The year 2020 was thrown into disarray by the COVID-19 virus with far-reaching repercussions. Lockdowns and social distancing led to disrupted workforces that resulted in an economic recession, affecting millions of people worldwide. In such times, the markets are often one of the first to react to major disruptions as they did in 2020 as well.
On the morning of March 9, 2020, the S&P 500 fell 7% in four minutes after the exchange opened, triggering a circuit breaker for the first time since the financial crisis of 2007-08 and halting trading for a full 15 minutes. Other indices soon followed suit. The market entered a bear run (a decline of 20% or more from a previous peak). We now know the recovery was no less exceptional, given that the S&P had a bear run for just a month. It’s safe to say that the Covid crash of 2020 left a lasting impact. Many investors lost a lot of money, some as a result of falling prey to the idea that they could time the market to make large profits in the short term.
2020 showed us how extremely volatile markets can be, and left behind a lot of lessons for investors to learn from. In this article, we will take a look at 10 common investing mistakes investors can learn from based on the events of the past year, and how to avoid making the same mistakes in the future.
10 Mistakes to Avoid When Investing
Mistake Number 1: Trying to time the market
No one can time the market perfectly. We may all believe this a possibility in theory, but in practice, even industry stalwarts such as Warren Buffett and Charlie Munger say they do not know which way the markets will go! It is a good practice to invest for the long-term as short-term volatility will then be negated. The number of moving elements – factors that influence your investment returns – are far too many, some in our control and some beyond. Therefore, timing the market is a myth.
Market predictions are somewhat like weather predictions – It may rain the day the weather person said chances of precipitation are nil, and it is like that you didn’t carry your umbrella. With investing, always be ready for rainy days.
Firstly, it is recommended to invest only your spare money; secondly, invest only after assessing your risk profile and the risk involved in the investment product you choose; thirdly, be mentally prepared for dips and blips in the market. Know when to exit through research and do not follow the crowd blindly.
The Covid-led market crash is a perfect example to illustrate this. Investors fled the market as stocks began to tank as a reaction to the spreading virus and as countries announced lockdowns around the world. However, those who saw the dip as an opportunity to get into the market or increase investment stood to benefit once the markets recovered.
Mistake Number 2: Assuming portfolio diversification as a guarantee against a loss
Well, it is not. Diversification of your investments refers to investing in several sectors or assets – i.e., not have all your eggs in the same basket. There’s no way of knowing which sector will outperform the others and which will be adversely affected in the longer run. Hence, holding a diverse mix of investment options would mean that some part of your investment may not be in great shape.
However, the objective of diversification is to balance losses, rather than prevent the chance of loss altogether. A good mix of assets will result in a portfolio that won’t decline steeply in its value – i.e., there will always be some investments in your portfolio that will buoy and protect your capital. However, investors should be aware and prepared for the likelihood that there can be and will be some losses.
It is important to remain invested and not react to a bad spell in the market. Diversification, as a part of your financial planning, is required to meet your financial goals. This point is especially important for individual investors who are extremely vulnerable to downturns in the years leading up to retirement, primarily due to volatility, drag, and sequence risk. Say your investment portfolio ran into a loss of 20%. You’ll need to gain about 30% to get back to even. However, if you withdraw money out of the investment during a downturn, your recovery amount is compromised.
Mistake Number 3: Using historical data as indicative of an outcome in the future
“The biggest mistake investors make is to believe that what happened in the recent past is likely to persist.” – Ray Dalio
No analyst or investor can predict the future. While historical data is helpful when it comes to predicting the trends and patterns based on certain markers, the actual outcome is difficult to ascertain.
A study by J.P. Morgan states that the average bear market decline from peak to trough is 42%, and the average duration is 22 months. The global financial crisis of 2007 began in October, and the bear market lasted 17 months. This came with a decline of 57% from peak to trough. Compare this with the Covid crisis – the markets had a maximum decline of 34% in the S&P 500, and the bear market lasted only for a month.
Despite this, the panic caused was on a huge scale as a result of fear. People saw an unprecedented fall in a very short time, and the pandemic, with its unpredictable nature, doubled the fear.
The Covid market crash taught us that no matter how much past data we possess and refer to, the future cannot be predicted. There are no guarantees. But it also taught us that not giving into selling driven by fear will help us keep our funds intact and could eventually lead to growth.
Mistake Number 4: Making financial investments based on emotions
The heart knows what it wants, but when it comes to financing and investing, it is best to keep romanticism at bay. Let your brain do the talking. Try not to get swayed by emotions – of greed as well as of fear.
Everyone wants to be the king of the market when the bulls are on the run. However, the opposite is true when a downturn happens in the market. Be aware of behavioral biases such as Herd Mentality, i.e., avoid being a victim of blindly following the consensus of the crowd. Keep in mind to also avoid Loss Aversion bias, which refers to the intense fear investors feel of loss-making such that it drives them to focus more on avoiding losses rather than making a profit.
Market volatility is not a cup of tea for the impatient, reckless, and impulsive. Your emotions can be the difference between making it to the deal or losing it. When the markets went down in 2020, a lot of people nervously sold their assets and stocks to hoard cash. Those who kept their cool eventually profited. Implemented strategies to keep a check on your emotions and decisions through market ups and downs. That way, you can save yourself from making a decision that can potentially hurt your capital.
