I started in the financial services over 19 years ago as a part time job to put me through graduate school. Neither my college nor my social background was in finance so I got most of my education on the job. I have always desired to learn, so I took advantage of every opportunity that I could get to ask questions of people in the business who were smarter than I (nearly everyone I talked to, at first). I read everything I could get my hands on, sat in on every meeting I could sit in on, and researched the questions that people asked me for which I did not know answers. My finance education did not come from a university, but I think what I received was far more valuable than any college degree that could have been conveyed upon me. Many of the mistakes that I made cost me money directly (which I later came to call my "tuition") and subsequently many of the mistakes that I have witnessed clients making over the years have cost them dearly. Mistakes are fine - everyone makes them - but the key is whether or not a person learns from those mistakes. Some people never learn. Others only learn from personal experience. The wisest will learn by observing and learning from the mistakes of others. My desire in writing this article is to share the mistakes that I have witnessed most often over the last two decades in hopes that some people might benefit from the mistakes of others and avoid paying the costly "tuition" that Wall Street often extracts from retail investment accounts. I would hope that this article provides some clarity to the often murky world of investing and I would encourage readers to share it with struggling or frustrated investors everywhere.
Know What You Own
One of the things that amazes me most is when people invest hard earned money into a company and when I discuss the investment with them, in many cases, they don't even know what industry the company is in. It should be a given that this isn't a wise investment strategy. That it is a recipe for losing money should also be a given. It could be less risky to take your money to a roulette table in Vegas and place your chips on a handful of numbers. The payouts are at least clearly marked there and one knows what is required to win on the bet. Investing in a company that one knows nothing about is gambling, pure and simple. It may pay off, but it would be nothing but sheer luck if it did.
Hand in hand with knowing what you own is to know why you own it. I've had clients buy AT&T (NYSE:T) for example, because of its outsized dividend. They say they like the stability of the share price and want to collect the income. But when a disappointing quarter comes and the stock price drops a bit, they panic and sell the stock for a loss. They said they owned the stock for income but the dividend was quickly forgotten when the share price dropped a few points. Similarly I've seen people who hold income securities like preferred stock funds quickly sell out when the market hiccups a bit. They forgot what they were owning (income SECURITIES, not super high yielding CDs) and they forgot why they were owning them (regular monthly or quarterly income, not growth). One of the most glaring examples of this was when I saw people panic-sell investments in the Exchange Traded Fund (NYSEARCA:GTAA) because it was a large position in their account and they wanted to be "more diversified". The fund, at the time, was a fund of funds and held positions in about 80 other ETFs in virtually every publicly traded asset class in the market. Those who did not like the performance of the fund were likely interested in becoming less diversified. Some of the worst investing decisions are made when people don't understand the investment they have made.
"I don't want to buy that stock because it's too expensive and it won't be able to grow as much as a cheaper company." I've heard this statement uttered more times than I can count over the years. Share price has NOTHING to do with the value of a company. It's share price times the number of shares that matters. In other words, if a company has 10,000,000 shares outstanding and it is trading for $10 a share, its market capitalization is $100 million and that is roughly what it would cost to buy the entire company's assets and debt. If the same stock had only 1,000,000 shares outstanding and the price was $75 per share, the company would have a market capitalization of only $75 million and would thus be worth less than the stock which trades at $10 per share. This fact particularly seems to confuse people who buy a stock because they think they are going to make a bunch of money from a stock split. Stock splits create zero value for shareholders. None, nada, zilch. In a 2:1 split, a person will have twice as many shares, but the stock price is immediately cut in half. The only reason why companies split their stock is to make it seem more affordable to the general public and encourage ownership participation from smaller investors. Thus, higher priced stocks are 1) no safer than lower priced stocks, and 2) no riskier than lower priced stocks. They just have a higher share price. Larger market capitalizations, however, are generally associated with more safety and stability. With mutual funds and ETFs, as a general rule, the share price means even less. It is usually completely meaningless in regards to one's potential for gain or loss because it only represents one's percentage of ownership in the fund which is making the investments. Fund companies most often engage in share splits to give the investment the appearance of better value.
