Investing is a game of large numbers. Damage control is one of the ways you can make those numbers work in your favor.
In a diversified portfolio, and over a long time horizon, you are going to make a great many investments. There will be both winners and losers, so the key is to make sure the losers don't outweigh the winners. This is not simply a matter of the number of investments that work out, but also depends on the magnitude of your successes and failures. Limiting the impact of your mistakes is one way to to come out ahead overall.
One way to do this is being able to recognize an error and diagnose what to do about it. This can be tricky, because some mistakes are more obvious than others. Also, rectifying an investment mistake does not always entail simply dumping the stock.
Here are five common investment mistakes, and tips for what to do about them:
Mistake No. 1: You buy a stock that plunges in value
Obviously, it is going to cost you when this happens, but how you react will determine just how costly this mistake turns out to be. Basically, you have three options: sell the stock, hold on to it or increase your investment now that the price is down.
If you sell a stock while it is tanking, you will certainly have plenty of company -- after all, the falling price is a sign people are bailing out of the stock in large numbers. However, it may not be the right move.
How to fix it: You have to ignore the price movement and focus on the company itself.
Has something fundamentally changed in its products or markets that diminishes the company's business prospects? If the answer is yes, then you might be better off selling because the drop in price might be just the first phase of a series of declines for a company that is going downhill.
However, if the company's long-term business prospects remain bright, you should hold on to the stock, or possibly buy more now that it is cheaper. If you double up on a stock while it is down, even if it just comes back to its original price, your investment will be making money because you bought some at a lower price.
Mistake No. 2: You bought a good company but paid too high a price
The problem with great companies is that everybody wants to own them, so they are expensive. You may find that you bought a company that is very successful but paid such a high price that it will be tough to make any money on it.
How to fix it: What you have to analyze in this situation is the future growth prospects. A company with a dominant market position can reward even a fairly high entry price if that market has plenty of room to grow. In that case, it may take a little longer for your investment to pay off, but eventually it will grow into the price you paid.
On the other hand, if the company has pretty much saturated its potential market, you may want to sell the stock because its upside will be limited.
Mistake No. 3: A stock you own falls short of its earnings forecast
You will probably take a short-term hit if this happens, but don't panic out of the stock. If the earnings miss was the result of a one-time event, the company should soon be back on track.
How to fix it: Get out before it's too late. If the company's less-than-stellar performance is due to disappointing results in its core business, you may want to get out before more disappointments follow.
Mistake No. 4: Your portfolio has dead money
Some of the stocks in your portfolio just sit there year after year without moving much. Dead money can really weigh down a portfolio, creating a drag on your overall returns and tying up money that could be used for more promising opportunities.
How to fix it: You should always have an upgrading mentality to your investments. Continually challenge whether there are more attractive alternatives that should knock some of this dead money out of your portfolio.
Mistake No. 5: You missed a huge investment opportunity
You wanted to buy the next big thing, and now the price has already moved.
How to fix it: Missed opportunities can be agonizing; but rather than chase a high price, put this company on your wish list. Next time there is a market decline, or if the company has some short-term bad news, use it as an opportunity to buy in at a reasonable price.
It would be great to avoid mistakes altogether, and certainly that should be your goal. Realistically though, given that some mistakes are inevitable, knowing how to approach damage control is the next best thing to error-free investing.
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