The Most Common Mistake of Investors

Read? Why does stock price move?

And more ideas from Jeff Augen ...

Investors often make the mistake of assuming that they have unique insights that market has failed to recognize. They buy stocks that they believe are under-priced, or they purchase high-yielding corporate bonds because their instincts tell that the risk of default is exaggerated. In the worst cases, these mistakes evolve into an an investment strategy.

Unfortunately, the investment community tends to overuse the words "under-priced" and "over-priced." Strictly speaking, a financial instrument cannot be under priced unless the market is inefficient. The opposite is generally true; market tend to be very efficient, especially with regard to pricing of heavily traded stocks that are closely followed by large institutions. An investor who believes he has discovered a discount would usually be better off assuming that he has missed something. Humbleness is the most valuable attribute an investor can have.

Most investors would prefer to believe that they can out-think the market. They continue to believe that have this capability even when they are wrong and lose money. When someone buys a stock and the price falls, they often blame the market or the lack of knowledge of other investors. In modern times, it has also become fashionable to blame large institutions and hedge funds. Message boards and investor char rooms on the Internet are filled with various forms of the statement: "Large institutions are driving down the price so they can buy more."

However, when a stock rises, the same person will automatically credit themselves with making a good investment. If the stock rises immediately, they are also likely to take credit for perfect timing. Few investors ever adopt the opposing view that when they make money it's because they are lucky, and when they lose money it's because they made a bad investment.

Finally, many investors may declare that short-term trading is always difficult because precisely timing the market is impossible. They believe, however, they have a better chance of making accurate long-term predictions. That belief implies that complexity and uncertainty decrease over time. Unfortunately the opposite is true - complexity and uncertainty tend to increase as new forces come into play. Complexity as the situation might appear, it can't compare to the uncertainty of the future, which includes new competitors, new products, and ever-changing market place. Nothing changes faster than future.

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If you really like what you have been reading so far, you may want to read further "Trading Realities - The Truth, The Lies, and the Hype In-between" by Jeff Augen