Chap ter 14

Ten Mistakes Investors

and Traders Make

Nothing is more harmful to a new truth than an old error.

Johann Wolfgang von Goethe, Proverbs in Prosee, 1819

Traders make several mistakes in how they select

products, when they open or close, and what forms of analysis they
use. Following are ten of the most common mistakes investors and
traders make.

1. Placing Money into Trades without

Knowing the Risks
The most common mistake investors make is quite basic: Committing
money without awareness of the risks. This means all risks, not just
the best-known market risk. With market risk, chances are that after
a position is opened, it will lose value. Investors easily fall into the
trap of thinking of their basis price as their “zero price,” assuming
that the value must rise from that point. But the entry price, or basis,
is the price in a continuum of rising and falling prices of the auction
market. This is obvious, but it needs to be acknowledged.

Key point: The price at which you enter a position is not zero,
but only the current level; the next move can be a higher price or
a lower price.

M. C. Thomsett, Investing in Energy

© Michael C. Thomsett 2014
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66 Investing in Energy

In addition to market risk, there are many other types of risk. These
include knowledge and experience risk, namely, the risk that an inves-
tor will take up a position without adequate understanding of the mar-
ket, the sector, or the industry. The basic research you are expected to
perform requires responsible initial research. Only when you know
the fundamental risks (as well as opportunities) can you expect to
make an informed decision about where to commit your capital.
Other forms of risk include leverage risk (for those using mar-
gin accounts), liquidity risk (selecting investment products that are
not easily or efficiently traded), and diversification risk. The latter
includes the risk of overdiversification, which is often overlooked
because underdiversification is emphasized among financial profes-
sionals and in the financial press. You underdiversify when too much
capital is placed at risk in a single product or a range of products and
all of them are subject to the same risk exposure. For example, while
an energy-based ETF provides diversification within the energy sec-
tor, it may also be underdiversified if the entire basket of securi-
ties is likely to rise or fall based on the same market and economic
forces. Overdiversification occurs when capital is spread among so
many different products that you can earn only the average of the
whole portfolio. This may have been the long-standing problem of
the large mutual funds. Because they must broadly spread money
among so many companies, they never outperform the market and
more often underperform the index of markets.
Another form of risk is the double effect of inflation and taxes.
Calculating a breakeven based on these two factors reveals that you
might need to earn a much higher rate of return than you think just
to maintain net purchasing power. Taxes deplete earnings to the
extent of your effective tax rate (for example, if your total federal
and state effective tax rate is 40%, you are netting only 60% of your
gross investment income). This is not entirely accurate given the
special advantages related to long-term capital gains and dividends
in some situations, but the point remains valid that taxes reduce
your true investment income. Added to this is the effect of inflation.
Many people think of inflation as causing higher prices, but another
way to look at it is as an eroding force on your capital. For example,
if you experience 3% inflation, it means that last year’s dollar is only
worth 97 cents in purchasing power today. A goal of your invest-
ment program may be to attain as a minimum the breakeven rate of
return you need to offset inflation and taxes.