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Classic investment mistakes
This article appeared in the February 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
You've heard of 'madding crowds' and 'following sheep', so think for yourself.
By Nathan Bell, Intelligent Investor
Here are nine classic investment mistakes that, to be successful, you should avoid at all costs:
1. Don't trade fast and often
Charlie Munger, Warren Buffett's business partner, often refers to the huge mathematical advantages of "doing nothing" to your portfolio. Let's blindly ignore the very large tax benefits of holding shares for the long term and just consider the effect of brokerage.
Someone who turns over (buys and sells) all the shares in their portfolio several times a year is at least a few per cent behind the eight-ball, even with internet brokerage rates as low as 0.3 per cent. Add up the brokerage from your last tax return to see what we mean.
There is also an important, but less measurable, benefit to taking a longer-term approach. It makes you think long and hard about which shares to include in your portfolio. When considering buying a share for 10 years or more, you tend to pick quality businesses - and that can only be a good thing.
So, if your intention is to lose money (and enrich your broker), trade fast and frequently.
2. Don't follow the mainstream media
Munger refers to a human condition known as "incentive-caused bias" and it explains the functioning of media quite nicely. There is a widely held belief that emotional, confrontational, dramatic coverage sells more newspapers than rational, factual reporting. Hence the tendency to induce panic in investors when calmness would better serve their interests.
But incentive-caused bias does not just affect the media. Just look at how honest managing directors can first convince themselves, then their board, then their shareholders, how an offshore acquisition or hostile takeover will be great for everyone - especially themselves. Generous options packages offer a fitting explanation for many examples of corporate foolishness.
To lose money, avert your eyes from a factual assessment of a situation and bury yourself in the opinions and arguments of those with a vested interest.
3. Don't follow fads or 'hot stocks'
In his highly recommended book, Influence: The Psychology of Persuasion, Robert Cialdini talks about another human condition known as 'social proof'. The evolution of the human species, and sheep, was greatly assisted by a tendency to follow the crowd: safety in numbers.
Anyone who thinks that social proof is solely the preserve of the historian should study the mania of the dot-com boom. Millions, with the fear of standing apart from the crowd, played a huge role in sparking and then fuelling the mania. Conformity still dictates many areas of life but following the sharemarket crowd can be a costly mistake. As Buffett says, "you pay a very high price in the stockmarket for a cheery consensus".
That is why we are most often excited when others are depressed and fearful when others are optimistic. If you're intent on seeing your net worth dwindle, follow "hot" shares and sectors.
4. Don't beat yourself up over lost opportunities
In an imperfect activity like investing, mistakes are absolutely inevitable. But odd as it may sound, sometimes even when you're right, you're wrong.
To call tech shares overvalued in mid-1999 was undoubtedly correct. But from mid-to-late 1999, as speculators pushed prices higher still, it did not feel like it. It is a fact of life that someone will always be getting rich a little quicker than you are. But then again, they may become poor just as quickly by adopting the same approach.
If you take the conservative decision not to invest in a stock, and it goes up anyway, don't fret. Just be patient, because other opportunities are often just around the corner.
5. Don't buy cyclical shares at the top
There is a natural human tendency to extrapolate recent events into the present and even the future. So when a cyclical share company such as a steel company or property developer has a few tough years, investors tend to make the assumption that the bad times will last indefinitely.
In the same way, when these companies show a few years of good results, thanks, for example, to strong Chinese metal demand, a booming property market or some other factor, the market tends to extrapolate the good times just as readily.
It is the same mistake made at different ends of the cycle. At the peak, investors can confuse a cyclical share with a growth one and bid the shares up, perhaps to a very high price-earnings (PE) ratio. But when earnings are at a peak, that is exactly when cyclical shares should be selling on a low PE multiple. When earnings fall, as they inevitably do with a cyclical downturn, the shares come crashing down.
6. Don't follow overly acquisitive management
In his comprehensive book, Two Centuries of Panic, Trevor Sykes says "more companies are ruined by bad management than by bad economies". We agree. Overly acquisitive managements - those hell-bent on growth, seemingly at any cost - are especially prone to getting into trouble.
Acquisitions often involve large amounts of debt, which increases risk. As interest rates rise, a growing portion of cash flow has to be diverted to service debt rather than be deployed in the business or paid out as dividends. And acquisitive managements, often suffering from delusions of grandeur, can overstretch themselves.
Also, acquisitions tend to cloud the company's financial accounts. This can fool bankers and shareholders for a while but by the time the gravity of a tough situation comes to light, it is too late. Backing such management is almost bound to lighten your wallet.
7. Don't invest in rapidly expanding financial institutions
Depending on the riskiness of the borrower, a financial institution might make a "spread" or "margin" on loans of anything from 1 per cent to 5 per cent each year. But when a loan goes bad, it can lose 100 per cent. It is a risk that must be managed very, very carefully. Buffett once remarked that a bad bank manager can flush all your equity down the toilet in your lunch hour.
And watching the accounting ratios like a hawk won't always save you either. In banking, growth can actually be used to hide bad loans temporarily. A bank that is experiencing a high rate of loan delinquencies can easily halve that rate temporarily by writing new loans and doubling the size of its loan book. After all, a new loan takes time before it can go bad. But hastily made new loans are likely to be of poorer quality than existing ones. That is why we get worried when financial institutions aim for rapid growth.
8. Don't work to the 'greater fool' theory
Some investors seem happy to buy expensive shares knowing full well they are overvalued, because they feel confident that someone else will come along and pay an even higher price. That is what happens in almost every boom. It's a game of financial musical chairs for suckers and will end up costing you a bundle.
9. Don't buy 'gonna' companies rather than 'doer' companies
These companies are going to do this and going to do that. Such unproven companies and their attendant management teams are a great way to lose capital.
But even well-established companies can be "gonna" companies. Management will explain away the poor performance of the past few years and concentrate on saying what it will do in the future. Chances are it will be putting on a similar show a few years down the track. Those who stick with proven companies and managements should do well.
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