10 Underrated Investing Mistakes: Stocks, Bonds and Crypto
Individual investors make financial mistakes for all sorts of reasons — emotions and biases, lack of knowledge, misinterpreting what is happening in the market or the economy, or receiving bad advice. Each segment of the financial markets has its own specific characteristics, risks and driving factors. Failing to properly understand and appreciate them is usually one of the biggest errors private investors make, especially beginners. In this post, I will highlight the 10 major ones I have observed across the equity, bond and crypto markets.
Avoid these to protect your portfolio
The content of this post does not constitute financial or investment advice. It is intended for information and education purposes only.
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Stocks: a world of possibilities… and dangers
1. Underestimating the macro impact
Yes, individual stock performance is influenced by both firm-specific and macroeconomic factors. But if you are investing in the market as a whole (for example, via ETFs), then research clearly shows that the real economy and total payouts are key drivers of returns. Many beginners are told by their advisers that they should not focus on what happens with growth, inflation, nonfarm payrolls, etc. One could say that short-term changes in these macro variables are indeed likely not significant. But you would do yourself a huge disservice if you do not try to understand the bigger picture — medium and long-term trends, structural changes, and significant shifts in economic policy. They can influence and define whole decades in an economy’s development, resulting in unexpected impacts on stock performance.
If you discard the importance of the macro environment, then you will run the risks of:
– misinterpreting the stage of the economic cycle the economy is currently in, what stage follows, and what implications that has for investor sentiment, risk appetite and the markets;
– missing possible megatrends that open up potential for outperformance in particular sectors of the economy (or even just individual companies) that are able to take advantage of them;
– not preparing your portfolio properly for the impact of unanticipated economic and geopolitical shocks.
2. Over-concentration
This is one of the most common mistakes and in my experience, it mainly occurs due to overconfidence. When you feel you have caught some asset that is a great outperformer, why put money on anything less, right? Wrong. One company/sector/country/factor will not always be able to sustain abnormal returns — there are limits to this. For instance, competitive advantages that some companies may possess get depleted or outcompeted after some time; sectors focusing on hot new technologies may find themselves short on funding and high on leverage when monetary policy suddenly tightens; countries with exceptional growth can suddenly suffer from enormous geopolitical shocks or be unable to repay debts in foreign currencies. This is why you often hear this message from professionals: diversify, diversify, diversify.
As you can see in the charts above by JP Morgan AM, market outperformance alternates across segments and it is very difficult to predict with any certainty which one will be next. That is the reason why attempting to ‘pick the winners’ as an individual investor is basically a fool’s errand. Many make this mistake, presuming that what did well in the past or what seems trendy in a given short period, is what always will come on top in the future. And especially when there is ‘fear of missing out’, you could irrationally overexpose yourself to a single sector or a single company, without acknowledging that a great historical momentum may be coming to an end. When your investments have some (or all) common risk drivers, their behavior over time will very likely lead to some more or less significant co-movement, which is the type of concentration that may not be beneficial for your portfolio.
3. Reliance on hyped historical anomalies
It is human nature to look for patterns in everything, but in analyzing stock performance this reaches another level. People I have worked with have come up with observations of how certain phases of the moon or positions of their star signs can be used to time/predict the market. And while these kinds of reasons may not be scientific, there are other anomalies related to abnormal returns, which have been well-documented in academic literature, studied and applied in practice. For example:
– if stocks have not performed well in the fourth quarter of the previous year, then they might outperform in January of the current year (i.e., the January effect);
– returns tend to be higher on the last trading day of the month and the first 3 trading days of the next month (the turn-of-the-month effect);
– when information is released publicly for the first time, there is a reaction to good news — inflation of stock prices — and bad news — stock prices become depressed (the overreaction effect).
