February 2007
Now that 2007 is underway, I thought it was time to update my "Top 10 Things Not To Do" list when it comes to investing. For any that follow the markets relatively closely, it is amazingly easy to make these mental mistakes. Mistakes, or more accurately the avoidance of them, are the things that separate good investors from poor ones. This is meant to poke fun, so please don't take offense if you think I'm talking directly to you! I'm probably not.
1. Don't think about what you should be doing.
If you only have one overwhelming tendency when it comes to investing it should be a strong reflex to look at things a little differently than the crowd. Think about it. If you desperately try to invest in what you should be investing in because everyone else is doing it, then you're probably going to be doomed to financial failure. Your life will be filled with tech stocks right before their fall. You'll consistently own Blue Chip stocks at really high prices because of their quality. And you'll find yourself investing in real estate investment trusts at just the wrong time. It will all happen with uncanny regularity.
2. Don't fear intelligently embracing ugliness.
Embracing some ugliness is not an easy thing to do. In fact, entire children's fairy tales are based on it. However, don't forget the endings of these stories because they usually turn out great. Now, using some intelligence and common sense, embracing some ugliness can go a long way when it comes to investing. Think of the stock market as a kind of fortune teller that works out of an office located in a house of mirrors. What you'll hear is only half the story. The hot story-and-trend based stocks will probably burn you more than not and stocks surrounded by real uncertainties usually are worth some further study.
3. Don't forget about high fees.
High fees tend to kill returns over time. If there is one thing that can be counted on with certainty in this game of investing, it's that high fees damage your returns. If you find yourself wondering about what the fair price for financial advice is, ask around and compare. The industry is crowded beyond belief. Everyone and their brother-in-law claims to be a financial services expert. In economics, oversupply breeds competition and competition helps put a lid on price increases. But, in the upside-down and inside-out world of the "money handling" industry, something has clearly broken down.
4. Don't trust other people's opinions that much.
Deep down, we all know this. Most people have no idea what they are talking about. Even so, they tend to say everything with complete confidence. It is no different with investing. Markets are made up of contradictory opinions. That's what makes a market. When you sell, someone else is buying. When you think you've found the bargain of a lifetime, another investor is rejoicing out loud for being able to unload it on you. That is the way it works. Don't forget to do your own thinking and ignore the talking heads (both on TV and in your office). This is a good rule to follow if you want to consistently make money on your money. Better yet, it is good rule that will keep you out of trouble.
5. Don't forget to do the really easy math.
Investing doesn't require any heavy math skills. Honestly, this is coming from a guy with a degree in math. Simple addition, subtraction, multiplication and division are all that's needed. And just doing the easy math will help keep you out of serious trouble. When a stock sells for greater than 30 times its most recent earnings, be careful. Companies can't grow quickly forever. When a stock has a dividend yield greater than 7%, dig deeper for warts. Things that look too good to be true usually are. When the stock market provides less than a 2% yield, don't forget to at least compare stocks to 5% money market funds. It probably won't work over 5 to 10 years, but does that mean you shouldn't consider it as a short-term option?
6. Don't forget about the serious laws of nature.
Gravity is ever present in nature and also in finance. Things that go up do come down. And things go up really fast tend to slow down on their way up. The same is true with the stock market. Once investors start to pile into something, the stock might move up really, really fast. These are the smart people. The not-so-smart people pile on as its ascent is just slowing down and about to fall. Ironically, this is right about the same time that the smart people have started selling the stock. This dance is pretty predictable. Sadly most people fixate on the two or three stocks in history that never, ever seemed to fall. I suggest that you forget about those cases because they'll only suck you in to bad situations in the future.
7. Don't rely on your gut instincts.
When it comes to investing, most simply don't have a gut that is reliable enough to act on. If you really need to act on your gut reaction, try developing a sound philosophy first, act on it and then just mentally credit your gut for the results.
8. Don't forget that complicating things usually just complicates things.
This needs no explanation other than to say that most investors think they are smarter or deserve higher compensation when they do stuff that most ordinary people can't possibly understand. The question is do they even understand it themselves? Time after time, when you look back at investment debacles and strategic blunders, really smart investors realize that they forgot about the unexpected risk of something going terribly wrong. Black boxes are called black boxes for a reason; they are hard to understand and they tend to blind you periodically.
9. Don't think you're that much smarter than everybody else.
One of the worst things you can do as an investor is assume they are completely right about everything. The truth is you're not right most of the time. The funny thing is, the investment might work out but often you were bailed out by something positive and likely unforeseen. The investment thesis is usually only half right. That's why it is so important to hedge your lack of knowledge with a cheap enough entry price. A low price will help make up for your informational insufficiencies. When you buy a stock, you should consciously admit that you have zero certainty about the future of that company. Without certainty, you should demand a lower price to make up for your ignorance.
10. Don't forget that foolishly risking and losing money is worse than not having saved it in the first place.
Saving money is really hard to do. Basically, saving money is a form of self torture. You work hard, get paid and then you convince yourself to enjoy it the money later on. That isn't all that natural. Squirrels may be good at it, but their brains are much smaller than yours. So, when you think about how hard it was to act this way, it should help you realize how important it is to never, ever lose money in the market. At least, don't lose money by acting completely foolish. Just throwing the money into something without having done any real analysis is no different than playing the slot machine. You should expect to lose most of it, most of the time. It would probably be a lot wiser to just spend your money on something frivolous to begin with and then walk around saying, "Believe me, I really am a great investor, I'm just a terrible saver!"
Jason P. Tank, CFA
jason@frontstreet.com