Investing is a task unlike any other. Rarely is there an opportunity to outperform just by avoiding the big mistakes. The truth is, though, that the best investors aren’t those that hit home runs. The best investors simply avoid big mistakes.
Here are a few common mistakes that investors make in investment selection:
- Buying investments you “love” – Much like a mother can forgive her child for almost anything, an investor in love with a company, sector, or type of exposure, can easily overlook problems in their investment objectives. This happens most frequently with individual stocks – people who love a company often hold it even though the obvious decision is to sell. Take, for example, investors who loved the old school RadioShack. The company was a nerd’s favorite, but over time the company lost its nerdiness and its competitive advantage. Those who are loyal to the brand – one which used to be a leader in selling the most innovative consumer electronics products – have suffered a nearly complete loss of investment capital.
- Failing to understand the financials – There is a lot more to a company than its PE ratio or reported earnings. Railroads have been historically solid investments as their services become more valuable as the cost of gasoline trends higher. However, railroads have never, ever earned as much as they report. You see, railroads depreciate railroads against their original cost. This year, a railroad might replace rails installed in 1980 at 2012 prices, while depreciating the 1980 railway at 1980’s prices. Understanding the relationship between reported financials and the business itself is tantamount to finding good investments. If you were to look only at reported earnings for railroads, you’d think they’re twice as profitable as they actually are. Those who investigate deeply the financials of the business know that railroad earnings are never as high as reported.
- Missing the mark on exposure – I’ve said it before in an article about investing overseas – many investors chase the wrong kinds of exposure. For example, you shouldn’t buy Indian oil companies to get exposure to India’s impressive economic growth. You probably shouldn’t buy jewelers to get exposure to rising gold prices. Know what information is actionable, and which actually affects your investment. Indian oil companies will make no more or less money if India continues to grow. Jewelry companies are unlikely to make more money if gold or silver prices go up. Likewise, oil refiners make no more money when oil is $100 than when it is $50; oil producers would, however. Make sure that you’re actually getting the real exposure that you want when you buy any investment.
- Failing to do the legwork – If you invest in individual stocks, you should read every SEC filing that comes from the company. If you invest in ETFs, you should read the prospectus for each ETF, and understand the index it tracks. If you invest in mutual funds, you should know what they hold, and who the managers are. Funds and ETFs take much less time to follow than individual stocks. Know how much legwork you can realistically do, and align your portfolio to match the amount of time you can invest into watching your portfolio.
Investors who make the fewest mistakes will be those with the best performance. The mathematics are obvious: it takes an 11% gain to erase a 10% loss; a 100% gain to erase a 50% loss. The fewer mistakes you make, the better your portfolio will perform.
Readers: What other investing mistakes would you add to this list?