Evaluating Six Investing Mistakes To Avoid

I read this article today, and he invited comments.  Here are my comments (his words are in italic):

While no investment approach is successful all of the time, here are six common investing mistakes to avoid:

Inability to take a loss and move on.

This is a good point, subject to what I will mention later.  If you learn new data about a company, such that you conclude it is worth far less than your original estimates, yes, it is likely you should sell.

 

But often when investors sell after a disappointment, they sell too cheaply.  Bounces often come after disappointments.  The key question is to estimate the new value, and calculate a new implied return, and compare that against the implied returns of alternative stocks.  Are you holding the stocks with the best set of likely returns?

 

Not selling winners.

The stock may have been a winner, but that doesn’t mean it can’t win more.  Don’t look through the rear-view mirror.  Look through the windshield.  What is your estimate of value NOW?  It may be a lot more valuable than when you first purchased it.  If uncertain, sell a little bit of it – it helps psychologically to do that, because taking a gain will make you more comfortable about the remainder of the position.

 

But if the stock is one of your leading ideas, even after a run-up, why sell any of it?  Again, rank the idea against the alternatives that you might reinvest in, and choose the idea that gives you the best likely returns, adjusted for risk.

 

In my opinion, too many people trim winners that have more to run.  Be bloodless, and evaluate the future prospects of the company versus those of alternatives.

 

Not setting price targets.

 

Fixed price targets are foolish.  Price targets should be dynamic, and shift with the estimated value of the firm.  Further, evaluate companies against alternative investments.  Only sell the stock of a company when you have a company significantly better in terms of implied returns to replace it with.

 

Trying to time the market.

I agree that it is difficult to time the market.  That doesn’t mean that it is not worth trying to do it on an intermediate-term basis.  Follow the credit cycle in the corporate bond market, and you will have a good idea of where stocks are likely to go.  When corporate lending falls apart, so do stocks.  Also, momentum tends to persist, so be more aggressive when stocks are above their 200-day moving average, and less aggressive when below the average.

 

Worrying too much about taxes.

 

In general, I agree.  Taxes are a secondary concern, particularly for those who use stocks for charitable giving.  Donating appreciated stock is a home-run strategy for those with long-term capital gains.

Not paying attention to your investments.

This is true.  If you can’t evaluate you own investments, you should get a professional to do so.  By professional, I mean someone trained to understand how investing works, because few truly get how it works.  They should at least hold a CFA Charter, and hopefully show some competence beyond that to show that they have transcended the training of one with a CFA Charter.

My main points to you are these:

 

  1. Don’t look through the rearview mirror.  Look through the windshield, and pick the stocks that offer the best returns now.
  2. Only buy a new stock when its implied returns are better than most stocks in your portfolio.
  3. Only sell a stock in order to fund a new stock with better implied returns.
  4. Good investing is a lot of work.  If you can’t do it, get a professional to do it for you.
  5. Consider taxes to the degree that it makes sense, and donate appreciated stock when you can.

 

The author’s six investing errors have a modest amount of merit, but the intelligent investor is dynamic, and adjusts to changing market conditions.  Your assets should be managed by those who are similarly dynamic, if you can’t do it yourself.

 

I read this article today, and he invited comments. Here are my comments (his words are in italic):

While no investment approach is successful all of the time, here are six common investing mistakes to avoid:

Inability to take a loss and move on.

This is a good point, subject to what I will mention later. If you learn new data about a company, such that you conclude it is worth far less than your original estimates, yes, it is likely you should sell.

But often when investors sell after a disappointment, they sell too cheaply. Bounces often come after disappointments. The key question is to estimate the new value, and calculate a new implied return, and compare that against the implied returns of alternative stocks. Are you holding the stocks with the best set of likely returns?

Not selling winners.

The stock may have been a winner, but that doesn’t mean it can’t win more. Don’t look through the rear-view mirror. Look through the windshield. What is your estimate of value NOW? It may be a lot more valuable than when you first purchased it. If uncertain, sell a little bit of it – it helps psychologically to do that, because taking a gain will make you more comfortable about the remainder of the position.

But if the stock is one of your leading ideas, even after a run-up, why sell any of it? Again, rank the idea against the alternatives that you might reinvest in, and choose the idea that gives you the best likely returns, adjusted for risk.

In my opinion, too many people trim winners that have more to run. Be bloodless, and evaluate the future prospects of the company versus those of alternatives.

Not setting price targets.

Fixed price targets are foolish. Price targets should be dynamic, and shift with the estimated value of the firm. Further, evaluate companies against alternative investments. Only sell the stock of a company when you have a company significantly better in terms of implied returns to replace it with.

Trying to time the market.

I agree that it is difficult to time the market. That doesn’t mean that it is not worth trying to do it on an intermediate-term basis. Follow the credit cycle in the corporate bond market, and you will have a good idea of where stocks are likely to go. When corporate lending falls apart, so do stocks. Also, momentum tends to persist, so be more aggressive when stocks are above their 200-day moving average, and less aggressive when below the average.

