My biggest investment mistake was selling a stock for a fourfold profit. Quick profits were taken when the mining stock rallied from 5 cents to 20 cents. Years later, it traded at around $4. That one still hurts today.
I recall not investing in JB Hi-Fi in 2003 at its $1.55 issue price, despite being a fan of its stores and noticing how popular it had become. JB Hi-Fi is now $57.
Yes, looking back at what could have been – the portfolio ‘coulda, shoulda and woulda’ stocks – is pointless. But it’s amazing how missed opportunities often stand out more than portfolio disappointments.
Of course, there’s been a fair share of bad stocks over the years. Every investor – even the pros who do it for a living – has had at least a few howlers in their lifetime. The key is learning from these mistakes to become a better investor.
My previous Monday column outlined what to look for in small-cap companies. This column considers the opposite: what not to do when investing in stocks.
Here is a list of 11 key investment mistakes. Entire books could be, and have been, written on this topic, so this is just a glimpse of what to avoid.
1. My kingdom for cash
Cash is most valuable when nobody has it. That’s usually when equity markets are tanking, and many investors are fully invested in shares.
When markets rallied, investors bought more stock, fuelled by greed. Now, when markets are falling, they can’t buy stocks at sharply lower valuations because they don’t have cash. And they don’t want to sell falling stocks – and crystallise losses – to free up cash.
Knowing when to have more or less cash in portfolios is a key trait that separates great investors from the rest. The stars start to take profits when markets rally and stocks become expensive, in turn boosting portfolio cash. Then, they put their cash to work (by buying shares) when stocks become cheap.
It sounds simple, but too many retail investors overlook the importance of a portfolio cash allocation and managing it to market conditions.
2. Diversification 101
A friend once claimed he was appropriately diversified because his portfolio held 20 Australian stocks. “What about bonds, cash or alternative assets?’ I asked. ‘Or holding global equities or emerging-market equities in the equity allocation?’
On closer inspection, my friend’s portfolio was almost 40% weighted in big-bank stocks – and thus vulnerable to a correction in that sector. He had not diversified sufficiently across or within asset classes.
If you are serious about investing, think about asset allocation at the start. That is, how you allocate portfolio assets between growth (equities) and defensive (fixed interest and cash) in a way that matches your investment needs.
Long-term investors seeking to build wealth will need Australian equities, global equities, local and global bonds, and cash. They might have other exposures, such as a small allocation to emerging-market equities and private equity/debt.
Once or twice a year (even more, for some investors), portfolio asset allocations will be rebalanced to return to target allocations. That is real diversification and a better strategy than filling portfolios only with large-cap Australian equities.
3. Running with the herd
Being seduced by market noise or investing with the ‘in-crowd’ can be costly investment mistakes. You don’t build long-term wealth by standing on the same side of the ship as everybody else – or running with the herd.
That’s not to say you should ignore newspaper reports or commentary from market analysts, economists, or central bankers. Just be aware that so much share market commentary is self-serving (to sell products) – or inevitably wrong.
Here’s a simple rule of thumb: take extra care if everybody seems to be talking about the same ideas. Pay more attention to neglected ideas.
Right now, one fund manager after another says it’s time to buy small-cap stocks. That might be true, but there seems to be a lot of small-cap hype right now – and plenty of small-cap managers eager to attract funds to manage.
Readers will recall I became more bullish on small-caps last year when they were still badly out of favour. That was probably a little too early, but I’d rather be that than be too late and overpay for small-cap stocks while running with the herd.
4. Trading
One of this market’s best equity traders once told me he considers it a good year if half his ideas are correct. He makes his money by minimising losses on bad trades and maximising profits on the good ones.
If even the best professional traders get half or more of their ideas wrong (on average), what chance do retail investors have?
Yes, some retail investors have become successful day-traders and others have made money through active investing. Even a few chartists I know have done okay over the years through technical analysis. All power to them.
Trading is a full-time, stressful and, at times, lonely job. Like most things, it requires skill and experience to do well. For novices, trading is a sure-fire way to destroy capital, your health and sometimes relationships.
The real money for retail investors is made through long-term investing, not trading. Long-term investing means being prepared to hold stocks for 7-10 years, or even longer if they still represent reasonable value.
5. Not letting profits run
My earlier example about selling a 5-cent stock after it hit 20 cents was an example of not letting profits run. The company’s prospects were rapidly improving, and its stock was still cheap at 20 cents.
Selling winning stocks too early is a painful investment mistake. That’s not to say you should hold stocks forever regardless of valuation, or never take profits. After all, the only profits that matter are the ones ending up in your bank account.
