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Sept 7, 2001

WHY SMART PEOPLE MAKE DUMB INVESTMENTS

You know about greed and ignorance.
Do you know about the Peter Lynch curse?

There are five big ways investors lose money and only one way they make it. So, the odds are stacked against you. By shedding some light on the mistakes, however, we can put the odds in your favor and greatly improve your investing results. You'll be less likely to invest in bad stocks, and you'll make a lot more money investing in good ones.

Let's start with the easy mistakes.

Emotions Make You Dumb

I know a guy, the president of a company, who is so smart and so competent, I'd trust him to run my lungs. I was having lunch with him one autumn day in 1999, and we got to talking about stocks. He told me he was mostly invested in an Internet stock fund and that it had risen 40% that year. I told him that was very nice, and I hoped he planned to get out immediately. He said he didn't, in fact he was putting more money into the fund.

Because I like him, I tried to force him to examine the economics of the companies in which he was investing. I said to him, "John, when your company offers to buy another company, you typically offer 1 to 2 times their recent yearly revenues. When you buy one of these Internet companies, you're paying over 100 times revenues, and the companies are losing money. Would you pay 100 times revenues for any company, much less one that was losing money?"

He fumbled and couldn't give me a straight answer, but I couldn't convince him to get out of his Internet fund. Needless to say he got creamed a few months later in the dotcom debacle.

Here we had one of the smartest guys I've ever met, and a guy who was very savvy about business. How is it he could see so clearly what was right in buying a business, yet completely disregard it when buying a stock, which is simply a part of a business?

Go on a Greed Diet

Part of it is, of course, the fact that no matter how many times you explain it to a person, most simply can't keep in their mind that when they buy a stock, they are buying a business. But we talked about that in detail last week, so let's go on to the other part of John's problem.

Few people have the emotional solidity to resist the lure of easy money. Though all the evidence shows that the way to become wealthy is by gradually compounding your returns over a period of years, it is much more exciting to think you can do it overnight. It has a certain spiritual kinship with dieting. Everyone knows how to lose weight: eat better; eat less; exercise. But that takes time and discipline, so instead, folks waste their money and time on one fad diet after another, year after year, and never make any lasting progress. Investors do the exact same thing in stock picking. They go for the get-rich-quick stocks because they don't have the patience and discipline to let good investments work for them over time.

The first discipline you have to exercise in investing is to swear off greed. Anything that promises to make you rich overnight is likely to lose you a bundle. If an investment concept is a hot topic at cocktail parties and on CNBC, it is probably a loser. The money has already been made by the early buyers (usually company insiders and venture capitalists) who are at this stage looking for someone like you, upon whom to unload the overpriced shares. Two years ago the rage was the dotcoms; last year it was Internet equipment; this year it will be biotech; next year it will be something else.

Big Stories

The stories around these lures are always big and exciting, and almost always laced with some truth to make them seem plausible. The thing that makes them untenable is the high valuations and growth assumptions. Last year the empty Armani suits on CNBC were all calling stocks like red hot Cisco Systems "must own" stocks. But anyone with any common sense and a hand held calculator would have avoided Cisco like the bubonic plague. Yes, it was in a fast-growth business, no, it was not possible it could sustain growth that would make your investment a good one. But to see that, you had to do the math and face the facts.

Big stories work on fear too. Fear can make you a foolish buyer or a foolish seller. Many people buy overpriced stocks for fear of missing out on riches, but many also sell stocks simply because a big story has them scared to death.

My readers more than quadrupled their money in less than a year when Oracle Corporation got panned in early 1999. While the market was running from the stock, we bought it at a split-adjusted price of $6.03. We started taking profits at $28 while it was still on the way up, and were completely out of it months before it reached its recent low in the $11 range. We made our huge profits in Oracle by buying it when emotions were highly negative, and selling it when emotions were wildly optimistic.

Prejudice Hurts Here Too

Prejudice is a disease of perception that cripples reason. If you are infected with prejudice, you don't see things the way they really are. You may look at a man, and instead of seeing who he is, you see some preconceived notion of what you think he is. This not only hurts him, it hurts you. You miss the opportunity to experience what that person has to offer.

