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Avoid these 2 mistakes and become rich!

July 24, 2009 10:12 IST

There are two big mistakes most investors make.

The first is following the crowd and not trusting their own intuition. Doing what everybody else is doing is often okay in the short run but in the long run it's usually wrong. Take five steps back and look at the big picture.

Is there a general market trend up or down? Has there been a shift in the trend? Are we really in a growth time frame or is this a time when companies are laying off people, having a difficult time increasing prices, holding off on capital investments, etc? What is your personal experience or experience of family and friends? What is your intuition telling you? You may believe that intuition has no value in investing, but how many of you knew the stock market was overvalued and yet in-vested because everyone else was making money and you felt left out of the game? Try to understand your motivation and create some belief of what the future is going to look like.

The second common mistake is not looking enough at history and understanding history and market valuations. People may understand the past twenty years at most, but they don't really study and understand the last one hundred years. You can see patterns when you're looking at the whole twentieth century. You look at the last twenty years and the stock market has done extremely well, but you look at twenty years before that and stocks did very poorly. So you have very long periods of time where the markets don't do anything.

History helps you see that. Markets tend to get greatly overvalued. You have extreme greed and extreme fear. What you see when you review long-term history is that when you have extreme greed, markets become very overvalued and bubbles occur, and, when you have extreme fear, markets become very undervalued - and, therefore, present a very valuable opportunity to buy.

It's very useful to understand these big cycles up and these big cycles down - what some people call regime shift. Ben Graham said something that was extremely valuable in his classic book, The Intelligent Investor. There used to be a belief - because of our traditional market allocation models and modern portfolio series - that you should hang in there for the long haul. Ben Graham, who is one of the best value investors of all time, said that in a normal 50 / 50 portfolio, when markets are greatly overvalued, you go 25 per cent in stocks, and, when markets are very undervalued, you go 75 per cent stocks.

You're really going against the crowd when you do that so it's very hard, but that keeps you from getting caught being greedy. You look at the markets and say, "Is the market overvalued or undervalued, and how much risk am I willing to take?"

In 1999, for example, valuations were very high, so it was time to start lowering stock allocations even though the share prices were still going up, and everybody was euphoric about the market. In hindsight, it certainly proved to be the right rule, but it was a difficult thing to do at the time. You want to be heavily invested when things are cheap and very cautious when things are expensive. You have to avoid saying that it's different this time and that markets are going to keep going up because of technology or whatever.

When you alter your strategy as valuations become very cheap or very expensive, do so gradually. In 2000, for example, the average investor in Japan had about 3 per cent in stocks, whereas the average recommendation in the United States had about 68 per cent in stocks, according to Barron's.

In the late 1970s, the average recommendation was between 25 and 30 per cent in stocks, and that was the time just before the beginning of the bull market. It just shows that we tend to see the very short past and not look at valuations and the big picture.

Major trends are very slow to change, so the investor doesn't have to do something every week. Once or twice a year is often enough to rebalance your asset allocation in order to reset it to your original allocation. Yes, it's very hard to take money off the table when things are going up, and it's very hard to add to equity portfolios when things are cheap, but this is exactly how you grow wealthy over the long-term.

A golden rule to remember is that greed and fear control the market in the short run. If you can understand greed and fear as the central short-term components, you can see what's going on and realize the pattern. Investment valuations at the time of purchase determine long-term returns. When people are more fearful, great values are created; when people are greedy, bubbles are created.

So, don't pay attention to short-term noise. It doesn't matter what the market does in the short run. You have to understand the basics - what's going on in the big picture - and not worry about missing some of the upside. In other words, let neither let greed nor fear hold you in their sway, indeed, it's in times of pervasive fear that great values are available.

(Excerpt from The Invincible Investor. Published by Vision Books.)

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