Reversion to the mean
One of the most important concepts to understand in investing is the concept of mean reversion. If you're not a statistician, mean reversion simply means that investments tend to trade near their average valuations over time. As I write this in early 2015, The S&P 500 (NYSEARCA:SPY) has a 100 year mean of trading for approximately 14 times earnings (a buyer of an average large company stock would pay $14 for a stock that was earning $1 per share). It currently trades for slightly more than that, near 20 times earnings. The implication here is that the market is currently a bit expensive compared to the past and that it is likely that prices will either have to come down or earnings will have to increase in order to revert to the historical averages. Along those same lines, global indices and asset classes also tend towards mean reversion. Callan publishes a periodic table of investment returns that illustrates this concept beautifully. Just because an asset had a bad year or two does not mean that the asset is going to continue to underperform the assets that have led the pack. In fact, mean reversion generally suggests that those assets that struggle the most will at some point be the best performers - and vice versa. This is why caution is advised when buying a sector fund or a growth stock that have very high price to earnings ratios. If the company or sector cannot grow earnings to justify their high share valuations, it is likely that the valuations will fall. Conversely, good companies with good earnings quality which trade at significant levels below their historical averages will generally revert higher to their mean, all else being equal. Said another way, investment pendulums often tend to swing too far one way, then they compensate by swinging too far the other way before finding a nice equilibrium.
Investments that drop in value are not necessarily bad investments
One of the first things a person should do when selecting an investment is decide how long they plan to hold the investment. In other words, what is the exit strategy? Some traders plan to hold stocks for only a few hours or days. Others prefer a much longer time span. You should determine up front how long you intend to hold your investment or under what circumstances you would sell it prematurely and not deviate from that plan. In setting up such a plan, one must consider why an investment might drop in value in the first place.
The fact that the market value of good investments can and will drop sometimes (just as poor investments can sometimes rise in value) goes hand in hand with mean reversion. Sometimes it takes longer than other times, but reversion to the mean is a very powerful force that investments rarely escape over time. So when a person buys an investment and it drops in value, it's silly to assume that they've "lost money" and it must be a bad investment. If, for instance, the investment was made with a five-year time horizon in mind and the drop in value has come after only eighteen months, it should be understood that there has not been sufficient amount of time elapsed to let the investment do what it was originally supposed to do for you. No investment goes up in a straight line and anyone who expects that to happen does not understand how investing works, nor what they are buying and why.
With this being said, I'm not discouraging risk management techniques where people have a pre-defined strategy to sell investments (regardless of quality) if they drop below a certain percentage. If that's part of a portfolio strategy, it can be an effective loss prevention mechanism. I'm talking about people who have no plan and instead let themselves be emotionally drawn into the fear of a decline in value which leads them to sell prematurely. In reality, that person should have never been invested to begin with. A person should have a reasonable expectation of the amount of income and/or capital gains they expect to make over the investment's life span - as well as a timeline for this to occur - before they make their investment. As an aside, I see the same thing happen to people who buy annuities that contain large early withdrawal penalties for a period of years yet are talked into surrendering those annuities and incurring sometimes massive fees. I am surprised at how many people are willing to give up 10% or more just to get out of an investment early. When you identify your investment horizon, be prepared to let the investment work for that period of time. Carefully delineate other reasons (upfront) why you would want to exit the investment early. If you have a pre-defined strategy, you will limit the role that your emotions play in determining your profits and losses.
There are all sorts of reasons why investments can drop in value and even stay there for an extended period of time. This is part of the reason why establishing a reasonable time frame for an investment to achieve the desired goals should be an integral part of the original investment process. Consider that even those who bought into the NASDAQ (NASDAQ:QQQ) peak during the 2000 bubble eventually recovered their losses when given enough time.
Diversity is a well-known buzzword among investors. Everyone knows about it, but many people do not practice it. I have witnessed many portfolio destructions occur over the years and what I have seen happen usually unfolds in one of several different ways. None of these would be major events if investors minded their position sizing.
- Rule #1: Never, ever risk more than you can comfortably afford to lose on any trade. This can mean that you establish pre-defined stop-losses up front (e.g. sell if the investment drops 15% from its purchase price) or it could mean that you separate your investments into "safe" and "risky" buckets. Either way, make sure you do not risk money that you cannot afford to kiss goodbye. Not following this rule is a surefire way to ensure you will lose money investing. Your emotions will make certain of that.
- Margin trading. Just. Don't. This can result in extreme violations of position sizing. Particularly on growth stocks and when margin interest rates are high. If you want to leverage yourself, take a course on options and learn how to use them to your advantage. In 2000 I watched a margined $200,000 portfolio which was concentrated in Lucent (ALU) turn into a $5000 portfolio within a year due to stock declines and repeated margin calls which resulted in forced liquidation. When investing, use margin sparingly. A good rule of thumb is to use margin only when you don't need to use it, if that makes sense. Even professionals are not immune to the allure of margin. I watched in 2013 as Sprott Resource (OTCPK:SCPZF) racked up massive margin debt that ended up forcing unwanted liquidations, getting the CEO sacked, and sinking the stock price to new lows. There are many insiders who frequently use margin to increase their stake in their company. Even with the in-depth knowledge they have of their firm I've seen many of them have to sell large amounts due to margin calls. Avoid margin.