In investing too, prejudice is harmful. One common thing I see is a person who is a member of one political party having a negative outlook on economic developments because another party is in power. Instead of seeing what the real political and economic landscape looks like, he sees only walls. He doesn't realize they've been constructed in his own mind.

The political climate is important, but don't look at it from the point of view of a zealot. Look at it as if you were a complete outsider landing on earth for the first time in search of investing opportunities. Then you will clearly see the true picture.

You've Got Personality!
Lose it!

One of the things that make each of us unique is our particular set of personality traits. This is one of the beauties of getting to know people. But in investing, personality can be a hindrance, so you have to put it aside while you're making your investing decisions.

Once a reporter asked former World Chess Champion, Bobby Fischer, how he would describe his style. (Many chess players tend to play in a particular manner. They may be very careful, playing mostly defense, or toward the other extreme, very aggressive, constantly on the attack, or anywhere in between.) Fischer answered the reporter's question without hesitation. He said, "If you have a style, you're not being objective."

What he meant was that every position on the chess board is different and has different requirements, dangers, and opportunities. You can't handle every position the same way. The same holds for investments. You may have a tendency to cheer for the underdog, and may tend toward stocks that are down in price and no one likes. On the other hand, you may be the kind of person who always loves a winner. You may tend to pick stocks that are performing well above the averages.

The fact is that either of those types of stocks can perform beautifully, or terribly. You have to objectively assess the situation and see clearly what the fundamentals of the situation are. Though I've made a lot of money on out-of-favor stocks, I've personally also done well with stocks like Intel, that were big winners, but showed every sign of continuing that performance. Always be open to either type, and always be willing to walk away from the type you tend toward, if the fundamentals don't add up.

You can carry the chess analogy further. In terms of the market in general, you don't want to be on the attack when you should be in a defensive mode. That is, you don't want to be bullishly putting a lot of money into the market if all the indicators are screaming that bearish caution is in order. Nor should you be timid once all the pieces are in place for a strong advance. Of course, that requires judgment, and is not always easy, but it is a lot easier if you're keeping an open mind.

The Peter Lynch Curse

One of the great investors of our time, Peter Lynch, inadvertently did the novice investing community a great disservice. His dictum of "invest in what you know" has been widely quoted. The thesis is that when you see a product or service that you know and love, you should look into it and see if there's an investment opportunity there. The problem is that most people didn't pay attention to the other part of what Lynch said. That is, make sure you understand the financial realities of the company before you invest.

Having heeded only part of what Lynch said, they bought stocks like Yahoo, or Amazon.com because they were great products or services that people liked to use. Unfortunately, not heeding the rest of Lynch's advice, they didn't look at the financial valuations to see if the great companies made good investments. Many a shirt was lost that way. Many more will be lost in the future.

Summary of Investor Mistakes

Let's review those mistakes once more.

Greed - Trying to make too much money more quickly and easily than reason dictates

Fear - Responding reflexively to negative comments or news without analyzing its implications.

Prejudice - Having immovable preconceived notions about politics, economics, business, etc.

Personal tendencies - letting your basic emotional disposition dictate your investment choices

Enthusiastic Ignorance - Buying stock in a company based only on an evaluation of product without investigating the market valuation and financial resources of the company.

The Only Way to Make Money

There's only one way to consistently make money in the stock market. You have to buy stocks that are selling for less than they're worth, and then sell them when they are priced at what they are worth, or more. (Actually, there's a trading technique called short-selling which can also make money for professional traders, but that's beyond the scope of this article. I'll deal with it another time.)

That advice sounds almost condescending in its simplicity, but it is true. However, the techniques for finding such stocks require a certain amount of knowledge of financial accounting, basic economics, and market psychology. All of those things can be learned by reading these pages regularly.

Talk to you soon.

Jack

 




   
Copyright 2001 by Jack Adamo. All rights reserved.