Five Investing Mistakes You Should Avoid

For starters, beware of holding on to losers too long and of not doing your homework.
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The only unassailable truth to investing is that there is no scientific formula to beating the market. Even so, we have encountered a handful of common mistakes made by investors through our email exchanges with subscribers which, if avoided, could improve trading and investing results. We look to employ all of these rules into our investing philosophy for Breakout Stocks, with the belief that it will yield positive returns for our subscribers.

Mistake 1: Failing to cut losers

The first mistake we encounter is investors who hold on to losing stocks because they are "already down, so downside is limited," or they have "held it so long, what's the point in selling?"

If investors were able to avoid this type of thinking and approach each equity holding in the present with disregard to the past, disastrous situations like

Lucent

(LU)

can be avoided. For readers new to our content on

Real Money

, we have been advising subscribers to avoid shares of Lucent. While widely held by investors hoping for a turnaround and more than 90% from its all time highs, Lucent's shares are bound to fall short of investor and analyst expectations. We first wrote about Lucent in August, and readers who listened to our advice then have saved themselves from further losses.

Remember, a stock that trades lower from the first day you bought it is likely doing so for a reason. We believe one common reason for this is that institutional investors with more experience navigating particular sectors are moving out of stocks that are headed for some rough times. The media produce one positive story after another on whatever companies and/or sectors happen to be performing best in a particular time frame. When this happens, the stock's best returns have already been delivered. Unfortunately, this is often the time when individual investors decide to get in, and they wind up on the wrong side of what was once a very profitable investment.

So when you see prolonged and accelerating weakness in a particular stock, don't be afraid to sell. Usually, the money can be put to better use. Stocks trading above 1 cent a share always have 100% downside potential.

Mistake 2: Not doing homework

We believe it is vital for long-term investors to have a disciplined stock selection process. One of the worst things an investor can do is buy a stock solely on the basis of superficial reasoning, such as the release of a certain product or the hiring of a prominent executive. For example,

Verizon

(VZ) - Get Report

has heavily promoted its burgeoning fiber-optic Internet access business. Investors who diligently researched the company would have likely discovered Verizon was under severe pricing pressure from voice-over-Internet phone service providers of late as cable providers and independent operators entered the space. This dramatically cut into the company's growth rate and ultimately Verizon's stock price.

The homework process is different for everyone. To be successful, a fundamentals-oriented investor should know how a company makes its money, have a solid understanding of the company's financial position including its balance sheet and debt obligations under bank agreements, and be aware of potential risk factors. In the case of Verizon, the risk factor was competitive pressure. As part of our research process for Breakout Stocks, we carefully examine company financial statements, assessing the overall market for the company's products and services, and identify major threats to our thesis.

It is also helpful to put together some type of routine when doing homework. For example, an investor might want to start with looking at financial statements, then move on to management, and then examine competitive threats. We believe a routine allows investors to make the research process more efficient and more effective, as it helps tune out the noise and instead helps you focus on the most important data.

Mistake 3: Being afraid to change directions

Investors should not fear change. In fact, change can save you tons of money and make investing much more enjoyable.

Why?

You are investing in the stock market, which is a mechanism that allows for price changes and sentiment shifts on a daily, if not hourly basis. We aren't recommending you become a daytrader or market-timer, but we do believe at least being aware of the constant change in the market or economy will make you a better, more profitable investor.

For instance, if you are long

Intel

(INTC) - Get Report

as a play on strong demand from computer and server makers but your research begins to show that

Advanced Micro Devices

(AMD) - Get Report

is introducing better products at a faster clip for a lower cost, the sensible move is to move your money from Intel to AMD.

This example, which is taken directly from the second half of 2005, was a classic example of some investors' refusal to change their minds. The result was too many investors betting in Intel. When the company disappointed investors with its fourth-quarter EPS results and AMD topped forecasts, there was massive selling of Intel's shares for losses and late-to-the party buying action in AMD.

Don't be afraid to throw all of your old homework out of the window and adopt a new strategy when current events dictate such action.

Mistake 4: Buying on tips and rumors

Buying a stock on the basis of a tip or rumor is one of the biggest mistakes an investor can make. There is no way to know if the information is true or even remotely related to truth. Very often, people have a vested interest in spreading rumors due to their own position in a particular stock. The most common type of rumor is generally related to a merger or acquisition, which generally provides an instant windfall to shareholders of the companies being bought. However, these events are among the most difficult to predict, and rumors on potential deals should never be trusted.

Understand, too, that if

Securities and Exchange Commission

get the impression that you traded on l inside information, you will be in an awful lot of trouble. The authorities are a lot more sophisticated than many investors believe, and the potential reward is not even close to being worth the risk. And logically, if a person had inside information, why would they share it and run the risk of getting caught?

In our experience, we have never seen a tip or heard a rumor -- save from major news media outlets -- that turned out to be a moneymaker. More often than not, rumors are started on Wall Street trading desks -- by traders with large positions that they want to sell at a higher price -- and not in corporate boardrooms or investment conferences.

Mistake 5: Owning too many large-caps:

If you follow the advice of most Wall Street firms and strategists, you likely own too many large cap stocks in hopes of outperforming the market. Over the last five years, small- and mid-cap stocks have outperformed large caps by some 70 percentage points, and 80% of the top 100 performing stocks in 2005 were of the small- and mid-cap genre.

Since stocks like

General Electric

(GE) - Get Report

,

Citigroup

(C) - Get Report

,

Home Depot

(HD) - Get Report

and

Microsoft

(MSFT) - Get Report

largely dictate the moves of the major indices such as the

S&P 500

. A portfolio loaded with these giants is unlikely to perform much better, or worse, than the broader indices. So diversifying into smaller stocks with a bent toward growth may enhance returns. T

he purpose of the Breakout Stocks service is to introduce time-strapped investors to a new world of stocks that they would normally ignore or wouldn't have enough time to discover on their own. As we find largely unknown companies with lots of upside potential, we hope our subscribers are energized to start investigating small and mid cap stocks as possible additions to their portfolios.

The TSC Breakout Stocks Team is Michael Comeau and William Gabrielski, research associates at TheStreet.com. In keeping with TSC's editorial policy, they don't own or short individual stocks. They also don't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. For more information about Breakout Stocks, please

click here.