When an investment we've made doesn't turn out well, we often blame others for its poor performance. But we typically miss warning signs we should have paid attention to. Before you make your next investment move, consider whether these signals are flashing "proceed with caution."
First, you feel this investment is a sure thing. I hear investors say all the time that something "has to go up." Unfortunately, when it comes to a capricious market, nothing has to go up or down.
I wish I had a dime for every time I heard how gold is a sure thing given all the deficit spending around the globe. If you can't think of at least three reasons your investment could turn out poorly, you're probably ignoring this warning sign.
Second, it makes economic sense. An example of this would be the advisors who reduced the bond exposure of their clients going into 2014 because the Federal Reserve announced it started tapering its quantitative easing. With Fed slowing its purchase of Treasury bonds, the logical conclusion was the reduced demand would cause interest rates to rise.
Of course, just the opposite has been happening lately. I call investing based on common economic knowledge "following the herd."
Third, you got that investment idea from the media. It doesn't matter if it's print, Internet or TV. Author and financial theorist William Bernstein's prime directive to investors is "be early to the game." If one's strategy has already appeared in the mass media, the ship has sailed. In fact, you're probably too late once it's in an academic journal.
An example of this is Harry Dent's book "The Great Depression Ahead." Those who acted on this seemingly sure bet near the bottom of the market missed out on one of the strongest bull runs in history.
Fourth, making the investment feels good. Danger ahead -- this is the most compelling of the four warning signs.
Quite frankly, it feels good to buy something after it has gone up and to sell something after it has plummeted. This is a human tendency that's both consistent and easily measured. We move into funds after they have been stars, and Morningstar does a great job of measuring how much investor returns lag the funds themselves.
An example here is that money flowed into equities at record levels in 2007, as stocks hit a then all-time high, and flowed out of equities from 2008 all the way until the beginning of 2013, when stocks hit a new all-time high. Though stocks were on sale in late 2008 and early 2009, nobody was buying. Getting out of stocks was the only way to stop the pain.
Each of these warning signs can be turned into guides for making a new investment. Before you make your next move:
- Be sure you can list three circumstances that can make your investment turn out poorly.
- Understand that the market often turns economists into fools.
- Don't buy what the media is recommending.
- Remember that pain is good when it comes to investing.
Following these rules won't always result in success, but being a true contrarian has a much better track record than following the herd.