With heads rolling at two of the biggest banks on Wall Street there is a lot of chatter about a recession occurring in 2008 and yet another bear market. Some of us who stayed painfully invested through the last bear market are looking back at the lessons learnt and are trying to position ourselves as best as possible for the future. The changes I made last year to protect the model portfolio from the bursting of the housing bubble have yielded results and I have accelerated this process in recent weeks by increasing our cash position, adding short positions and naked puts.
Looking over an ocean of fear and uncertainty where companies like E*Trade (ETFC) lose more than half their value in a single trading session, I am reminded of some of the worst mistakes that an investor who is just starting out can make. Given below is a list of 10 mistakes that even seasoned investors are likely to commit from time to time. While many of these classic mistakes should be avoided, the last one and the crown jewel amongst them should be avoided at all costs. So here goes,
- Thinking that a low priced stock is actually a cheap stock. A company with a $2 stock can actually be more expensive than a $60 stock. If you stop thinking that you are buying stocks and instead start thinking of it as buying companies, the distinction becomes very clear. With all other things being equal, if I were to give you a choice between buying 10% of company A for $1,000 or 50% of company B for $2,000, which would you rather buy? A stock could be priced low because there are so many shares outstanding that each share represents an extremely tiny piece of the company. Consider Sirius Satellite Radio (SIRI) where the stock price is $3.51 but with close to 1.5 billion shares outstanding, the market cap is $5.16 billion and every share you own represents less than a billionth of the company. Now compare this with Peet’s Coffee (PEET) where each share is going to cost you almost $30 but the total market cap is just a little over $400 million. In addition, Peet’s is a profitable company and has a higher level of insider ownership. A stock may also have a low price per share because investors have priced in declining sales, declining profits or the risk of bankruptcy into the stock price.
- Forgetting that investing involves risk and there is a good possibility that an individual position can drop significantly. If all stocks went up all the time, wouldn’t all of us become trillionaires? You will get some investments right, you will make mistakes with others and then there will be some that may be hit by unexpected events. As a subscriber mentioned to me in an email, even if you get 6 out of 10 positions right, you can be a successful investor.
- Putting bad money behind good by averaging down on losing positions. There are instances where this could work but for the most part, it leads to additional losses and an obsession with the position that will make you lose sleep at night, check its price first thing in the morning and often attack people who may have a differing opinion about your position. If you are convinced a sector would do well, buy two or three positions in the most promising companies or buy an Exchange Trade Fund (ETF).
- Forgetting that markets and prices are driven as much by psychology as by valuations. If markets were only driven by valuation, they would not be very exciting and we could all just invest in index funds, checking our portfolios once a year.
- Using tips from friends, family and internet websites like this one without doing your own research and analysis. Investing is a lot of hard work and a time consuming activity. Unless you trust someone’s investing capabilities and are paying them to do it for you, be prepared to do your own digging and don’t depend on what someone else tells you.
- Investing too early in an emerging technology can easily see your portfolio wiped out if you have concentrated positions. I have personally fallen prey to this mistake with WiMax through my investment in Airspan Networks (AIRN) but thankfully had a diversified portfolio and also decided to hedge my WiMax bet.
- Not selling a position for tax reasons. If you are trading in a taxable account, you pay higher short-term taxes on positions you sell less than a year after you buy them. If you sell a position 366 days after you buy it (the holding period has to be greater than a year), you would pay the lower long-term tax rate, which is currently 15%. I often tend to make this mistake by holding on to positions longer than I should because of tax reasons. While this works well with some positions, for the most part selling when you believe the stock is fully valued or overvalued is a good idea. Understanding the type of company you hold also makes a big difference. Holding on to a small cap or highly volatile stock is much more risky than holding on to a large cap company that pays a dividend and happens to be in the consumer staples sector. You could buy insurance against a drop in the price of your position through put options with an expiry date set to when it is more tax efficient for you to sell. To reduce the cost of your insurance, you could also use a neutral strategy like an options collar.
- They say a trader is only as good as his last trade. If you are a long-term investor, you probably don’t have to worry about this but there is an important lesson to be learnt from that statement. Markets, sectors and businesses constantly change and you have to adapt quickly to stay ahead. What worked in a bull market will most likely not work in a bear market and hence relying on a single technique or strategy through different market conditions is a big mistake. While it is important to retain some of your core beliefs, it is equally important to tweak your approach based on the input you are receiving from the market and the real world. Start-ups do this all the time
- Ignoring companies you are familiar with and whose products you use every day in favor of exotic or complex investments for a chance of huge returns. I have personally committed this mistake a couple of times. While visiting my dentist for an appointment roughly three years ago, I noticed that they were using a simple yet powerful piece of software. While I made a mental note to follow up on who makes this software, I did not check on it until a year later when I went in for another appointment. This time I jotted down the name and found out that the software was made by Schick Technologies. When I looked up the stock, I realized that in the year that lapsed between my first visit and the following one, the stock had more than doubled and eventually merged with Sirona Dental Systems (SIRO). Thankfully I learnt from this mistake and went on to successfully invest in companies like Seagate Technology (STX), my broker of choice TD Ameritrade (AMTD) and toy maker Mattel (MAT).
- The last and most critical mistake an investor who is just starting out can make is giving up on investing altogether after taking a hard (but not critical) hit. There is a good possibility that if you were to avoid the first nine mistakes, your portfolio may not suffer a big drop but as any student of risk management will tell you, fat tail risks tend to occur more often than people expect. Just take a look at the cover story of the latest edition of Fortune magazine “What were they smoking?“. I still recollect the day back in 2002 when a friend and I were looking at Red Hat (RHT) trading at $4 and saying to ourselves, “this is too cheap, how can it go any lower?”. As geeks we believed we had a slightly better idea of Red Hat’s potential than the average suit on Wall Street. However my friend did not act as the memory of a big (but not crippling) loss made him the personification of the saying “once bitten, twice shy”. I decided to stay the course and through new investments in companies like Priceline.com, was able to recover all my bear market losses and then some. Over and over again I have come across people who lost a bunch of money in a bear market and then decided to become highly conservative even though they were years or decades from retirement. This has lead them to stay out of the market during their best years and earn subpar returns.
If there is one thing I would hope to achieve from this post, it would be to convince new investors that the opportunity cost of staying out can be much higher than staying invested and taking an occasional hit. Investing does not have to mean buying stocks and there are many ways of limiting risk.
What was your worst investing mistake?