The World of Investments and Money

Saturday, June 2, 2007

Investment blunders of the rich and famous

I've just finished reading a book on Investments, named "Investment Blunders of the Rich and Famous...and What You Can Learn From Them".

Some of the important advice the author of the book gives to investors, and some of his comments in the book are:

- Beware of cheerleader advisors.

- If you have a clear picture of your preferences for the future and what you need to accomplish them, you simply pick the investment alternative that best meets your needs. However, the person with unclear preferences doesn't pick the alternative that fits the goals; he or she picks the option that looks best compared to the alternatives.

- The willy-nilly approach of most investors gives them a lack of solid foundation from which to make decisions. As a result, investor allocations and stock picks are frequently not aligned with their goals. One consequence is that the typical investor spends time moving money from one investment to another, trying to meet an obscure goal. Investing without a plan, or road map, leads to a lack of discipline. The lack of discipline allows your psychological biases and emotions to invade the process

- The more active the investor, the worse the net return. Cost of trading eats away a big part of the investment. Active trading magnifies your emotions and psychological biases that cause these bad choices.

- Investors don't like to sell losers, only winners. They sell when the stock is going higher and hold on to the stock when it is going low. This is not a good strategy.

- Investors have fixed their sights on the purchase price. This is called anchoring. Investors frequently anchor their hopes to fixed prices. The purchase price is one anchor. The highest stock price the investor has seen also becomes an anchor. Investors typically wait for the stock's price to reach these anchors before making a trade.

- Gamblers tend to treat winnings as if the money is not quite theirs yet. Their behavior seems to suggest that the profits are still the casino's money. Specifically, the feeling of betting with someone else's money causes you to accept too much risk. Similar behavior could be seen in the stock market, too.

- Many investors have realized the alluring trap of frequent trading and using debt to buy stocks. People have gone bankrupt when they borrow to trade.

- In order to earn a high return, you must take market risk. We want to take market risk while avoiding firm-specific risk. This is because we are compensated for market risk, but not for firm-specific risk. If you own just one stock, you are taking both types of risk. In fact, most of the risk you are taking is firm-specific risk. However, if you add one randomly selected firm to the firm you hold, you reduce the total risk in your portfolio by 24%. This risk reduction is completely due to the reduction in firm-specific risk. Add two more randomly selected stocks and the total risk in your portfolio is only 60% of the risk of holding just one stock.

- It now makes sense to reduce the firm-specific risk in your portfolio further by holding over 20 randomly selected stocks. In fact, a 30-stock portfolio is optimum.

I found the book title a misnomer since the book was about general Investment theories and not about investment blunders of the rich and famous, but it was an interesting read.

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