When you first learned to drive a car, you probably didn't handle the car like a NASCAR racer; you fumbled around with the stick shift or hit the accelerator too hard, maybe even running up on the curb. Watching a beginner in any field is ugly. It's the same with investing. Like any skilled craft, it takes practice and discipline. Unfortunately, the stakes are higher than in most fields -- sometimes, your life savings are at risk.
Retail investors -- that is, everyday people and not corporations -- face two seemingly unpalatable choices: Step into the arena of the financial markets, and place their savings at risk, or park their money in a savings account and let inflation erode the value of their money as the years pass by. Fortunately, the dilemma is more imaginary than real. Average people can profit from investing by learning to mitigate risk. Investing well is a lifelong pursuit, but a little knowledge can prevent you from making disastrous mistakes with your finances.
In my own career, I've seen amateur investors make the same mistakes repeatedly, with cringe-inducing results. In the police line-up of bad investments, these are the usual suspects. Steer clear of them and you'll avoid getting mugged by the markets.
1. Investing in industries you don't understand.
Several years back, I came across the executive of a local bank who had owned a large chunk of stock in his own company. Sometime in the late 90s, on the advice of a broker, he liquidated most of this stock and decided to diversify his investments. At that time, the stock market was in the middle of the dot.com boom and investors were throwing money at start-up companies, completely overlooking the soundness of these companies as businesses.
Mr. Bank Executive had friends who invested in tech stocks and earned absurd returns of 80 percent or more per year, and of course he wanted to cash in on the stock bonanza. He invested exclusively in software companies, even though this guy never used the products they produced or had more than a vague idea of what they did.
You can guess what happened; by 2002, he had lost about two-thirds of a million dollar portfolio after the dot.com bust and the post-September 11 slump demolished the companies he had invested in.
The moral is this: If you want to pick your own stocks, as opposed to letting a fund manager do it for you, you must do your research and look at the fundamentals of the company. Warren Buffet, the richest investor in the world, spends countless hours examining the SEC filings and shareholder reports of the companies in which he invests. He repeatedly warns investors to stay away from companies that make products and services they don't understand.
2. Basing calculations solely on past results.
Around 2004 or so, our company advised a client who owned a successful auto parts business. He was middle-aged, with years of business experience under his belt and roughly a million dollars in savings that he was looking to invest. Mr. Business Owner found a sure-fire method of picking stocks: Look at a stock chart, find the stocks that had risen the fastest in the past and invest in those. His reasoning rested on the assumption that the stocks that had risen in the past will continue to rise in the future, because the future must always resemble the past. But of course, applying such crude logic to everyday life would yield ridiculous results: If you lobbed a hammer into the air, you wouldn't assume that it would continue to rise infinitely simply because it had continued to travel upward for the last few seconds.
The key to selecting stocks is to find companies that are undervalued with a potential for growth, and buy them before their value increases. Though our guy's method seemed logical on a superficial level, it revealed a fundamental misunderstanding of the market: Sometimes an increase in a stock's price can't be sustained because the stock is overrated or the company has maxed out its potential for growth. As a result of this mistake and other errors, the business owner lost about $100,000 of his portfolio value. (Eventually, he turned the entire portfolio over to my company, and we were able to help him recoup his losses with a more nuanced investing approach.)
3. Focusing on the level of return only.
Mr. Business Owner made another gross error. He developed a kind of tunnel vision that caused him to look at the growth of a particular stock without any regard to risk, which led him to invest mainly in small cap and international growth stocks while neglecting safer (but duller) blue chip stocks. His goal was to earn a 15 percent annual return on his stocks. But of course, you don't get something for nothing: in order to make that kind of return, you have to assume heavy risk -- a burden that he ultimately couldn't stomach. As a result, he ended up selling his stocks when the market bottomed out and using the money to buy low-yielding certificates of deposit. This brings me to the next point...
4. Pulling your investments in and out of the market at random intervals.
Another client of ours was an office manager who had a healthy amount of money in a 401k account with her employer, who managed her funds prudently. However, she sliced off a section of her savings, calling it her "fun money," and decided to get a higher rate of return by investing it on her own. Luckily, she invested most of this money in reliable blue-chip stocks. Her stock choices were fundamentally sound, but the problem was her inability to pick a strategy and stick to it.
Several times, the markets got rough and even her blue-chip stocks underperformed. She then called me and my partner and directed us to sell off her stocks. She told us that she wanted to get out of the markets, protect her wealth, and "wait until the market got better."
"How do you know when things will get better?" we asked her. "It's not as though a bell will ring and tell you when the markets are safe." She replied, "I feel it in my bones that it's time to get out." Against our advice, she pulled her money out of the stock market and placed her money in low-interest CDs. Naturally, when the market started to go up again, she regretted her decision and directed us to reinvest the money in stocks. And then -- you guessed it -- stock prices would decline, she would pull the money out, and the same pattern would repeat itself.
This client had an uncanny knack for doing the wrong thing at the wrong time. Her intuition was the best predictor of short-term stock movements that the world had ever seen -- except that stock prices always moved in exactly the opposite direction of what she expected. If she had left her money in, the stock values would have eventually returned to their previous levels, she would have recouped her losses, and she would have started earning a profit again from the power of compound interest. Instead, over a period of four years, she ended up losing about half of the $50,000 she had invested.
You might be a conservative investor or an aggressive investor, but you need to decide on an investment strategy and stick with it. In the long run, the markets tend to move upward. If you keep moving your investments in and out of stocks, then you're depriving yourself of the ability to earn interest on your money.
5. Dumping your life savings in one investment.
Will company x be the next Google, or will it be the next Enron? No one knows, really. Market analysts can devise sophisticated metrics and analyze the company's finances, but no one can really predict whether a company will succeed or fail. That's why financial planners keep repeating the mantra of diversification. Of all the lessons of investing, this is the most important. I've seen lack of diversification produce some disastrous results. A case in point:
Before the housing bust, my company took on another local businessman as a client, this one the owner of a successful construction business. At age 50, he had become a self-made millionaire in ten years, creating a business worth $25 million. During a meeting with him, we found that his entire net worth was completely tied up in his own company (he even had an unpaid mortgage on his home).
Though the business was doing well at that time, we saw a red flag: It's unwise to put all of your wealth in any one investment, no matter how sound it appears. So, we advised him to save off about $5 million of his equity in the company and use the money to pay off his mortgage and set up a well-diversified portfolio of stocks, CDs, municipal bonds, and alternative assets (oil, currency, commodities, etc.). He only partly followed our advice: He invested some money in municipal bonds, but then turned around and put the bonds up as collateral on a bank loan to buy new equipment.
Around 2008, the great housing bust hit California, and our client's construction empire crumbled. Demand for building slowed down, revenue dried up and he could no longer pay his creditors. His construction business collapsed. The bank repossessed the municipal bonds when he stopped making loan payments. And to add insult to injury, he even lost his home. He ended up bankrupt. It was a stunning reversal of fortune.
I admit that this is an unusual, worst-case scenario. But lack of diversification can be a serious wealth assassin.
No investment method is foolproof; if anyone tells you otherwise, hold onto your wallet. Taking the right precautions, however, keeps risk to a minimum. If you don't feel comfortable making your own investment choices, then it's okay to turn your portfolio over to a professional fund manager -- after all, not everyone feels confident enough to install the wiring in their house or fix the transmission in their car. Sometimes a professional can save you time and money. Always remember: your money is a fragile resource, so handle it with care.