The most common mistakes investors make in the stock market

This article looks at the biggest mistakes nearly every investor makes, following the analysis and the philosophy of one of the world's greatest investors: Warren Buffett.

1. Trying to predict the market

Buffett has said that he and Charlie Munger simply do not think about the market, and that Ben Graham made a mistake when he occasionally tried to value it. They look at individual businesses instead. Buffett knows of nobody who has genuinely made a great deal of money by predicting the market's moves, but plenty of people who have done well by picking the right companies.

Focusing too much on what the market as a whole is doing is a mistake so easy to make that even Buffett's own role model fell into it.

Why is predicting market moves so seductive? Because the tide can lift every ship — and also sink it. You picked an excellent stock, and then Covid arrived. You found another great business, and ran into rate rises, inflation and war. We want to buy at the bottom and sell at the top. It sounds easy, doesn't it?

Buffett says you should concentrate on two things only: what is important and what is knowable. Where the market is heading is certainly important, but is it knowable? Nobody knows what rate rise the Fed will announce at its next meeting. And that is just one of roughly a hundred variables that matter.

Buffett focuses instead on what is both important and knowable: finding excellent businesses at fair prices. Recognising that a ship is superior is far easier than forecasting every storm. Sometimes hurricanes come and one of your ships goes down; other times you have the wind behind you. Over time, betting on the better vessels pays.

2. Anchoring to your purchase price

Buffett has made the point that when a stock trades at 50, someone who paid 100 feels terrible and someone who paid 10 feels clever — and that all these emotions have no impact whatsoever.

Look at Amazon's share price over the past five years. Julian bought in June 2022 and is up 5 per cent: after four months, he is probably content. Mario bought in July 2021 and is down 38 per cent. Anna bought five years ago and is up 140 per cent.

The million-dollar question: does any of this matter? Should Julian, Mario and Anna treat the same shares differently depending on when they bought? Should Julian and Anna sell to "lock in the profit" while Mario waits to "get back to even"?

Put that way, the answer is plainly no. The only thing that matters for today's decision is the company's likely future performance. If Amazon were worth 50 per cent more in a year, all three would gain 50 per cent from today's level.

The mistake is becoming attached to your purchase price. Amazon's shares could not care less what you paid. Shares feel no empathy: from today onwards they treat the investor who is down 38 per cent exactly as they treat the one who is up 133 per cent. Buffett suggests always starting from a clean slate.

3. Aggressive growth projections

Buffett regards it as a mistake for any company to forecast 15 per cent growth a year — though many do. Very few large companies manage to compound earnings at that rate, and he does not expect it to happen.

Have you ever told yourself: "This stock looks expensive, but if earnings keep growing like this it will soon be a bargain"?

Many highly valued companies defend their share price by projecting extraordinary growth. Expecting very high growth rates is a mistake. This is not an argument for avoiding growth companies: Buffett likes investing in businesses that can grow, especially when they can do so without much capital. It is growth at any price that is the trap. Every time you buy a stock at twenty times earnings or more, you need those earnings to grow dramatically to earn a good return. And that is not easy to achieve.

4. Using a lot of leverage

Buffett has argued that the only way an intelligent, reasonably disciplined person can really get into trouble when valuing investments is through leverage: if someone else can pull the plug at the worst moment of a general financial disaster, you are ruined. He and Munger have had friends to whom exactly that happened.

Heavy leverage is the financial equivalent of Russian roulette. Investing is not a game built for the impatient, and nothing signals desperation quite like a portfolio full of borrowed money.

Why is leverage so dangerous? Because if you are borrowing, you can be right and still never be allowed to play your hand out.

Take an example. Jonas, a hedge fund manager, decides to short GameStop on 15 March 2022. He too is using leverage, but he is borrowing shares rather than cash — precisely why Buffett dislikes short selling.

Jonas borrows and sells a million dollars' worth of shares and posts 500,000 dollars as initial margin: the broker wants to be sure he can return those shares. GameStop trades at no less than twenty times its best year of the decade, and the business has faced serious headwinds for five or six years. Jonas holds a good hand — perhaps not a pair of aces, but a pair of queens.

He will never get to play it. A week later the shares rise from 19 to 31 dollars. Jonas now owes his broker more than 1.6 million dollars in GameStop shares, plus the maintenance margin: around 2.1 million in total. The first margin call arrives, 600,000 dollars, which Jonas meets. A week after that the stock trades at 47 dollars: the debt climbs to almost 2.5 million and a second margin call of 1.1 million lands — more than he can afford. He is forced to buy the shares back and closes the position at a loss of 1.5 million.

In the end Jonas would have been right. But because he used leverage, he can never profit from that call.

5. Missing the wood for the trees

Buffett has said that Berkshire has made a great many mistakes in acquisitions, and that the mistakes always came down to misjudging the future economics of the industry the business operates in — not an unfavourable lease, a particular labour contract or a questionable patent. Three things matter: the future economics of the business and its industry, the management, and the price. Get those three right and you need not worry about every detail.

Buffett is said to be able to close a deal in fifteen minutes. That is partly the product of vast experience and partly because he likes to keep things simple. In fifteen minutes he cannot grasp every detail of a company — the due diligence bankers and consultants spend months on — but he can decide on those three points. And that is what counts in the end.

Getting caught up in too many details makes you miss the wood for the trees. It is probably the hardest mistake on this list to avoid.