- Ratcheting up risk. When someone who has modest means to begin with over-commits to an investment and that investment doesn't work many people think they then need to concentrate their portfolios and increase their risk levels to catch up to where they were before. This becomes very emotional and usually results in investors losing more money due to hair-trigger loss aversion and poor investment choices. On the rare occasion that this method of investing actually is effective, the false impression that many investors get is that it's easy to make money in the market so managing risk isn't that big of a deal. This reinforces foolish investment decisions. Think Enron or Fannie Mae (OTCQB:FNMA), and see rule # 1 above about never risking money you can't afford to lose.
- "Sure thing" tips. These most often come in the form of penny stock promises of 1000% returns, oversized option allocations, or supposed insider tips. The story behind the investment seems so compelling that it appears there is no way to lose. Investors may even be in touch with company management, so they feel involved in the company's decision making process, causing an initial oversized investment commitment. When the investment drops, investors usually double down, triple down, or quadruple down. At some point they have no capital left to add to the investment and feel that they are "all-in" with the company. They think they might as well see if management can pull things through. Management rarely pulls things through. If they do the original investors' positions are usually so significantly diluted that there is no recovery for them. Check your mailbox and you'll see many of the companies I'm talking about. Many even come with largely ignored warnings stating that the story they are telling may not be completely true, should not be relied upon for investment decisions, and that the newsletter writers will be selling their own position in the stock as the volume (and price) in the stock picks up. Again, see rule #1.
- Unrealistic expectations. An investor might start out with a well-diversified portfolio that includes a small position in a risky stock or two. If the timing is right, those risky positions may double in value while the rest of the portfolio has modest gains or even losses. Abandoning their discipline and expecting unrealistic total portfolio gains, the investor sells their boring investments and buys way too much of the risky stock (often at the high) that has already doubled or tripled since the initial investment. Reversion to the mean occurs and the risky stock drops. Think Tesla (NASDAQ:TSLA) or First Solar (NASDAQ:FSLR).
- Favored investments/sectors/cyclicals. This mistake is usually made by educated professionals like engineers or physicians who may understand the details of a product or service very well but do not take the time to understand the business model of the company that is attempting to develop the idea. They also may fail to consider the macro environment into which the product is being released. The ideas are often good ideas or good prospects until something goes awry with the business model or the economy. This mistake here usually doesn't come from adding too much on the way down, it comes from an initial over commitment to what seems like the next million dollar idea. Think emerging technologies like graphene and 3-D printing, small biotech and cancer cures, new commodity field discoveries.
Selling winners too early and letting losers remain.
It's human nature to want to avoid recognizing a loss on a loser. It's also human nature to want to capture winnings too early. Using stop losses can be an effective way to avoid this mistake and allow your well-run companies to continue to increase in value while limiting the losses in the poor performers. I remember selling Apple (NASDAQ:AAPL) in the early 2000s because it had increased from 18 to 22 in a matter of weeks shortly after Microsoft (NASDAQ:MSFT) had thrown them a lifeline. Who wouldn't want to brag about a 20% return over a couple of months, right?
Many brokers now allow stop losses to be entered on a trailing percentage basis. So if you wanted to limit your risk on a given position to 15% even on the gains in investment, a trailing stop sell trigger would continue to adjust higher as the position gains in value. This tactic can allow investors to ride trendy stocks higher while mitigating some of the downside risk of those stocks if they go out of favor.
Do not ever assume the dividend is "safe".
I've seen more investors get burned on this mistake than perhaps any other investing mistake. Inexperienced investors looking for yield will often do a quick screen on Morningstar or Yahoo Finance and turn up a list of stocks that are paying double digit yields that seem too good to be true. Perhaps management has even recently reaffirmed their intentions to pay the high dividend even though the payout ratio exceeds available cash from operations. Almost invariably the dividend will eventually get cut and with the cut the price of the stock will get slashed. Know how to determine if your dividend is likely safe. Is it paid based on GAAP earnings (like in the case of a C-Corp)? Or is it based largely on Funds from Operations (like in the case of a REIT). Perhaps it is based on Net Investment Income (like in the case of a Business Development company). Maybe the high yield is because the investment is self-liquidating (like in the case of many royalty trusts). In any event, companies that pay out more than their available cash rarely continue to do so for any length of time. Know that when the dividend gets cut, the value of your investment usually gets cut with it. And know that management rarely telegraphs a dividend cut in advance. Never assume that anyone is telling you the truth, including assurances of management's "intent". Do not believe the hype, but do believe the financial statements.
No you do not always need to be invested.
