to avoid when managing your investment portfolio

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In previous blog posts I introduced basic concepts about investment that I invite you to read. In this article I took a slightly more technical approach to give you additional tips when managing your investment portfolio. Based on my personal experience, here are 7 mistakes I think you should avoid:

1. Not having a strategy

In my opinion the very first step when deciding to invest your money is to come up with a strategy. You need to determine what is your goal, how much money will be required to make that goal happen and when you intent to cash out. The objective, the target and the investment horizon are the three factors that are the basis of your strategy. This will then determine your risk aversion and therefore the type of instruments you should invest in. For example, if you want to put money aside to buy a property in two years, you should invest in safer assets than if you are saving for a retirement that will occur thirty years from now.

2. Not doing your research

Once you have set up your investment goals, it is important to improve your financial literacy. Consult a financial advisor, do some research on the different investment options available to you and keep track of the news. If your intention is to pick your own stocks, then you have to understand the fundamentals of company valuation. If you decide to get into day trading of stocks, options, FX products or commodity futures, then make sure to get training through webinars and the appropriate literature. If you are more of a passive investor like me, either because you lack the knowledge or the time, then two good alternatives are mutual funds and index funds.

A mutual fund is an actively managed diversified portfolio of stocks and bonds that financial institutions offer to individuals wishing to grow their money. Management fees are deducted from your returns to compensate the fund managers, who pretty much do all the work for you. An index fund on the other hand is a collection of stocks or bonds that replicates the composition of a market index such as the S&P 500. I personally love index funds because service fees are much lower and you still get diversification (managers do not need to be compensated for their stock picking strategy because the fund passively follows an index whose composition seldom changes and is publicly available).

A third option that has been trending for years now is exchange-traded funds (ETFs), which can be seen as a middle alternative between active and passive investing. ETFs allow you to buy units of funds that trade like individual stocks available on the stock exchange. However contrary to mutual and index funds that can be set up with the assistance of your bank or an investment management firm, you need to open a brokerage account on your own to pick the ETFs you want, like you would do for specific stocks.

3. Lacking diversification

One of the most important things to understand when learning how to invest your money, is the concept of diversification. The popular say “do not put all your eggs in the same basket” essentially means do not invest most of your funds in one company, in one type of asset or in one industry. This will protect you from big swings in the value of your portfolio. Diversification helps reduce your exposure to idiosyncratic risk, a common term in finance that means the risk of loss due to specific events that affect a company. What you want is to limit your exposure to market risk only, which is the part of investment risk that cannot be diversified away. In other words, the more variety you have in your portfolio, the higher the ups and downs will cancel each other out, leaving you only with the residual risk of loss due to an unpredictable global economic event that would affect the market as a whole.

Below is a visual example: a couple of months ago I bought $1,000 worth of a crypto-currency mining company called HIVE, thinking I would bank a big buck on this new trend. I purposefully did not pick any other instrument that would have balanced my risk and two months later the stock dropped to $675 (a 32% loss). Since there was nothing else in my portfolio to even out this loss, I took it all in. This is a prime example of lack of diversification. When something like this happens, you can either cash out your investment and take the loss, or do nothing, in the hope the stock price will eventually pick back up.

 

4. Checking your account everyday

When I was getting started into investing, I would check the value of my holdings every single day. Please don’t do that! It will only bring you an enormous amount of stress and you will be more likely to make poor decisions, such as buying when markets are high and selling when they are low. So unless you are day trading, which often implies holding positions only for few days or hours, there is really no need to constantly check your balance if you are confident in your long term strategy. Markets will fluctuate everyday several times a day, but what ultimately matters is the value of your portfolio on the day of your initial investment versus the one on the day you plan to withdraw the funds. In other words you should focus more on your investment horizon than on the periods in between. This will keep you from making detrimental emotional decisions.

5. Trading to make a lot of money

Some people get into investing to make a lot of money. I actually know several people who were able to generate high returns with day trading. However what is often dismissed is that high returns call for high risk. Therefore if you go down that path, you should expect periods of sharp losses as often as periods of steep gains. Because of this high volatility, trading is really more a matter of personality and risk appetite. Therefore you should engage in it only if you like the thrill and you are able to bounce back from your losses quickly.

6. Thinking you can beat the market

The main reason why it is almost impossible to generate higher returns than most banks and investment funds is information asymmetry. Indeed, big financial institutions have an “insider” advantage that most individuals lack, which allows them to rip the benefits of a profitable opportunity before everyone else. Plus their technological infrastructure is so powerful that their trading speed is literally faster than the platform your broker will provide you with. These market makers are so far ahead that by the time you receive the information that will trigger your buy or sell, millions of other individuals like you will have received it as well, leaving you at best with just a small fraction of the total market return.

There is actually an extensive amount of literature in quantitative finance to help professional portfolio managers minimize risk while maximizing returns. So assuming there is one way to beat the market, chances are the whole industry would quickly catch up and any undervalued or overvalued asset on the market would eventually revert to their true value. Some hedge funds actually specialize in identifying arbitrage opportunities to make fast profits, but this requires a large research team and a high level of tech infrastructure that is not available to amateur investors.

7. Dismissing behavioural finance

It is important to recognize that markets are not as perfect as depicted in books. For example, the value of a stock does not always reflect the true value of the underlying company. This is because several external factors push investors to buy or sell assets, hoping (or fearing) that certain consequences will follow. Examples of external factors that sometimes result in investors making irrational financial decisions are: presidential elections, tax reforms, merger announcements, new product release, movements in interest rates, terrorist attacks, natural catastrophes and geopolitical events. The impact of psychology on financial markets is referred to as behavioural finance and it plays a huge role in the economy, particularly during booms and recessions. It is therefore important to recognize this phenomenon to avoid following mass movements with no valid reason.

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