Golden rules for losing money

Investing successfully poses many challenges. In these pages we aim to show you some of the techniques that can help you to rise to these challenges but first, one of our favourite tools, from mathematician Carl Jacobi.

He was fond of saying, 'invert, always invert' and that's what we're going to do, here and in our next issue. Instead of looking at how to make money, we're going to look at great ways to lose it. That way you can aim to minimise your mistakes-a vital part of investing successfully.

So here they are, classic investment mistakes guaranteed to ensure woeful performance.

1. Trade fast and trade often

Charlie Munger, Warren Buffett's business partner, often refers to the huge mathematical advantages of 'doing nothing' to your portfolio. Let's blindly ignore the very large tax benefits of holding stocks for the long term and just consider the impact of brokerage.

Someone who 'turns over' (buys and sells) all the stocks in their portfolio several times a year is at least a few percent behind the eight ball, even with internet brokerage rates as low as 0.3%. Add up the brokerage from your last tax return to see what we mean.

There's also an important, but less measurable, benefit to taking a longer-term approach. It makes you think long and hard about which stocks to include in your portfolio. When you are considering buying a stock for 10 years or more, you tend to pick quality businesses. And that can only be a good thing.

So, if your intention is to lose money (and enrich your broker), trade fast and frequently.

2. Follow the mainstream media

Hopefully, your subscription to The Intelligent Investor inoculates you somewhat against this particular human folly, especially after reading our cover story last issue. Most people, though, aren't so resistant.

Munger refers to a human condition known as 'incentive-caused bias' and it explains the functioning of media quite nicely. There's a widely held belief, and it may be correct, although declining newspaper circulations suggest otherwise, that emotional, confrontational, dramatic coverage sells more papers than rational, factual reporting. Hence the tendency to induce panic in investors when calmness would better serve their interests.

But incentive-caused bias doesn't just affect the media. Just look at how honest managing directors can first convince themselves, then their board, then their shareholders, how an offshore acquisition or hostile takeover will be great for everyone, especially themselves. Generous options packages offer a fitting explanation for many examples of corporate foolishness.

To lose money, avert your eyes from a factual assessment of a situation and bury yourself in the opinions and arguments of those with a vested interest in convincing you of the veracity of their own opinion.

3. Follow fads or 'hot stocks'

In his highly recommended book Influence: The Psychology of Persuasion , Robert Cialdini talks about another human condition known as 'social proof'. The evolution of the human species, and sheep, was greatly assisted by a tendency to follow the crowd-safety in numbers and all that.

Anyone who thinks that social proof is solely the preserve of the historian should study the mania of the dot com boom. Millions, gulled with the fear of standing apart from the crowd, played a huge role in firing the mania. Conformity still dictates many areas of life but following the stockmarket crowd can be a costly mistake. As Buffett says, 'you pay a very high price in the stockmarket for a cheery consensus.'

That's why we are most often excited when others are depressed and fearful when others are optimistic (see our review of FKP on page 6). And it explains why we're worried about China, nickel stocks and other areas like the spate of listed investment company floats that are currently running hot.

If you're intent on seeing your net worth dwindle, follow hot stocks and sectors.

4. Beat yourself up over lost opportunities

Here, you might want to refer to our cover story from issue 135/Sep 03 , 'Right decision, wrong result'. In an imperfect activity like investing, mistakes are absolutely inevitable. But, odd as it may sound, sometimes even when you're right, you're wrong.

To call tech stocks overvalued in mid-1999 was undoubtedly correct. But for the next six months, as speculators pushed prices higher still, it sure didn't feel correct. It's a fact of life that someone will always be getting rich a little quicker than you are. But then again, they may become poor just as quickly by adopting the same approach.

If you take the conservative decision not to invest in a stock, and it goes up anyway, don't fret. Just be patient-other opportunities are often just around the corner. But if you are interested in blowing your capital, now's a good time to capitulate and buy at these higher prices.

In next fortnight's issue, we'll look at some more 'Golden rules for losing money'. Try and save your pennies 'till then.

As we said last issue, to make money, sometimes it's better to first concentrate on not losing it. With that in mind, here's the second part of our series, with five more golden rules for losing money.