The problem is that such anomalies do not rely on sensible economic logic, they are not linked to the fundamental drivers of stock returns and are therefore a very risky way to invest. Overreactions tend to occur, but so do underreactions, hence, on average, the stock market could still be (largely) efficient and such outperformance is unlikely to persist. Moreover, some of these have been debunked and shown to work only intermittently or fade away completely once discovered and exploited en masse. And some of them also do not hold internationally. In general, deciding on an investment strategy around patterns like the ones described above would not be a sound approach for most individual investors.
bonds: the devil is in the details
1. Incomplete understanding of the risks
Many individual investors, especially beginners, seem to believe that since bonds are an instrument of credit, they only carry credit risk. But if there is anything the recent shocks to markets and the US financial system showed us, it is that there are many other risks to consider before investing, such as:
– yield curve risks — when the yield curve changes its position or shape and that causes bond values to move unfavorably;
– reinvestment risk — if a bond offers regular coupons and the investment horizon is relatively long, then there is a risk that these coupons might be reinvested at ever lower rates, thereby earning less than the yield expected at the time when the bond was first acquired;
– embedded option risk — many types of contingency provisions could be part of a bond’s indenture, giving rights to the holder or the issuer; as a result of these options, early sale or redemption or other actions could be applied that impact the value of the bond unfavorably.
If you do not have a sufficient understanding of what those risks are and how they develop over time as macro and market variables move up and down, then you might not be ready to invest in bonds. The reason is that you would be unprepared to understand how or why prices would react, and you would not be able to correctly position yourself to protect your portfolio or expand it. It would be useful for any individual investor to study carefully the features of a bond or bond fund before adding them to their overall portfolio.
2. Underestimating regime changes
Bond prices have this unbreakable bond with interest rates/yields. This is why the dependence of bonds on monetary policy regime changes and inflation regime changes is so strong. Especially in the long run. For example, the high-interest-rate regime in the US that started in the late 1970s-early 1980s, intended to defeat higher inflation, kicked off 40 years of persistent decline in US Treasury yields (see below for the 10-year US treasury note), with the minimum reached just before the pandemic.
Because these regime changes cannot be predicted with certainty and the regime itself can last for several decades, investors need to be aware of them before deciding to ‘buy and hold’ for a long period. For instance, acquiring bonds in 2020 or 2021 would have exposed you to a significant risk of losses once major central banks around the world started hiking rates, causing bond values to collapse throughout 2022–2023. It was the effect that regional US banks suffered from for several quarters and subsequently several of them failed in early 2023.
Beginner investors should remember that for their bond investments, the inflation rate is a much more important factor than short-term interest rate trends. Especially if one depends on income from these investments, inflation can and will eat into that nominal income over time.
3. Ignoring where the bond ranks in the capital structure
If you are investing in corporate bonds, then different issues can have a different claim priority in the capital structure of the company:
– Senior vs. subordinated debt — this is about the priority of payments: senior has the highest priority and therefore the lowest risk and typically also the lowest interest rate.
– Secured vs. unsecured debt — with secured debt, the debtholder has a direct claim — a pledge from the issuer — on certain assets and their associated cash flows. Unsecured bondholders have only a general claim on an issuer’s assets and cash flows and therefore, when there is a default, unsecured debtholders’ claims rank below those of secured creditors and hence have lower payment priority.
– First lien vs. second lien debt — with the former, there is usually an asset pledge against the loan, while with the latter (or any further lien), there could be a pledge but it ranks below first lien in both collateral protection and priority of payment.
For issuers, having debt of various priority rankings allows better optimization of the cost of capital depending on the type of business and the sector, while for investors, different issues could have different benefits and varying income in terms of coupons. But since the risk can also differ quite significantly, neglecting to review the rank type could be a major error. For example, in the chart above you can also see the differences in the recovery rates and how they fluctuate over time. The priority of claims in bankruptcy or a restructuring determines who can benefit first from a realization of assets, which may leave certain classes of creditors with no recovery of value:
– Creditors with secured claims have the right to the value of those particular assets before other claims and if the value of the pledged security is less than the claim’s amount, the difference turns into a senior unsecured claim.
– Creditors with senior unsecured claims take priority over all subordinated creditors (a creditor is senior unsecured unless expressly subordinated).
– Unsecured creditors have a priority over equity holders.
crypto: a new hope or a speculative scam?
1. Understating the risks
Crypto assets have some characteristics that can be seen as return-enhancing features by enthusiasts but also represent unique risks that should not be underestimated by investors who are used to investing in more traditional assets like stocks and bonds:
– Volatility — Price jumps and drops of many crypto assets can be quite extreme, with drawdowns much more frequent and significant than those for stocks and bonds. This high volatility can produce higher returns in shorter periods of time, but since 2018 risk-adjusted returns have actually not exceeded those of stocks, for instance. This level of volatility can lead to quick and severe unexpected losses, which means crypto may not be suitable for individual investors with low risk tolerances.
