One of my favourite Mungerisms is this: “Tell me where I’m going to die, that is, so I don’t go there.” This illustrates the importance of negative knowledge – the knowledge of what not to do.
With that, I’d like to share a list of “Don’ts” in investing that I’ve been using for years. This list is something that has been very helpful for me in generating solid returns in my own personal portfolio, and for The Motley Fool Singapore’s stock recommendation services. Without further ado…
1. Don’t jump in and out of stocks
Finance professors Brad Barber and Terry Odean once studied the six-year trading records (from 1991 to 1996) of over 66,000 households in the U.S. and published their findings in a paper titled “Trading Is Hazardous to Your Wealth”.
What they found was that in the six-year block, the investors who traded the most earned an average return of 11.4% per year. Sounds great? Turns out, the market had generated a return of 17.9% per year for the same period. What’s more, the average annual return for all the investors in the study was 16.4%.
David Swensen, the famed chief investment officer of Yale University’s multi-billion-dollar endowment, once gave a lecture and recounted how fund investors’ returns over a 10 year-period had lagged the returns of their funds, often badly, and by as much as 13.4% per year (!!). The reason, Swensen mentioned, was that the fund investors were buying and selling their funds at all the wrong times.
2. Don’t assume that a stock that has fallen hard can’t fall anymore.
There’s a joke that’s often attributed to famed hedge fund manager David Einhorn that goes:
“What do you call a stock that’s down 90%? A stock that was down 80% and then got cut in half.”
Here’s the story of a real stock that will show you why Einhorn’s joke is worth remembering.
Six months ago, on 29 September 2017, the stock was trading at S$0.395 apiece after falling by a stunning 75% in over a period of just 12 months (meaning that the stock was trading at S$1.60 on 29 September 2016). It can’t go any lower, can it? As of 28 March 2018, the stock in question – the embattled commodities trader Noble Group Limited (SGX: CGP) – closed at a price of S$0.077. That’s a decline of a further 81% from 29 September 2017.
The lowest that a stock can theoretically reach is zero. If a stock has an extremely shaky underlying business with a debt-laden balance sheet (just like what Noble has) and goes bust as a result, its shareholders will be left holding an empty bag.
3. Don’t underestimate the power of simply holding onto stocks
Financial adviser Nick Murray once said that “Timing the market is a fool’s game, whereas time in the market is your greatest natural advantage.” How true.
My own personal experience also provides an example of the power of simply holding onto stocks. I had bought shares of computer, console, and mobile games maker Activision Blizzard back in October 2010 at a price of US$11.31 each. For the next two-plus years after my purchase, the company’s stock price was languishing between US$11-US$13, basically doing nothing.
4. Don’t blindly invest in a company just because its stock looks cheap
Noble is useful here again. A year ago from 28 March 2018, Noble had price-to-book and price-to-sales ratios of just 0.44 and 0.03, respectively. But, in that one year period, its stock price has fallen by a massive 96% from S$1.91 to S$0.077. This comes after the company’s book value per share had been chopped from US$3.03 to a negative US$0.60 in that time-frame.
The lesson here is that a cheap valuation can’t give us much protection if a stock’s underlying business performance is poor.
5. Don’t overpay for a company’s shares
If you had bought shares of local real estate giant CapitaLand Limited (SGX: C31)at the company’s pre-financial-crisis peak of S$5.51 (adjusted for dividends) that was reached more than 10 years ago on 26 April 2007, you would still be down by over 30% from today’s price of around S$3.50.
During that time frame, the real estate company’s book value per share actually increased by 4.5% per year. That’s not especially fast, but the company was still building value for its shareholders over time. So what had caused Capitalist's dismal performance in the stock market? Valuation is the answer. On 26 April 2007, the company was valued at 3.2 times book value – that was an expensive price to pay.
6. Don’t pay too much attention to what the economy is doing
It’s near-impossible to guess what the economy would do. And even if you could, there’s very little about the economy’s performance that can tell you what stocks would do next. The chart below shows how various US economic and financial indicators had fared when it comes to forecasting what US stocks would do over the next 10 years:
As you can see, even rainfall in the US can tell us more about the country’s future stock market returns than its GDP numbers, corporate profit margins, and bond yields.
Investing legend Peter Lynch once said that “If you spend more than 13 minutes analyzing economic and market forecasts, you’ve wasted 10 minutes.” When it comes to the stock market, it’s best to study individual businesses and invest accordingly.
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