Common Investing Mistakes and How to Avoid Them

This article is an excerpt from the Shortform book guide to "The Most Important Thing" by The Princeton Language Institute and Abby Marks Beale. Shortform has the world's best summaries and analyses of books you should be reading.

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What are common investing mistakes that are easy to make? How can you avoid these pitfalls?

While safe investing sounds straightforward in theory, investing is more complicated in practice. As The Most Important Thing by Howard Marks points out, that’s because investors often succumb to emotional or intellectual pitfalls when investing.

Let’s look at the primary investing mistakes that you must avoid to maximize your success.

Common Psychological Pitfalls

While Marks admits that investing markets might be perfectly efficient if investors were fully objective and rational, he contends that the opposite is true: Psychological influences affect investors’ decisions, cutting into potential profits. And though Marks lists an array of such influences, we’ll focus on the effects of three key common investing mistakes: greed, fear, and the desire to conform.

Pitfall #1: Greed

First, Marks argues that greed leads investors to make suboptimal decisions as it causes them to abandon caution. He points out that when investors are overcome by their desire to earn money, they cast aside risk aversion in hopes of earning an outsized profit. For instance, a greedy investor might spend an exorbitant amount of money investing in an unproven cryptocurrency, leaving them exposed to massive losses if the investment fails. For this reason, Marks maintains that greed is one of the most potent forces working against investors.

Pitfall #2: Fear

On the other end of the spectrum, Marks holds that fear causes investors to leave profits on the table because scared investors are unwilling to take even well-informed risks. According to Marks, fear paralyzes the would-be investor. For example, a fearful investor might see an opportunity to purchase a security for far below its intrinsic value, only to be frozen by the possibility that they’ll ultimately lose money. In this way, fear can hinder investors from maximizing their potential returns.

Pitfall #3: Conformity

Both greed and fear, however, can result from a greater problem afflicting investors: the desire to conform to other investors’ behavior. Marks argues that conformity often leads investors to act irrationally when the consensus view is misguided, as it often is. Specifically, he contends that pressure to conform causes investors to forsake their own due diligence when assessing securities and incur excessive risk, as they reason that the consensus view can’t be mistaken. In turn, this behavior leads investors to purchase securities that they would never have purchased otherwise.

Common Intellectual Pitfalls

While emotions like greed and fear can spell disaster for investors, Marks argues that intellectual mistakes can also lead to subpar investments. Specifically, he contends that investors who are too credulous and those who fail to consider rare outcomes are susceptible to large losses.

Pitfall #1: Excessive Credulity

First, Marks maintains that gullible investors often accept delusions that require them to ignore past investing wisdom. For example, you might recognize that investing markets have experienced cycles historically, meaning that peak bull markets often lead to bear markets with their associated price drops. Even knowing this, the credulous investor could become convinced that these past norms no longer apply, causing them to continue purchasing securities under the delusion that prices can only rise. In this manner, credulity can result in excessive risk that leaves investors exposed to potential losses.

(Shortform note: Excessive credulity in investors might stem from the ought-is fallacy—the fallacy of believing something because you want it to be true, not because of evidence that it is true. Informally known as wishful thinking, this fallacy explains why investors might purchase securities believing that their price can only increase, even though historical evidence suggests otherwise. After all, it’s natural for investors to want their securities to only increase in value.)

Pitfall #2: Lack of Imagination

In a similar vein, Marks argues that investors who lack imagination will fail to plan for rare contingencies, leaving them vulnerable to loss when those contingencies occur. He maintains that such investors plan for the future by extrapolating from the recent past, assuming the future will reflect the past. However, this lack of imagination means they won’t account for instances when the future does diverge from the past—for example, when the dot-com bubble burst in 2000, as technology companies’ stock prices plummeted despite investors assuming that these prices could only increase. Consequently, investors without imagination pay the price when the future doesn’t meet their expectations.

(Shortform note: One possible reason why investors suffer from lack of imagination is that they rely too heavily on what Daniel Kahneman calls System 1 thinking. As opposed to System 2 thinking, which Kahneman defines as our ability to slowly and deliberately form judgments (like solving a complex math problem), System 1 thinking involves quick, intuitive judgments without voluntary effort (like performing basic arithmetic). According to Kahneman, System 1 thinking leaves us prone to extrapolating “patterns” from data that are actually random, like assuming a coin is rigged because it lands on tails several times in a row. Thus, investors that use System 1 thinking might assume market trends will continue indefinitely on the basis of recent data, although these data are often random subsets of larger data sets.)

How to Avoid These Pitfalls

Marks contends that there’s no foolproof strategy for avoiding these pitfalls. However, he does offer one main suggestion to investors: Remain keenly aware of market conditions, especially the supply-and-demand relationship for securities, because such awareness will help you realize when securities are mispriced.

For example, to avoid succumbing to greed, you might recognize that capital is flowing too freely into fledgling, high-risk securities in the technology sector as investors hope to find a diamond in the rough. In such a situation, cognizance of this market trend would help you realize that these securities are likely overpriced. Similarly, to avoid excessive credulity, you might recognize an inordinate demand for (say) real estate because investors think real estate values can only increase. By remaining aware of this, you’ll be poised to avoid the trap of thinking that past trends about the housing market are no longer relevant.

(Shortform note: Experts offer a variety of strategies for remaining on top of relevant market conditions like Marks suggests. For example, they point out that following news aggregators, such as Google News, can keep you aware of pertinent investing reports from a wide array of sources to ensure you don’t miss market developments. Moreover, they note that social media can provide direct access to the most important pieces of information about securities markets.)

Common Investing Mistakes and How to Avoid Them