I have taken stock (no pun intended) of six common mistakes investors make. Financial illiteracy, the use of conventional wisdom, and herding after others are among the causes to blame.

Trade volumes have skyrocketed over the last decades and since investors from all skill and awareness levels are joining the market, understanding investor psychology is increasingly necessary. Advances in technology have eliminated the obstacles to entry for new investors.

In this post, we will provide a list of six common mistakes that investors make when investing in the stock market.

Smaller investment horizons and speculation determine stock prices

Short-term volatility in markets exist because of investors’ attitudes. A fresh field called behavioral finance looks at how human opinion and psychology effect investment decisions.

Trading of securities and the tension between supply and demand determine prices. Fundamentals drive long-run prices; they are metrics that test the firm’s value based on economic models and accounting ratios.

Equity prices deviate from long-run sustainable values because of short-term investment horizons and speculation in investment decisions. Adapt to uncertainty with investing styles that depend on fundamentals.

Six common mistakes investors make

1. Investors make their selections based on previously available knowledge. Information learned or shared is not useful if it is data that everybody else knows, it is likely that the price builds in this piece of information.
2. Investors compare absolute prices when testing value between stocks. Using fundamental analysis and financial ratios are the correct methods to test stocks for the long-term.
3. Investors rely on risky assets by relying on “technical” analysis. It is the main approach of assessment among non-finance experts. Technical analysis is the technique of identifying patterns in stock prices.
4. Investors underestimate further losses and further profits: When a stock price is increasing, investors pull-out too quickly. When prices are going down, investors are over-optimistic about restoring their losses and remain invested for too long. There needs to be patience when selling at a profit. Thee decision to act when dealing with a losing investment must be swift. Don’t overestimate your power of recovery from losses.
5. Investors invest long-term savings in day trading: “putting all your eggs in one basket” and especially in risky investments, can jeopardize your long-term goals. The investment portfolio must match the investment horizon and risk profile of the investor.
6. Investors ignore the risk to return ratio when picking stocks and rely only on potential earnings. For this purpose, the risk to return ratio (Sharpe ratio) is a useful measure that adjusts return to risk. Higher growth stocks typically have higher returns. However, this higher return potential can mean higher downside risk than say a stable stock with modest returns. So we must adjust returns for risk, since there is a higher risk of loss in the growth stock.

Conclusion

If we are aware of the factors above, we can avoid common mistakes, have mental clarity, and understand price swings during both booms and busts. When faced with uncertainty, we should try our best to take only educated risks. One point that can guide your thinking is knowing that in markets, fundamentals prevail overtime.

I hope the above list helps you understand some misconceptions associated with investing and the correct rationale to address them.