Avoid These 3 Huge Strategy Potholes

08/10/2012 9:00 am EST

Focus: GLOBAL

It's one thing to make money and another thing entirely not to lose money. If you avoid the three big-picture problems below, you'll be far ahead of the average investor in knowledge and profits, write the staff of Motley Fool UK.

Building wealth through investments in the stock market isn't for the lazy or faint-hearted. Successful stock-picking, in short, calls for research, analysis, judgment and timing—not to mention an element of occasional luck.

Even investors opting for the very simplest means of doing so—an index tracker that tracks the FTSE-100 or FTSE All-Share, for instance—have to sift through tracker providers' various offerings in search of low costs and low tracking error.

Presently, of course, that search would point you at trackers from Vanguard or HSBC (HBC), either as funds or ETFs such as the Vanguard FTSE 100 ETF (London: VUKE) or the HSBC FTSE 250 ETF (London: HMCX). But times change, and so too do tracker "best buy" tables.

Destroying wealth, on the other hand, is a much more straightforward affair. Easily done, it requires no skill, and in contrast to the multi-year timescale required to build up a decent-sized portfolio, it can happen in a matter of days or weeks.

Take, for instance, these three wealth-sapping pitfalls—each of which claims fresh new victims each year.

1. Lack of Strategy
Look at successful investors such as Benjamin Graham, Jim Slater, and Peter Lynch, and what you'll see is a consistent strategy. Sure, they deviated from it occasionally, but in the main it is generally possible to describe each of them by their strategy.

Graham, for example, was a "deep value" investor. So in many ways is Warren Buffett, a Graham disciple who studied under Graham at the New York Institute of Finance in the early 1950s.

But while the success of those pursuing a given strategy is in part simply down to that strategy itself, there's another, more subtle reason why following a strategy helps to avoid money-losing wealth-sapping decisions.

And it's this: working within a single strategy, the investor becomes more skilled at weighing-up potential competing investing decisions, and evaluating how well they fit the strategy in question. Try to be a growth investor one day and a value investor the next, and you'll fail to perform well at either role.

2. Making the Simple Too Complex
Warren Buffett famously called derivatives "weapons of mass financial destruction." I'd add a few more to the list.

Spread betting, for instance: I've seen figures claiming that three-quarters of retail "investors" making such bets lose money. Daytrading, too, seems to burn through a lot of investors' cash before dumping them penniless on the pavement.

Stop losses are another example, despite the value that some investors consistently place on them: there are just too many examples of people being "stopped out" by short-term adverse movements in price that were just meaningless noise. Likewise automated buy orders—just ask the people who bought into Royal Bank of Scotland (RBS) and Northern Rock as they crashed spectacularly into the buffers.

3. Failing to Diversify
As a number of investment gurus regularly point out—David Swensen and James Montier among them—asset allocation plays an important part in determining the overall return that an investor makes over time.

But diversification is a challenge on many levels. There's diversification of asset classes: cash, property, domestic shares, foreign shares, bonds, and so on. But also diversification within asset classes—arriving at a suitably-diversified mix of shares, for instance.

Build such a mix, though, and not only is the risk of a meltdown reduced, but the required "rate of recovery" is lower. As the most recent edition of Graham's classic Intelligent Investor points out, a 50% fall in the price of a stock will take 16 years to catch up with the rest of the market—even if you're getting double the market's overall 5% rate of return.

What to Do?
Whether as income investors or investors looking for long-term capital growth, we're enormously influenced by these words of wisdom from Warren Buffett:

"Your goal as an investor should simply be to purchase, at a rational price, a part-interest in an easily understandable business whose earnings are virtually certain to be materially higher five, ten, and 20 years from now... If you aren't willing to own a stock for ten years, don't even think about it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value."

But how to find such shares? Spend any time on our popular discussion boards, and opportunities abound to exchange views with countless other investors. My own particular favorite, as it happens, is our popular board for income investing, the High Yield Portfolio board.

Low-cost investment trusts are another option. Cheaper than mutual funds, and arguably easier to buy and sell, there are popular trusts to suit most investing styles.

For capital growth, Scottish Mortgage Investment Trust (London: SMT) is a good bet, combining low costs with a sector-leading track record. For income investors, City of London Investment Trust (London: CTY) has delivered year-on-year dividend increases for 45 years—as has Bankers Trust (London: BNKR), another dividend stalwart.

Read more from the Motley Fool UK here...

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