This article will acquaint you with the common mistakes generally made while investing in stock markets which lead to investors not making desired levels of profits and even making losses. Through hand-picked lesser known sayings of five well-known investing legends, I intend to paint a composite overview of investment approaches one should adopt and those that one should avoid.
1. Investing in random stock recommendations without knowing about the business is dangerous
Investing in the stock of a business that you know nothing about is equivalent to gambling. Peter Lynch in his bestseller book ‘Beating the Street’ wrote “Your investor’s edge is not something you get from Wall Street experts. It’s something you already have. You can outperform the experts if you use your edge by investing in companies or industries you already understand.” The same also applies to our Indian stock markets. By knowing about the business economics of the company behind the stock you can minimize your investment risks and maximize your profits over time. However one should be patient and not expect profits to grow overnight.
Another quote of Peter Lynch from his book ‘One Up On Wall Street’, that seems relevant in this context is “If you can follow only one bit of data, follow the earnings. I subscribe to the crusty notion that sooner or later earnings make or break an investment in equities. What the stock price does today, tomorrow, or next week is only a distraction.” Here both present and future potential earnings should be taken into consideration.
2. Too much diversification might take away from your profits
Everybody has heard of the wise saying ‘Do not put all your eggs in one basket’. However, Philip Fisher in his renowned book ‘Common Stocks and Uncommon Profits’ talks about the evils of the other extreme of over-stressing diversification. He says that “the disadvantage of having eggs in so many baskets is that a lot of the eggs don’t end up in really attractive baskets and it is impossible to keep watching all the baskets after the eggs get put into them”.
The importance of knowing about the business behind the stock in which you want to invest into has already been emphasized upon in the point above. If you invest in many companies, you might end up diverting chunks of your investment from companies you know very well about and believe to be fundamentally strong to companies you don’t know anything about. This will increase your overall risks and minimize your potential returns, which you certainly don’t want. Thus, you should adopt only a healthy, calculated level of diversification and not overdo it.
3. Don’t fall prey to the irrationality of Mr. Market but use this herd mentality to your advantage
It is popularly believed that markets already reflect fair prices of stocks and this might be true many a times. However, author of the widely acclaimed book ‘The Intelligent Investor’, Benjamin Graham introduced the famous manic-depressive character ‘Mr. Market’ in this book and through this metaphor tried to explain that contrary to the popular beliefs, the markets are mispriced and sentiment-driven quite a few times. At such times share prices may go ridiculously high, where investors irrationally overvalue markets or ridiculously low, where everybody indulges in panic selling without much reason totally ignoring fundamentals behind individual stocks.
If you have chosen your stocks after due diligence then you should realize that these price fluctuations due to either economic cycles or irrational sentiments are temporary and not panic and participate in such herd mentality. You should rather take advantage of the situation and accumulate value stocks at such undervalued prices which in turn will provide you with a wider margin of safety and greater profits.
According to Warren Buffet the secret to getting rich is to “Be fearful when others are greedy and be greedy when others are fearful”. Simply put, it reinstates the same line of thought discussed above in the context of playing with the irrationality of Mr. Market to your advantage.
4. Understand the difference between cheap and attractive
Many a times we come across shares which are trading at low prices (52 week lows / life time lows etc) and get lured to buy them thinking they are available for a bargain and are going to multiply our fortunes. However, this greed sometimes clouds our judgment and we fail to differentiate between what is cheap and what is attractive. Thus, we make ourselves vulnerable to fall into a value trap where we end up buying cheap stocks that once represented good businesses and were valued high but overtime have deteriorated and no longer represent fundamentally sound running businesses. These stocks may not rise back to the levels they were once at and the perception that they are available for a discount is delusional.
Warren Buffet famously said “Price is what you pay and value is what you get”. So when we pick stocks we should pay heed to both the aspects, the price at which it is trading and the value of the business it represents. It is only when a stock of a fundamentally sound company with growth potential is available at a reasonably low price (as compared to its fair value) that you can call it attractive.
According to the book ‘Poor Charlie’s Almanack’, Charles T. Munger’s great lesson of investing is “A great business at a fair price is superior to a fair business at a great price”. Stocks of great businesses generally trade at higher P/E multiples and valuations (unless you can spot one before the street) as it is believed by the majority of investors that the company has enough growth potential to justify those valuations in future and they see it as a relatively safe bet.
If you have chosen to buy the stock of any such company and by chance have the opportunity to buy them at prices reasonably lower than their fair valuations (say, due to a bearish run driven by over-reactive sentiments of Mr. Market) then you should buy them rather than wait for them to reach their absolute bottom because they might never, given the strong fundamentals. It might still prove to be a more profitable investment in the long run than if you invest in a mediocre company which is significantly underpriced.
5. It makes sense for the captain to abandon his sinking ship
When we spend a lot of time and energy in picking a stock we think is fundamentally good and will serve our investment objective, but it happens to turn out differently, we often get into denial and ignore the red signals we are getting. We start looking for and paying more attention to selective information that confirms what we want to hear (confirmation bias) only to somehow get an excuse to justify our decisions and prove ourselves right. Sometimes we even go further by buying more of a fundamentally weak stock to average out and recover the losses. But as rightly pointed out by the legendary Warren Buffet in one of his annual letters to Berkshire Hathaway Inc. “Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.” Ego has no place in the process of rational decision making.
I do not intend to say that you should sell a stock that you are holding as soon as its price goes below your cost of acquisition. If your stock is still fundamentally sound but trading lower due to temporary market movements or other such reasons then it would definitely pay off to patiently wait. On the contrary, I am talking about a situation where you purchased a stock earlier thinking that it was a good investment but later on found out that somehow a mistake was made. If the parameters on the basis of which you had earlier thought the stock to be fundamentally strong, do not hold good or no longer exist, then you would be better off admitting to your mistake, selling your holdings and buying a stock with better prospects which will earn you profits eventually rather than sticking with your holdings to satisfy your ego and waiting for it to recover.
The excerpts taken from the famous books mentioned above reflect a very small portion of the immense knowledge and experience those books offer and I recommend anyone who is genuinely interested in enhancing their IQ (Investment Quotient) on stock market investments to read at least some of these great pieces of work by some of the greatest investing legends of all times.
The lessons discussed here are universal to investing in stock markets but I feel that they apply more to the long term investors than the short term traders for whom technical analysis might be used in addition as an appropriate approach. To know how to perform fundamental analysis or technical analysis of a stock, read the detailed articles on those topics in the Value Investing section of this blog.
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