Avoiding Bad Investments
2019 is here and no doubt you have financial goals for the new year, wanting greater prosperity and avoiding financial mistakes. However we are all prone to financial mistakes, whether it is parking tickets or forgetting to cancel your Deliveroo premium subscription after the free trial, these mistakes however rarely cost us hundreds of millions of pounds.
Even the world’s most eminent investors can miscalculate and end up deep in the red. Whether this can be attributed to an underperforming economy or simply overconfidence, it turns out the people that are held in high esteem when it comes to investment are still just people after all. More importantly is what mistakes did they make, and how can they be avoided.
Humans naturally seek explanations for world events, searching for rules or formulas that help provide a clear explanation. Unfortunately, the world is far too complex for that to really be viable. Iconic investor Benjamin Graham demonstrated why this is true in regards to investment.
Benjamin Graham experienced great success in his financial career and wrote what is regarded as one of the most influential investment books of all time, ‘The Intelligent Investor’, described by Warren Buffet as ‘the best book on investing ever written’. Graham’s most important contribution, however, was pioneering value investing, a powerful financial technique.
This concept focuses on Graham’s observation that the price of a company fluctuates more than its value. This means the cost of a company’s shares, its price, isn’t a true reflection of the company’s value, which is formed of things like revenue, assets, and future opportunities.
Why does this difference between price and value exist?
It exists because of the fickleness and emotions of humans. Humans set prices whilst businesses set values. In the 1930s for example, General Electric’s valuation plummeted from $1.87 billion to just $784 million, yet nothing disastrous had happened to the company’s assets, its employees or revenue that year, it was simply investor optimism and pessimism driving these changes.
During the Great Depression, Benjamin Graham suffered like most, and his philosophy almost ruined him. After seeing prices skyrocket during the 1920s, he recognised prices and value were extremely out of sync, so as a result, he decided to bet against the market and predicted that prices would fall, and he was correct, however, unfortunately, he misjudged the extent of the fall.
The stock market had taken a real beating by the 1930s, and assuming that the worst was now over, Graham began to heavily invest, however, the prices continued to fall, and the market wouldn’t truly bottom out until 1932, by that time, Benjamin Graham’s portfolio had lost 70% of its value.
Experiences like Graham’s highlight that there are no iron-clad laws when it comes to investing, and there is definitely no magic formula. Being aware of value is critical, but do not become a slave to it. Cheap can always get cheaper.
Imagine you are at a football match, and to make it more exciting you place a bet on the outcome. It is a tough call, both teams are a similar skill level. However, once your bet is placed, you instantly feel more confident about your choice. Suddenly another fan approaches you, and asks if they can buy your bet slip for more than you bet initially, would you sell it?
It is unlikely you would.
In 1991, Kahneman, Knetsch and Thaler described what they called the endowment effect. The hypothesis argues that we ascribe more value to things simply because of our ownership. This doesn’t mean our possessions are inherently appealing, they’re just harder to give up.
Endowment effect illustrates two important points:
- Objective thinking melts away when we have ownership of something
- Our confidence rises once we have made a decision
It is in that moment we fall prey to our overconfidence.
Let’s take one of the most famous investors of all time, Warren Buffet, for example. Buffet has an amazing track record, between 1957 and 1969, the ‘Oracle of Omaha’ managed a partnership which returned gains of 2,610%. In 1972, Buffet and his company, Berkshire Hathaway, purchased See’s Candy for $30 million, since then it has generated $1.9 billion in pretax revenue.
Fast forward to 1993, and Buffet had a long list of success stories, he was flying high and was very confident, but his biggest mistake was just around the corner. Berkshire purchased Dexter Shoe Company for $433 million in 1993.
Dexter was an US-based manufacturer and had Buffet’s total belief and confidence. Buffet wrote to Berkshire shareholders, ‘Dexter, I can assure you, needs no fixing; It is one of the best-managed companies that I have seen in my business lifetime’. Warren was so enamoured with the new purchase that he failed to recognise the winds of change blowing through the industry.
Just 5 years later and Dexter was in free fall. The rise of manufacturing powerhouses like Taiwan & China had crippled the US domestic shoe market. By 1999, Dexter’s revenue had declined by 18%. In 2001, Dexter ended its US shoe production, and Berkshire folded the company into its other shoe firms within its portfolio.
Despite a number of successful deals in succession, Buffett has failed to be vigilant and consequently paid the price.
Investing can be a dangerous game — even for the most experienced and talented players. By studying the greats and the errors they’ve made, we can learn from their mistakes without million-pound price tags.
Take cryptocurrency, for example, it is bringing a lot of new investors to a highly volatile market without much experience. It is important to focus on avoiding unforced errors rather than shooting for big wins, and if you do win, stifling overconfidence is crucial.
Above all, do not become attached to your assets. Emotions like fear, anger, envy and greed are your portfolio’s worst nightmare.