One Big Investing Mistake

When investing, as elsewhere in life, people tend to make costly mistakes over and over. For example, the best time to review our stock-picking methods is when our portfolios are getting fatter, yet people tend to wait until mistakes have manifested themselves before they seek to correct them.

"Wow, maybe glucose adduction devices aren't as big as I thought they'd be." That's a sentence to utter before 90% of your investment has vaporized. Yet, for all our focus on the billions of dollars lost when the dot-coms collapsed, someone sold Yahoo! (Nasdaq: YHOO  ) at $250 a share, and someone walked away from Qualcomm (Nasdaq: QCOM  ) at $200.

I like to hope that it was some small investor who said, "Wow, that's about as good as it could possibly get," and walked away a millionaire. But what are the questions you ought to be asking yourself today? One stands above all others: Am I investing in companies that I know anything about?

Is there a stranger in my portfolio?
You get a hot tip, you see a name on a screen, or notice it after a big move, and you buy it. Each week, we get questions from people who own companies about which their knowledge barely transcends the ticker symbol. Questions like, "What do you think about Emulex (NYSE: ELX  ) at these levels?"

I don't want to dissuade people from asking questions, but whenever I get a question like this, my first instinct is to shout, "Sell it." It doesn't matter what we think about Emulex -- we didn't put our hard-earned money into it. I'd venture to guess that less than 1 in 10 investors who own Emulex knows what a fiber channel host bus adapter is, much less why it matters, what the market looks like, and whether Emulex has a sustainable competitive advantage.

They're investing in a company they have no chance of understanding. Their only clue as to whether the business is going well is the stock price -- a hopelessly derivative gauge. How can this end in anything other than heartache? (No offense to Emulex, I hope. I chose this company purely based on it being the subject of the most recent question I received.)

Reading the fine print
Ah, but dollars are dollars. What matters is whether the stock goes up, right? One of those organizations that compile a great deal of mostly useless statistics came up with this shocker: Only about a quarter of all investors read company financials or annual reports. Not before they invest, not after they do, never. This is particularly dangerous in technology, where you can be assured that a couple of folks in a garage somewhere can come up with a new design that renders the existing leaders obsolete. How do you stay ahead? Certainly not by buying a company you don't understand without reading a financial statement.

Even with a read of the financials, most of us haven't a prayer of making such qualitative judgments on companies that make surfactants, lambdas, or monoclonal antibodies. Some of us are technologists, or chemists, or biologists. For these people, companies pursuing these businesses are natural grounds for investment ideas -- there's an advantage of knowledge the rest of us do not possess.

But this isn't the only route available. You can focus and study a sector when you become highly knowledgeable. My colleague Tom Jacobs' knowledge of biotechnology comes not from formal education or avocation; in fact, he's a lawyer by training. But a few years ago, he found himself interested in biotechnology and set about to gain as much knowledge as possible through reading, asking questions, and studying. Let's also not forget that Tom Jacobs is a natural smarty.

So when he picked Ligand Pharmaceuticals (Nasdaq: LGND  ) for The Motley Fool's Stocks 2003 (Stocks 2004, this year's version, is on sale now), it wasn't a stab in the dark, and it wasn't an "Uncle Fred special." Tom knew the company, and he knew the market. Not coincidentally, the stock has nearly tripled (more on this in a minute).

Focus, focus, focus
If you want to get ahead in investing, find an area or two that catches your interest and become an expert. This needn't be the next big thing -- some of the best performers in the 1990s were boring old regional banks like Fifth Third Bancorp (Nasdaq: FITB  ) or restaurant chains like Outback (NYSE: OSI  ) . If you can't describe what the company does in two minutes, get out of the stock.

The problem, of course, is that many people greatly overestimate their own knowledge of a company and the challenges it faces, especially those who have been rewarded for their "wise" investment decisions with some heady gains. Two weeks ago, I wrote a critical article about Canadian energy company Ivanhoe Energy (Nasdaq: IVAN  ) . If I haven't heard from every shareholder since, I'm sure that was just an oversight.

Many made a point of telling me how much money they've made on the stock, as if that makes some difference about whether the company is a compelling investment today. Ivanhoe is an energy and a China story. I didn't sense that many people who wrote knew much about oil exploration, and I certainly don't think that the majority knows much about operating in China. Taiwanese businesspeople I know have found it impossible to get money out of China once it's there, a condition that I also found in my experiences in the country several years ago. China is a hard, hard country for business, and yet people are sold on it being the greatest investment opportunity around.

It's a great story
But how many people who are sold on it, who have put their money into companies selling themselves as China plays, have any knowledge at all of the difficulty of returning capital from China to shareholders even if the companies manage to generate profits? That the Taiwanese have had little success in doing so ought to be a huge red flag. Instead, most investors are blissfully ignorant of the incredible risks they face. They don't understand China, and yet they're betting that China will pay off enormously. That the stocks may go up on the hope of success doesn't make success itself any more certain. In fact, I'd suggest that a rising stock price actually lessens, or eliminates, any risk cushion that once existed.

Of course, even those who sold Qualcomm and Yahoo! at the very top may have been blissfully ignorant of the risks built into those stocks. Think about it -- as little as six months prior to its collapse, you could have sold (or bought) a share of Enron for more than $70. The majority, however, didn't sell. Even with extensive knowledge of a company, there are many, many things that can go wrong. Your best defense is to think through and anticipate as many potential land mines. Most investors fail to take even these basic steps to protect their own capital.

Don't be one of them. I'm not suggesting that you stay away from risky companies, or even that you stay away from China. I am suggesting that you do everything in your power to understand the businesses and incumbent risks before you plunk down your hard-earned money.

Fool on!

Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann did receive several wonderful parting gifts from his experiences in China, including a scroll written by the last emperor. He holds none of the companies mentioned in this article. Please consider a gift ofMathew Emmert's Income Investorthis holiday season!


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