Some of the most successful investors that I know are "crisis investors". That is, they keep much of their money in cash or "boring" investments and wait for blood in the streets opportunities. When they see those opportunities, they dance with joy and deploy their cash. Such opportunities may come around only a few times a decade but when they come they are often worth a fortune to a person who can deploy lots of cash into quality opportunities. People who feel that they must be invested at all times are often the ones who end up buying overpriced securities simply because that is all that is available for them when they are looking to deploy their capital. Do not feel the need to rush to make a purchase if you do not feel comfortable with the price and/or growth prospects of the investment that you are making.
Penny stocks will not make you rich, they will make you poor
I could write an entire book on this topic because it took me so long to believe it myself. Penny stocks are the premier speculative expression of the American dream where one can be a part of a ground floor opportunity to go from rags to riches. Unfortunately, it almost never happens and there are hundreds of reasons why. Penny stocks are very easily manipulated because of their low floats, limited disclosure, lack of access to capital funding, and limited institutional ownership. On a personal note, it pains me to say that my father took his entire inheritance of $100,000 back in 1985 and invested it in a "diversified" portfolio of 140 penny stocks. When he recently died I was tasked with figuring out the value of these investments. After 30 years, the portfolio was worth a mere $2000 - that's poor performance in anyone's book.
Penny stock buyers should know that :
- Warren Buffett does not want to buy the company.
- The sponsor of the company will not "bail you out" if the company loses money.
- The company's lack of capital, lack of experience/history in the sector, and lack of established clientele will impede its growth prospects
- The aggressive business plan revenue projections rarely, if ever, come to fruition.
- Most successful business takes equity capital to grow. Penny stocks will primarily raise that capital by diluting your ownership in the company…often at price levels that are unfavorable to your investment.
- When your favorite penny stock issues convertible debt it is usually a precursor to insolvency.
John Bogle of Vanguard has been talking about this for decades. He's right. Fees do matter. Pay attention to how you are getting charged, why you are getting charged, and what benefit you are receiving for your fees. Sometimes the fees you pay are buying valuable benefits. Often, however, financial fees are merely legal ways to siphon money from your account to theirs. This is especially prevalent in annuities, loaded mutual funds, and other packaged products where I have seen annual fees as high as 4% or more. The cumulative effect of such fees can be absolutely massive when compounded over time. Be aware of your fees and make sure you are actually receiving a benefit from your expenses. There's a nifty little calculator here that allows you to see the long-term effect of fees on your portfolio value.
Know your major risks
If you don't know the major risks that could go wrong with an investment, you will be caught off guard when those risks occur. An owner of a long term bond, for instance, should be aware of how a rise in interest rates will affect the value of his holding. A holder of foreign equities may see the value of their investment rise in local currency but still lose money due to strength of the dollar. Likewise, foreign investment can be subject to certain taxes that are not customary to America owners. Each investment and investment type has its own unique risks. While no one can eliminate them completely, we can make reasonable assumptions about them and plan for how we would respond if they transpired...IF we understand them. Buying without considering the major risks of each type of investment is a recipe for loss of principal. Know what you own and generally how it works.
I was going to wrap up by writing a section on private equity and mistakes that I've seen investors make in that arena, but I think that list alone would be as long as the rest of the article. New laws have recently been passed that allow smaller investors to be involved in raising funds for startup companies. While I love this opportunity because my heart loves freedom, I also know that it will be an invitation for fraud, poor management of funds, and lots of loss. When investing in private companies, much more could and does go wrong than when investing in public companies. Add to that the fact that most private investments are illiquid and you have little choice but to go down with the ship if something does go wrong. On the plus side, private equity generally does allow you closer access to management. You can get your hands on the books of the company, hear and feel the vision and strategy of management, and can often have a more direct role in the success of the company. Make sure you read that thick document of risks and conflicts of interest very carefully and find out whatever you can about the ones running the company. They may indeed be great guys. But they also may be convicted felons. Do your homework thoroughly before you invest. This is your money and, while we do have a well-regulated framework of securities laws, when fraud or loss occurs the simple truth is that most or all of the lost money will be gone forever. If the deal sounds too good to be true, it very likely is. Think twice before you invest in the public markets. Think four times before you commit to a private investment.
You do not have to be an Ivy League graduate to be a good investor. Everyone makes mistakes and there are hundreds of different approaches that a person can take when they are developing an investment style. But just as no one would buy their primary residence over the internet, sight unseen, no one should buy a serious stock market or bond market investment before doing some homework into what they are buying and how they expect it to make money for them. Learning from one's own mistakes is good, but learning from the mistakes of others is far better and less expensive. Information and opinions are readily available with the assistance of search engines, message boards and blogs. Never be afraid to listen to a dissenting opinion and never be ashamed to ask questions. In so doing, I sincerely hope that at least a few people might avoid the pain and heartache of paying that costly investment "tuition".
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is not intended to provide individual investment advice. It's intent is to give investors some food for thought as they consider making investments.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.