The worst investing mistake and how to fix it

Here's the biggest mistake investors make when buying and selling stocks, and a few simple tips to help you avoid it.

Warren Buffett once said ‘the worst mistake you can make in stocks is to buy or sell based on current headlines’.

Psychologists call it recency bias: our tendency to recall recent experiences and put greater weight on them, while forgetting about things that happened a while back. The result is that investors tend to over-extrapolate current conditions long into the future while ignoring the fact that bad times spur problem-solving and good times breed risk-taking.

The real trouble with recency bias is that business news is specifically designed to excite investors and keep you reading. If things aren’t running absolutely perfectly, it’s labelled a crisis, and everything else seems to be experiencing ‘explosive growth’.

We all love a good story, but if you’re jumping on or off the bandwagon at the same time as everyone else, you’re more likely to buy a stock when it’s overvalued or to sell when it’s undervalued.

It’s natural for people to favour activity over inaction when they see exciting headlines but unnecessary trading also bites into your returns due to brokerage fees. Research by the University of California found that those who traded the most lagged the overall market’s performance by 6.5%.

True, today’s news is an important source of information when valuing a company – a large merger or discovery of fraud, for example, could significantly swing an investment case. More often, though, the news is focused on short-term changes to earnings, which have little to do with where the company will be in 10 years.

When billing software maker Gentrack said it would miss its 2015 revenue forecast, the stock fell 35%, wiping NZ$60m from its market capitalisation – despite management explaining that it was due to a delay in negotiating contracts, which only amounted to NZ$2.5m. Investors couldn’t see past the temporary bad news. We upgraded the stock to Buy when it hit $1.80 and, with the contract kerfuffle now long forgotten, the share price is up 68% in just over a year.

How to stay sane

Humans are hardwired for recency bias, and avoiding the business news altogether could open up a whole other set of problems. But there are ways to help ensure headlines are a source of opportunity, not slip-ups.

1. Focus on long-term fundamentals: If you’re investing for the next 10 or 20 years, what happened in the markets today probably doesn’t matter. What does matter is where a stock’s current share price stands relative its intrinsic value, which is a function of all the cash it will throw off between now and forever. A lot can happen in that time, so ask yourself whether today’s conditions – good or bad – are likely to be temporary.

2. Take your time: Feeling that you need to act on advice immediately is a big no-no as emotions can throw your judgement, so sleep on it for a few days and see if you still feel it’s a ‘once in a lifetime opportunity’. What are the odds that today’s price is the absolute bottom and the stock is destined to go up forever, starting right now?

3. Recognise that panics are often the best time to buy: If you feel yourself getting swept up in media hype, remind yourself that the stock market will always bounce around in the short term. That volatility is a source of opportunity if you stick to buying high-quality companies when they’re undervalued. Over very long periods, shares are one of the best-performing asset classes, and the best times to buy have usually been when everyone is freaking out about doom and gloom headlines.

Our Buy recommendations have returned 13.9% a year on average over the past 15 years, outperforming the All Ordinaries Accumulation Index by 3.7% a year. That record wasn’t built by trading on current headlines and following the herd; it was achieved by valuing companies independently and then waiting for the newspapers to create opportunities.

To get more insights, stock research and BUY recommendations, take a 15 day free trial of Intelligent Investor now. You can find out about investing directly in Intelligent Investor portfolios by clicking here.

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