Mistake Number 5: Ignoring bond-market investments
Bonds, though maybe low yielding in some time horizons, can work as a guarantee against volatile stocks and investments. March 2020 saw the lowest yields on bonds in 10 years. The rest of 2020 was a bumpy ride, but the bonds fought their way up during the later part of the year.
With an investment that offers a low rate of return, quality matters. Not all bonds are quality bonds. Research or speak to your advisor to pick bonds that are unlikely to default, such as government bonds. Corporate bonds may require stringent scrutiny and quality assessment. Bond rates are pre-determined for the specific time horizon of the investment. However, they can be sold at any time at the secondary open market as per market price. Additionally, some even provide tax breaks. Therefore, many investors, especially high-net-worth investors, choose bonds over equity and use bonds as a haven for their money to grow slowly and steadily.
Bonds can help protect your portfolio from stock market volatility. If your equity investment is doing well, but you don’t want to sell yet, you can choose to trade the bonds to meet your immediate cash requirements. Simply put, bonds provide excellent rebalancing opportunities to improve your returns over time. In the current environment of ultra-low interest rates, I recommend only holding short-term treasuries to protect principle from a rise in rates over time.
Mistake Number 6: Not learning from past experiences
It is common to see investors burn their fingers at the market. What is essential to note is not how much they lost but rather what lesson they learned and came back to the market empowered with.
Warren Buffet said, “Be fearful when others are greedy, and greedy when others are fearful”. Putting that in the context of the Covid pandemic in 2020, markets fell because people panicked and were afraid as economies crashed.
When reflecting on past investment mistakes, it is good to ask yourself: Have you diversified your investment portfolio? Have you considered taxes before making investments? Have you set your financial goals and made appropriate investment allocations to help you achieve your goals and investment strategy? Are you pulling out your investment sooner than you ideally should?
Mistake Number 7: Tinkering with your retirement plan
Avoid dipping into your retirement funds when in need of money. Given that retirement funds are very long-term investments, young investors often wish to either withdraw funds or temporarily stop contributing towards their retirement. While a tempting option at the moment, the consequences could be harmful in the long run. Life is unpredictable. Look at how the pandemic laid waste to the livelihoods of millions across the world. The most secure jobs were threatened, and unemployment rates are at their peak in America. The future is unpredictable, let alone your finances. What you can do is prepare for it earnestly.
Do not skimp or skip on contributing to your retirement funds, be it employer-sponsored 401(k) or an IRA, or any other type of pension fund.
Investors who had been regularly contributing to their retirement funds remained unflinching by the short but intense 2020 crash. Most 401(k) contributors remained unaffected – this signals the virtues of a very good plan and system. Volatility can’t touch your 401(k), so don’t rule out investing in one in 2021.
Mistake Number 8: Not having an emergency fund
When it rains, it pours. It is highly recommended that you set aside at least 12-18 months’ worth of your salary to weather unexpected events. Emergency funds are cash savings kept separate from investments that you can dip into to lift you out of unprecedented situations, such as a medical emergency. People with such cash stashes are reported to have been better placed when the Covid-19 virus disrupted work environments and led to unemployment.
Emergency funds don’t just take care of you when you’re out of luck; they also keep your emotions in check. They are your defense.
Mistake Number 9: Ignoring life insurance and health insurance
The importance of insurance has been underlined in the recent past, especially by the ongoing Covid pandemic. It is a wise move to insure yourself and your loved ones against any threats to life and health. Reports claim that a large population of Americans could not even afford $400 in medical bills at the peak of the first wave of Covid in the US. We saw cases of anxiety and stress on a steep rise as concerns on the affordability of medication and treatment rose. Job losses caused by the pandemic only worsened the matter.
Life and health insurance are an integral part of financial planning. If you had previously thought you could do away with it, 2020 was a lesson learned the hard way. Do not overlook insurance. Find out and sign up for suitable plans.
Mistake Number 10: Not keeping a check on your spending habits
The pandemic helped most people reflect on their spending habits and budgets. It was not cars or clothes but essentials such as toilet paper that vanished off supermarket shelves during the initial phases of the pandemic. The world went online, offices moved to video-conferencing, and most meals were cooked at home. While difficult to adapt to at the start, people eventually adjusted to living within their means.
Hence, the opportunity to save increased when discretionary spending was forced-cut, which translated to a larger corpus for investments. At the end of the day, a penny saved is a penny earned!
Conclusion
2020 has been an eventful year. While the pandemic-led panic wreaked havoc at the markets, there were significant takeaways and learnings to be made as markets returned to normalcy. In essence, we see that the basics of investing principles don’t go wrong. We learned that being prudent is always helpful. We saw how fear could drive the markets crazy. 2020 also gave us life lessons. Things we took for granted were no longer available to us at the same ease and comfort, which gave us a chance to rethink our actions and our financial decisions.
Moving forward, 2021 sees a more careful and prepared investor, given that they learned from the mistakes stated above. We know that life is unpredictable. However, what we also know is that we can make things better if we learn from the past and avoid falling into common traps.