5. Buy cyclical stocks at the top

In last issue's review of property group FKP, we discussed the natural human tendency to extrapolate recent events. So when a cyclical stock like a steel company or property developer has a few tough years, investors tend to make the assumption that the bad times will last indefinitely. This can sometimes offer good opportunities for the canny investor, as it did for subscribers who followed our first strong buy recommendation on FKP in issue 84/Jul 01 .

In the same way, when these stocks show a few years of good results, thanks, for example, to strong Chinese metal demand, a booming property market or some other factor, the market tends to extrapolate the good times. It's the same mistake made at different ends of the cycle. Just at the peak of a cycle, investors can confuse a cyclical stock with a growth stock and bid the shares up, perhaps to a very high PER. But when earnings are at a peak, that's exactly when cyclical stocks should be selling on a low PER. When earnings fall, as they inevitably do with a cyclical downturn, the shares come crashing down. Farmers-who are used to the feast/famine cycle of a life on the land-seem less susceptible to this folly than most.

6. Follow overly acquisitive management

In his comprehensive book, Two Centuries of Panic , Trevor Sykes says that 'more companies are ruined by bad management than by bad economies'. We'd most definitely agree. Overly acquisitive managements-those hell-bent on growth, seemingly at any cost, are especially prone to getting into trouble. How so?

Acquisitions often involve large amounts of debt which thereby increase risk. As interest rates rise, for example, a growing portion of cashflow has to be diverted to service debt rather than deployed in the business or paid out as dividends. Secondly, acquisitive managements, often suffering from delusions of grandeur, can overstretch themselves. And, finally, acquisitions tend to cloud the company's financial accounts. This can fool bankers and shareholders for a while but by the time the gravity of a tough situation comes to light, it's too late. The collapse of speedily built empires like Austrim, Quintex and Adelaide Steamship are stark reminders of what can go wrong. Backing such management is almost bound to help lighten your wallet.

7. Invest in rapidly expanding financial institutions

Depending on the riskiness of the borrower, a financial institution might make a 'spread' or 'margin' on loans of anything from 1% to 5% per year. But when a loan goes bad, it can lose 100%. It's a risk that must be managed very, very carefully. Warren Buffett once remarked that a bad bank manger can flush all your equity down the toilet in your lunch hour.

And watching the accounting ratios like a hawk won't always save you either. In banking, growth can actually be used to hide bad loans temporarily (as, perhaps, we are about to see). A bank that is experiencing a high rate of loan delinquencies can easily halve that rate temporarily by writing new loans and doubling the size of its loan book-after all, a new loan takes time before it can go bad. But hastily made new loans are likely to be of poorer quality than existing ones.

This is why we get worried when financial institutions aim for rapid growth. Bank of Queensland, on which we have a negative recommendation, has targeted a 5% share of the national home loan market in 3-5 years, compared to its current 2.5% share. To achieve that, we suspect it will have to offer lower rates, or take on riskier business, to wrestle market share from the other banks-especially as it tackles markets outside its home state. If you want to improve your chances of ending up in the financial poorhouse, put your money into fast-growing financial institutions.

8. Work to the 'greater fool' theory

Some investors seem happy to buy expensive stocks, knowing full well they're overvalued, because they feel confident that someone else will come along and pay an even higher price. That's what happened in the dot com boom and it's what seems to be happening in the current nickel boom. Many investors buying nickel stocks now believe them to be overvalued, but assume they'll get even more overpriced-as in the Poseidon boom of the early 1970s. It's financial musical chairs for suckers and is likely to end up costing many investors a bundle.

9. Buy 'gunna' companies rather than 'doer' companies

'Gunna' companies are those that are 'gunna' do this and 'gunna' do that. Such unproven companies, and their attendant management teams, are a great way to lose capital. But even well-established companies can be 'gunna' companies. Management will explain away the poor performance of the last few years and concentrate on what it will do in the future (see Brazin or IAG this issue). Chances are it will be putting on a similar show a few years down the track. While those sticking with proven companies and managements should do well, if you're aiming to lose money, buy 'gunna' companies.

From shares.intelligentinvestor.com.au