Worrying too much about taxes.

In general, I agree. Taxes are a secondary concern, particularly for those who use stocks for charitable giving. Donating appreciated stock is a home-run strategy for those with long-term capital gains.

Not paying attention to your investments.

This is true. If you can’t evaluate you own investments, you should get a professional to do so. By professional, I mean someone trained to understand how investing works, because few truly get how it works. They should at least hold a CFA Charter, and hopefully show some competence beyond that to show that they have transcended the training of one with a CFA Charter.

My main points to you are these:

1. Don’t look through the rearview mirror. Look through the windshield, and pick the stocks that offer the best returns now.

2. Only buy a new stock when its implied returns are better than most stocks in your portfolio.

3. Only sell a stock in order to fund a new stock with better implied returns.

4. Good investing is a lot of work. If you can’t do it, get a professional to do it for you.

5. Consider taxes to the degree that it makes sense, and donate appreciated stock when you can.

The author’s six investing errors have a modest amount of merit, but the intelligent investor is dynamic, and adjusts to changing market conditions. Your assets should be managed by those who are similarly dynamic, if you can’t do it yourself.

1 Comment

  • Randolph says:

    I have a few comments and questions I would like to pose. First, I recognize there are various ways of trying to determine the value of a security. But when you reference implied returns for a particular stock, what are you referring to? Earnings yield, stream of future cash flows, book value, PEG? I’m assuming it’s some combination of factors to get at a range of values/valuations.

    And when you consider return, are you evaluating it with respect to price appreciation of your stock or improvement in the business? To clarify what I am asking, let me give an example: Consider buying shares in two companies (actual example from my portfolio). After two years, the earnings of Company 1 have increased about 40% (with some volatility), with prospects for continued growth while for Company 2, the earnings have increased about 45% (with some volatility), likewise with prospects for continued growth. On many other metrics, P/B, P/Sales, PEG, profit margins, etc. Company 1 appears to be a better value than Company 2. At any rate, I would still be satisfied with either investment in terms of internal performance metrics of the companies themselves.

    However, from a price performance perspective, Company 1 has been quite poor (P/E has drifted down from around 15 to near 11 over the past two years) while for Company 2, it has been fantastic (going from around 16.5 to nearly 29 at this point !). At 29 times earnings, you might think that it would be a good time to short Company 2, but short sellers seem to continually become ground down. Perhaps I should simply be selling Company 2 to buy more of Company 1, because 1 seems a better value. But if I had done so at just about any point in the past two years, I would be substantially worse off (in 2011, Company 1 is down 27%, while Company 2 is up 8%). Of course other investments I have made have returned in line with my expectations. The difficulty is that there is no consistency. I cannot tell ahead of time which ones will perform (from a price perspective) better, worse, or in-line with my expectations.

    This leads me to believe that regardless of the measures I use to determine whether one investment is a better value than another, doing better than average is exceedingly difficult (though perhaps the more appropriate conclusion should be that I personally am not using the right measures, or that I am not qualified to make sound determinations, or perhaps I simply haven’t waited long enough yet to see my beliefs confirmed by other investors).

    Moving on… Your points 2 and 3 imply that you would eventually hold a portfolio of equal (implied) return investments. That is, to buy a new stock, it should represent a better value than most (half?) the stocks you own. You would sell a stock (from the bottom half) to buy a stock that could go in the top half. Repeat until there is no top/bottom any longer. Why would you have any stocks in the bottom half (in terms of implied return) if that money is more likely to earn a higher return in the top half?

    I’m not trying to be pedantic here, but am trying to learn how to invest better. Like you, one question I ask myself when thinking about selling a position: “What would I do with the money that represents a *better* use.” If I am going to sell some of ABC to invest in company XYZ, that implies not only that I believe XYZ to be a better investment going forward, but that XYZ is going to return better than average, not only of my holdings, but of all other possible holdings. After all, instead of investing in XYZ, I could buy an index to earn the average. If I am going to take company specific risk to buy XYZ, I should be compensated for that with a greater potential return than I could get from the market as a whole. No? When I aim to satisfy your point 1 (invest looking forward), it isn’t clear to me I am getting it right relative not only to other specific investments I am making, but relative to the market as a whole.

    Finally, with point 4, if I conclude that good investing is too difficult for me, there appears to be quite a bit of research suggesting that getting a professional to do it isn’t going to offer any better returns than average *and* my expenses will be higher. Sure, some advisors will perform better than average as some will necessarily do worse (this is a mathematical certainty). So, you are left with trying to determine, looking forward, which professional is going to do better than average. As with picking a particular stock, this is no simple task.

    So far, I have found this to be quite challenging. Still, I keep trying to learn and improve. In spite of the gnawing suspicion that I am spinning my wheels for no additional gain (alpha), I continue to evaluate, buy and sell individual securities while also holding a portion of my portfolio in broad indices.

    Thanks for continuing to write thoughtful comments that help enlighten, or at least challenge the thinking, of other investors.

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