– No legal protections — Payments done with crypto are not like payments done with credit or debit cards. Crypto accounts are not like bank accounts. Generally, you cannot dispute purchases made with crypto and crypto accounts do not have depositor insurance. Once a transaction is made, it is irreversible and you can only get your crypto back if the other side sends it back.
– Irretrievable holdings — Hardware wallets (i.e., self-custody) mean that you can have full local control of your crypto holdings. But if you lose the device permanently or forget the access passphrase, you risk never being able to restore your holdings. There are many reports of people losing access to their holdings this way.
– Cyber risks — Any wallets or online accounts holding crypto can become subject to hacker attacks. This has also occurred in the past and has resulted in investors permanently losing access to their crypto assets.
– Whale dominance — Whales are companies or individual investors that hold amounts of cryptocurrency so large that they can influence the price and liquidity of that crypto’s market. This is the result of concentrated ownership. If a whale acquires a large amount of crypto, it may decrease the supply in the market, potentially leading to an increase in its price. The contrary can occur if they dispose of it. This makes market manipulation a lot easier than in markets for traditional assets.
2. Treating crypto like traditional assets
Crypto assets do not react to changes in sentiment and macro variables always in the same way, and can therefore behave unpredictably. Their correlations with other asset classes have evolved and shifted a lot over the period of their existence, for example here I discussed how that worked for Bitcoin. This means that their price moves can be aligned to those of other risk assets in times of severe market stress, but they could also diverge depending on the nature of the market shock.
Cryptos also have specific features and market specifics that mean the fundamentals are, at least to some extent, different from those of stocks and bonds. Some of these characteristics make them more akin to commodities, others — to a monetary asset, and yet others — to cash-flow generating assets (depending on what type of crypto we are talking about). All these differences need to be factored in when adding them to a portfolio consisting of traditional assets. Additionally, they impact the way that one can work out a fair value estimate for each type of crypto. See below an overview with some examples of valuation methods that can be used depending on the type, sourced from the CFA Institute.
3. The quick profit fallacy
This misconception usually goes hand-in-hand with the fear of missing out: you have seen others realize quick profits as a result of the volatility of cryptos, hence you are convinced you can and should do the same. The problem: others may have positioned themselves at a low price and may have held for longer. On the other hand, you may be entering after the price has already peaked, exposing yourself to a significant risk of a loss if it crashes. Yes, volatility can be a feature if one is lucky enough to have timed the market correctly. If not, it can hurt your portfolio significantly — and for years. Like most assets, cryptos are not a guaranteed get-rich-quick scheme or some free money-making machine. Investors need to be cautious, research the market situation and understand the cycle well before buying.
4. Probability for scams
On websites, social media or just in general as publicly hyped investment schemes, there are a lot of methods scammers have used to deceive and lure crypto enthusiasts. Since the markets have been largely unregulated until recently, some investors have lost large amounts of money over the years. There are a number of recent scandals that demonstrate how dangerous this field can be:
– The FTX collapse in 2022;
– The stealing of crypto as a result of the hack of the crypto exchange KuCoin in 2020;
– The hack of a cross-chain bridge at Binance in 2022;
– The Plus Token Ponzi scheme uncovered in 2019;
– The OneCoin Ponzi scheme that collapsed in 2017;
– The BitMEX crypto exchange fraud uncovered in 2019–2020.
If a crypto trading or investment operation is advertised in a way that sounds too good to be true, then it probably is. Usually, there are promises for huge risk-free returns that are supposed to be somehow guaranteed and earned over periods of days or weeks. This is already a major red flag. Again, research and due diligence play a major role in finding out what is a worthy investment and what is a fraudulent scheme.
conclusion
Many mistakes investors make have their origin in the insufficient knowledge or incomplete understanding of how the market for a given asset functions, what are the fundamental risks, and how that asset interacts with the rest of the economy. That is why the first step in avoiding costly errors is to educate yourself as much as you can. You can never get a guarantee that you will not make mistakes (actually, almost always the opposite is true), but at least you will become more likely to reduce their frequency and impact, as well as learn and avoid them in the future.
Author: Nikolay
Founder of MoneyCraft
