Sunday Book Review #73 – Investment Mistakes

Investment Mistakes is a simple compilation of 77 common errors made by investors.  Most of them are obvious and could have been written by any investor with a modicum of experience.  For example:

Mistake #2 – Do You Project Recent Trends Indefinitely into the Future?

Mistake #3 – Do You Believe Events Are More Predictable After the Fact than Before?

Mistake #4 – Do you extrapolate from small samples and trust your intuition?

Mistake #35 – Do you understand the arithmetic of active management?

Mistake #59 – Do you have too many eggs in one basket?

I’m not saying these points are inaccurate, or that being reminded of them isn’t a good thing.  It’s just that they aren’t great insights.    

As I was writing this review, my best friend Mike Callen, investor extraordinaire, called me to discuss various issues on his mind, and we spent a little time talking about investing.  (If you know Mike, you know he doesn’t need much prompting to share his collected wisdom.)  In the span of less than five minutes, Mike revealed that he regularly makes the following mistakes:

            Mistake #11 – Do you let the price paid affect your decision to continue to hold an asset?  (Mike will hold forever to avoid admitting a loss.)

            Mistake #12 – Do you believe you are playing with the house’s money?  (Mike regularly travels to Vegas and Reno, and still has a stash from a large jackpot that he is willing to lose incrementally without feeling any guilt or remorse.  His wife feels strongly that this is a mistake because she can think of some alternative uses for the money.)

            Mistake #15 – Do you let friendships influence your choice of investment advisors?  (Mike still holds a grudge against a friend who steered him wrong.  Live & learn?  Maybe.)

            Mistake #31 – Do you believe hedge fund managers deliver superior performance?  (Mike thinks hedge-fund managers are the gold standard.)

            Mistake #39 – Do you confuse before-the-fact strategy with after-the-fact outcome.  (Based on his experience in watching certain business and the entire market, Mike thinks he can buy high and sell low – a stock, an industry, or the entire market – by exercising some judgment and intuition.

 Out of the 77 mistakes listed in this book, there were a few that contained excellent insights.  Specifically:

            Mistake #11 – Do you let price paid affect your decision to continue to hold an asset?  I share my friend Mike’s weakness for this mistake, especially when dealing with a stock.  For some reason, I don’t feel the same way about my 401k investments.  For many years, I would tell co-workers that I would decide every day whether to have my 401k in stocks, bonds, or cash, and that it was irrelevant what I paid for those assets.  But when it comes to an individual stock, I am loathe to sell it for a loss.  If I need to sell some stocks, I will almost always sell one on which I have made a nice profit and therefore will be subjected to a capital-gains tax.  Go figure.

            Mistake #14 – Do you believe you are playing with the house’s money?  Again, I share this mistake with my friend Mike.  When my Ford or Lifetime Fitness stocks do down, I don’t get stressed because they have already gone up so much that they remain immensely profitable.  Yet when Goldman Sachs goes down, it feels horrible because it causes my loss to balloon. 

Mistake #22 – Do you confuse great companies with high-return investments?  I bought my Ford and Lifetime Fitness stock because they were great companies whose stock price had been a lot higher before the bubble popped in 2007-2009.  But for all I knew, they could have been already priced more than they were worth.  Old saying – I’d rather be lucky than good.

Mistake #36 – Do you understand that bear markets are a necessary evil?  This section was fascinating because it described not only the cyclical nature of business, but also the risk-premium that is created by the cycle.  If business (and the market) was steady, then the risk-premium would go away and stock returns would more closely approximate fixed income investments.     

Mistake #40 – Do you believe that stocks are risky only if your horizon is short?  The authors point out that this mistake is based on the American experience to date, but fails to consider that the American experience has been exceptional.  Other countries have not been so lucky – e.g., Egypt, Argentina, Japan. 

            Mistake #48 – Do you confuse speculating with investing?  “Investors get compensated for taking systematic risks – risks that cannot be diversified away.  The compensation is in the form of greater expected returns.  Bad risk is the type for which there is no such compensation.  Thus, it is called uncompensated or unsystematic risk.  Equity investors face several types of risk:

1. First, there is the systematic risk of investing in stocks.  This risk cannot be diversified away, no matter how many stocks or different asset classes you own….
2. Second, various asset classes carry different levels of risk.  Large-cap stocks are less risky than small-cap stocks, and glamour (growth) stocks are less risky than distressed (value) stocks.  These two risks cannot be diversified away.  Thus, investors must be compensated for carrying them.
3. The third type of equity risk is that of the individual company.  The risks of individual stock ownership can easily be diversified away by owning passive asset class or index funds that basically own all the stocks in an entire asset class or index fund….  Since the risks of single-stock ownership can be diversified, the market does not compensate investors for taking that type of risk.  This is why investing in individual companies is speculating, not investing.  Investing means taking compensated risk.  Speculating is taking uncompensated risk.” 

Fascinating.

            Mistake #49 – Do you try to time the market?  This mistake is the most obvious, but I include it here because it contained two eloquent quotations:

1. “It must be apparent to intelligent investors that if anyone possessed the ability to [time the market] consistently and accurately he would become a billionaire so quickly he would not find it necessary to sell his stock market guesses to the general public.”  David L. Babson, 1951.
2. “Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.”  Warren Buffett.