Five common trading mistakes – and how to avoid them

Every gardener knows you should never pull up the flowers to water the weeds. Yet investors often sell winners to add more to losing positions. 

It’s usually a mistake – one of several investors commonly make. In fact, I succumbed to one of these during the Covid-19 pandemic.

So, what are these common trading mistakes? And how can investors seek to protect themselves from themselves?

Selling winners to buy losers

Selling winning positions to add to losers can be tempting. However, there are several reasons why it could prove costly.

In any portfolio there are likely to be a few big winners, a few big losers and many ‘so-so’ performers. You need gains from winners to outweigh the losers. This cannot happen if you are constantly selling winners to buy losers.

Secondly, business success and failure tend to be self-reinforcing.

Amazon’s retail business has got progressively stronger because every year it has reinvested in lower prices, faster delivery, greater selection and new services. This has attracted more buyers and sellers to its platform, creating a virtuous circle. It’s a similar story with the other big US technology firms – scale begets scale, meaning the strong have got stronger.

Conversely, a struggling business is constantly playing defence, often with knock-on impacts to customer service, brand and reputation. It’s why successful business turnarounds are rare.  

So, I usually like to let my winners run (and may even add to them). With losing positions, I am cautious about committing further capital until I am confident the issues will prove temporary. 

Selling for valuation reasons

“Buy low and sell high” is a classic investing adage, but how do you know when a company’s valuation is too high? It’s very difficult. If a business is performing well and has excellent prospects, it’s very unlikely to be trading in the bargain basement. 

In 2014, Diploma, a company held in the Quality Shares Portfolio, traded on a price to earnings ratio (P/E) of over 19x – a significant premium to most industrial businesses. Despite this, it delivered a compound annual return of around 20%, even ignoring dividends.

I estimate you could have paid north of 45x earnings for Diploma in 2014 and still earned a c. 10% annual return (before dividends). In fact, even paying an ill-advised 80x earnings, you would still have beaten inflation. Of course, past performance isn’t a guide to future returns.

10-year annual return assuming different P/E multiples (%)

There are, of course, exceptions (there are no hard and fast rules in investing). That said, I think a lot more mistakes have been made selling winners too soon (due to perceived ‘high’ valuation) than selling too late. 

As a result, I am slow to take profits for valuation reasons, particularly when I am convinced in the quality of the business. It’s only where the valuation appears egregious and is pricing in goldilocks assumptions that I will look to take money off the table.

Portfolio tinkering

The temptation to tinker, in any endeavour, is often dangerous, but no more so than in investing. Potential drawbacks include:  

• Increased trading costs and taxes 
• Opportunity cost – time and energy spent considering trading decisions instead of developing a better understanding of the business
• An often unconscious shift in perspective from long-term thinking to short-term, reactionary decision making

I’ve analysed my own, and other fund managers’, trading decisions. I find little evidence that trading around existing positions – trimming X to add a bit more to Y – adds value. 

If you want to get in to a position, get in. If you want out, get out. Above all, resist the urge to tinker.

‘New shiny thing’ syndrome

It can be exciting to add new companies to a portfolio and, sometimes, it is merited. But there are also potential drawbacks.

Firstly, you probably understand existing positions better than new ones. No matter how long I spend researching new ideas, I’ve found there is no substitute for owning and following a business for years. 

Finding new ideas also demands time and effort which may be better spent elsewhere. Filling knowledge gaps in businesses and industries you already own should arguably take precedence.

Perhaps most importantly, existing holdings may have better long-term prospects than new ones. 

I’m always surprised to see fund managers introduce new ideas when they have small existing positions, often in the same sector. If you already own the best business in its industry, why not increase that position, rather than add a new, potentially inferior holding?

Don’t get me wrong - I always keep half an eye out for new ideas. But I spend most of my time monitoring existing holdings. And I’m never in a rush to add new companies that I’ve only recently started following.  

Shiny new things will always have allure, but I never forget the value of what I already own.

Trading at the start of a crisis

“Treat market volatility as a friend and be fearful when others are greedy”. It’s sage investing advice. But there is one problem – we are human beings, driven by feelings and emotion.     

At times of market panic, the rational part of our brain gets dialled down and the chance of making costly trading mistakes increases. To compound matters, every bone in your body will want to do something to alleviate the uncertainty. 

When the unexpected happens, it’s usually wise to take a step back. Don’t be whipsawed into making quick decisions. Once you are thinking more rationally you can make changes to the portfolio, if you still believe they are merited.

My experience during the pandemic informed this lesson. I sold luxury goods company LVMH in March 2020. This was a knee-jerk reaction, and a mistake. Had I waited a few weeks, I doubt I would have made that decision. 

It’s why, in the early stages of a crisis, my aim is to be ‘not stupid’ rather than brilliant, with a bias towards inaction, rather than action.

A few other pointers 

Trading decisions are never easy to get right. But how can investors stack the odds in their favour? I can offer a few pointers.

The first is to introduce a gap between the initial decision and action.

Say you are researching a new idea and decide it’s promising. Instead of pulling the trigger immediately, sleep on the decision. Go for a walk. Think about something else for a while. This will allow time for your unconscious to have its say. If you still feel the same a few days later, you can act. 

I’m a great fan of investment checklists. They create a natural break between researching the idea and execution, reducing the scope for emotions to override rational decision making.  

Keep a record of all trading decisions, along with reasons and track them over time. I’d also suggest making a note of your emotions – how were you feeling when you made the decision? You may start to recognise patterns. 

Above all, try to avoid looking at share prices or portfolio performance every day. You will only succeed in narrowing your time horizon and heightening your emotions. I’ve found I’m less likely to make bad trades if I focus on the playing field rather than the scoreboard. 

Don’t worry if you’re not an ‘ace trader’

I suspect most investors vastly overestimate their trading abilities. Luckily, I don’t think you need to be a great trader to be a good investor. 

The biggest investment gains don’t come from trading, they come from holding. 

If you invest in a portfolio of excellent businesses and own them for years, they will do a lot of the heavy lifting for you. Usually, the best thing you can do is sit tight, and let compounding work its magic.