Also true is that many investors underestimate how far winning stocks can rise – and how far losing stocks can fall. Look how well investors in the Commonwealth Bank float (in 1991) have done by holding their stock. Fortunes have been made.
The key is identifying high-quality companies, buying them when they trade at bottom-quartile valuations (often during market panic) and being prepared to hold them until they achieve a top-quartile valuation (and are overvalued). That’s when you sell.
6. Broking research
Australia has some terrific stockbroking analysts who provide insightful research that creates value for institutional and retail clients. It also has a large body of stockbroking research that promotes rather than analyses stocks.
This is particularly true of small-cap stocks. How many broking reports on small-cap companies have sell recommendations these days? Is some small-cap research more like investor relations material than proper analysis? Did the company pay for the broking firm to write a positive report on it?
Bullish broking research – with lofty price targets for a stock – can be persuasive. It can also be a quick way to destroy wealth when the research is designed to push the share price up, so the company can raise more capital.
7. Leverage
There might be times when a small amount of leverage makes sense. For example, borrowing funds to boost exposure to high-conviction ideas.
I learned the hard way with leverage many years ago. A portfolio that was 30% geared looked safe on paper … until equity markets tumbled during the Global Financial Crisis in the late ‘90s and the Loan-to-Value Ratio (LVR) got dangerously close to the margin call level (which would have forced me to sell).
Some stocks have enough leverage through their own borrowings. Avoid borrowing to buy stocks that already have a pile of debt and balance-sheet risk. Most of all, take great care using equity in the family home to borrow for shares.
8. Overlooking valuation
The most important aspect of any investment is what you pay for it. Yet for too many retail investors, valuation is a secondary consideration. They buy the stock based on a compelling ‘story’ – for example, its exposure to favourable top-down trends. They don’t realise that that outlook is well and truly priced into the stock because the market looks a year or so ahead.
Worse, some people ignore valuation under the premise that they are investing for the long term. Overpaying for assets, regardless of time frame, is never a good idea.
Avoid blindly relying on Price-Earnings (PE) ratios or other financial metrics. Some stocks have low PEs (and look cheap) because they have poor prospects for earning growth. Other stocks have a high PE (and look expensive) because they have excellent growth prospects.
Compare the PE to the stock’s historical PE, to others in its industries, and most of all, to its future earnings prospects.
9. Underestimating the value of advice
Arguably the best investment one can make is taking the time to find a financial adviser who is a good fit and working to build that relationship. A good adviser will earn their fees many times over if they put you on a path to wealth creation.
Yet, many investors prefer do-it-yourself investing to avoid fees. They invest directly rather than use active funds run by professional investors.
Self-Managed Superannuation Funds, online broking platforms, exchange-traded products …. these and other investment products/services all have their place for DIY investors. But don’t give up on the value of advisers and active funds.
10. Not focusing enough on capital preservation
There are two great investment rules. One, focus on capital preservation. Two, never forget rule one.
Preserving capital is the key to building long-term wealth. Limiting losses (you’ll never completely avoid them), means more capital in the market. It also means more time for the market to work its magic through compounding returns.
Ensure your portfolio has strategies to preserve capital. The best one is valuation – buying assets when they are undervalued (and have limited downside risk). Asset allocation/diversification is also critical to preserve capital.
Understanding when you sell stocks – and cop a loss – is equally important. Some investors implement a stop-loss (a pre-determined point at which they sell) to minimise losses. Others sell when their fundamental view on a stock changes.
The key is being prepared to sell if the company does not perform as expected. It’s much better to take a small loss early than a big one over time.
11. Low self-awareness
Investor psychology is an important part of wealth creation. But few retail investors, in my experience, take time to think about their biases, strengths and weaknesses – and how that influences their investment approach.
One of my biases is a tendency to anchor expectations to the past. I occasionally conclude a stock is cheap based on where it’s been, rather than where it is going.
One should know better, I know, but comparing a company’s current price to a past price (to gauge value) is an easy mistake to make. I understand that bias and work hard to overcome it,
What are your investment biases? Do you look for information that confirms your view (confirmation bias)? Do you ignore uncomfortable facts that contradict your view (cognitive dissonance)? Do you buy stocks based on a few anecdotes or a small sample of data (the law of small numbers)? Do you become overconfident with investing when markets are rising, and lack confidence when they fall?
Understanding the type of mistakes investors make – and whether you are prone to certain mistakes – is half the battle. The other half is learning from mistakes to become a more experienced, resilient, and successful investor.
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation, and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 21 January 2024.