6. Jumping seven-foot bars

Buffett has observed that some businesses are far easier to understand than others, and that neither he nor Munger likes hard problems — they would rather multiply by three than by pi. Some people think that clearing a seven-foot bar earns a more valuable medal than stepping over a one-foot bar. In investing, he says, that is simply not true.

This mistake is common because it runs against what success means in almost every other area of life: climbing impossible mountains, solving complex equations, passing hard exams. Everywhere else, difficulty is rewarded.

Investing does not work that way. Mathematical acrobatics and complicated forecasts about the future of industries offer no greater reward, and are often disastrous for results. Ask the mathematical geniuses and Nobel laureates of Long-Term Capital Management.

If you find a company with favourable prospects, honest and capable management, and you do not overpay, you are likely to do well. Simple ideas produce exceptional long-term results.

7. Narrowing your universe of opportunities

Buffett has described Berkshire's structure as the most logical one: it can do essentially anything that makes sense and is obliged to do nothing that does not. He considers it a mistake to narrow the universe of possibilities. Berkshire's own universe has narrowed only because of size, not by design.

Opportunities do not stay in one place for long, and you never know where the next one will appear. It pays to keep an open mind and not confine yourself to a single sector or segment.

Plenty of funds do exactly that: only ESG companies, only high-dividend payers, only European shares, only cryptocurrencies. Opportunities do not work like that. The managers probably know it too — a niche product is simply easier to promote and sell.

8. Always being active

Buffett has warned that if you feel you have to invest every day, you will make a great many mistakes. It is not that kind of activity: you have to wait for the perfect pitch.

Who is more likely to succeed: the tennis player who plays five matches a day or the one who plays five a year? The author who writes five times a week or five times a year? The investor who buys five stocks a week or five a year?

Investing is one of those rare exceptions where inaction is rewarded. You cannot buy the equivalent of a Coca-Cola at a fair price every day. There are long bear markets where opportunities abound, and bull markets where none can be found however many stones you turn over. And sometimes opportunities exist but sit outside your circle of competence.

Buffett says an investor should behave like a batter who cannot strike out: you do not swing at every pitch. You wait for the perfect one.

9. Over-diversifying

Buffett has said that if you really know businesses you probably should not own more than six of them. If you can identify six wonderful companies, that is all the diversification you need; you will make a great deal of money, and moving to a seventh instead of putting more into the first is, in his view, a terrible mistake. Very few people have grown rich on their seventh-best idea, while many have grown rich on their best one.

Diversification is a contentious subject among investors, but in essence it comes down to this: if you do not intend to keep up with individual companies, you should diversify — probably through an index fund that protects you from your own lack of knowledge.

If instead you are what Buffett calls a know-something investor, someone who enjoys following particular sectors and companies, you should use that knowledge to aim for above-market returns. Buy the thirty largest companies in the S&P 500 and you should not expect a return very different from the index itself.

10. Confirmation bias

Buffett has remarked that what human beings do best is interpret all new information so that their previous conclusions remain intact — a talent everyone seems to have perfected. He and Munger have made large mistakes precisely because they were reluctant to look at things with fresh eyes.

Munger had an analogy for it: the human mind resembles the human egg, which has a shut-off device — once one sperm gets in, it closes so the next cannot.

For an investor this is an expensive mistake. We love to seek out and read new information in ways that leave our earlier conclusions untouched, when we should be doing the opposite: staying rational and reassessing the case for and against every company we hold.

11. Following the herd

Buffett has said that people will go on making the same mistakes they always have: they become frightened when others are frightened, and when they turn greedy they turn greedy in crowds. That, he says, is where he and Munger have an edge — not in many other fields, but perhaps better than most at not being swayed by what others do.

Investing is full of counter-intuitive principles. In a great many areas of life it pays to listen to the crowd: if your parents and friends like your partner, she is probably a good match; if lots of people like a film, you probably will too.

Investing is not like that. In fact, if your parents and all your friends agree about the latest stock you recommended, that may be precisely the one not to buy. As another excellent investor, Howard Marks, puts it: what is obvious to the broad consensus of investors is almost always wrong.

How can that be? Because there is no such thing as a good idea independent of price. Tesla might conquer the car industry, but the shares will not be a good investment if the price already reflects the value of the entire industry. And we are most vulnerable when others — friends, in the worst case — are growing rich doing something that looks easy.

12. Mistakes of omission

Buffett has said that by far the biggest mistakes Berkshire has made are mistakes of omission rather than commission: the things he knew enough to do, that sat squarely within his circle of competence, while he sat there twiddling his thumbs.

Almost every mistake on this list is one of commission: you have to do something to make it. Yet sometimes the greatest mistake is doing nothing at all. Not asking that person out. Never taking a risk in your career. Or, as in Buffett's case, not investing in something that was an obvious opportunity.

The mistake stings more when combined with another from this list: anchoring to your purchase price. That is what happened to Buffett with Walmart in the early 1990s. He was building a position, but the price rose a little too quickly. If you believe a company is a great opportunity at X, it is probably still a good one at 1.1 times X — but his mind was tied to the first price he saw, and he waited for the shares to come back. They never did.

Hindsight makes us all clever. But when something falls within your circle of competence and you have identified it as an opportunity, you do not sit and watch, and you do not merely nibble.

The Investlytic team