Counterproductive investing patterns can literally hamper the effectiveness of an investment strategy. Common Investments Mistakes delves into some of these counterproductive investment strategies to help you become a better informed investor. In Common Investment Mistakes—Part 1, we talked about Active Trading and Familiarity Bias. Part 2 delves into Momentum Investing and Underdiversification Mistakes.

Momentum Investing

What is momentum investing? “Momentum investing is an investment strategy whereby the investor buys securities with high recent returns, and sells those with low recent returns, with the expectation that past trends will continue.”1 

Mohacsy and Lefer liken this concept of “momentum investing” to the Greater Fool Theory.3 The Greater Fool Theory is the belief by someone who makes a questionable investment, with the assumption that they will be able to sell it later to “a greater fool.” This means you don’t buy an investment because you believe the price is worth it, but rather because you believe you can sell it later at a higher price.2

What is wrong with momentum investing? Momentum investing can lead to speculative bubbles, such as the dot-com bubble of the second half of the 1990s. In “A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets,” Harrison Hong and Jeremy C. Stein, who were professors at Stanford and the MIT, respectively, illustrate that “short-run momentum can lead to long-run reversals when stock prices overshoot their intrinsic value.”1, 4


Underdiversification

The practice of spreading money among different investments to reduce risk is known as diversification.5 Inadequate portfolio diversification violates the principles of best practice set out in Modern Portfolio Theory, which Nobel Prize-winning economist Harry Markowitz developed in the 1950s.1

Proper diversification is critically important to a well-balanced investment plan. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns, without sacrificing too much potential gain.5 Common sense says “Don’t put all your eggs in one basket.” If you buy a mix of different types of investments, your overall portfolio will not be wiped out if one investment fails. If you had just one investment and it went down in value, then you would lose money. But if you had ten different investments and one went down in value, you could still come out ahead.7 In case you’re wondering, how many investments does the average investor actually hold? Three to four. 6

Our job as financial professionals is to create a roadmap for your financial and personal goals. Finding the right balance and diversifying properly is something we can help you achieve. Please call our office at 936-634-3378 for help, or a second opinion.

 

References 

1)  http://www.sec.gov/investor/locinvestorbehaviorreport.pdf

2)  http://en.wikipedia.org/wiki/Greater_fool_theory

3)  Mohacsy and Lefer, “Money and Sentiment: A Psychodynamic Approach to Behavioral Finance.” 

4)  Harrison Hong and Jeremy C. Stein, “A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets,” Journal of Finance 54, no. 6 (December 1999): 2143–84, http://www.economics.harvard.edu/ faculty/stein/files/UnifiedTheory.pdf (accessed May 20, 2010). 

5)  http://www.sec.gov/investor/pubs/assetallocation.htm

6)  Meir Statman, “The Diversification Puzzle,” Financial Analysts Journal 60, no. 4 (July–August 2004): 44–53. Available by subscription from JSTOR, http://www.jstor.org/stable/4480587 (accessed January 5, 2010).

7)  http://m.investor.gov/classroom/teachers/classroom-resources/what-diversification