How to Become a Terrible Investor

In a commencement address years ago, Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) co-chairman Charlie Munger evoked the late Johnny Carson, noting that Carson, "couldn't tell the graduating class how to be happy, but he could tell them from personal experience how to guarantee misery."

This theme -- studying failure rather than success -- is common for Munger. His past talks have recommended avoiding cocaine, AIDS situations, venereal disease, ingesting chemicals, and racing trains to the track as ways to gain happiness. All great advice, but of little use here.

Investors are inundated with advice on how to effortlessly become wealthy and successful. Much of it is nonsense. Studying what makes investors fail miserably will likely be far more informative, prescient, and timeless.

In no order of importance, here are seven things you can do to guarantee you'll become a terrible investor.

1. Use lots of leverage
Mae West said, "Too much of a good thing can be wonderful." Some investors look at her advice and think, hey, if I've found a great investment, why not leverage up and get two, three, or four times the goodness?

I'll go out on a limb and say that the only individual investors who consistently profit with leverage do so through pure chance. For one thing, margin debt (money borrowed from a broker to buy investments) comes with a very high cost of capital -- typically 7%-10% -- which, not surprisingly, is at or above the average market return. Second, margin holds you hostage to time and temperament. If you leverage a margin account 2 to 1, a 50% drop will wipe you out. Game over. Insert more quarters. And as we learned last year, even high-quality names like Apple (NYSE: AAPL  ) and Google (NYSE: GOOG  ) can fall 50% or more in horrifyingly short periods of time.

2. Hire a commissioned advisor
A good friend used to invest on her own. But after she lost interest, she hired a commissioned advisor instead. That's an admirable step in humility, but a dangerous one nonetheless.

She asked me to look at her new, post-advisor portfolio. Not surprisingly, it now consists exclusively of front-end-loaded mutual funds. Some of the funds command front-end fees (akin to cover charges at bars) of nearly 6%, on top of annual management fees of 1%-2%. More sickeningly, most of the funds were essentially market-tracking funds that an ETF could achieve for a negligible fee.

The only person who wins in this situation is the broker. To quote Munger again, "Most stockbrokers are a disaster waiting to happen."

3. Surround yourself with people who agree with you
Munger likes to emphasize the work method of Charles Darwin, who spent a better part of his life trying to prove himself wrong. As Munger notes, "He always gave priority attention to evidence tending to disconfirm whatever cherished and hard-won theory he already had." Most investors can't say the same.

If you want to guarantee you'll lean precisely nothing, converse with people who share your same views and agree with everything you say. That'll do it. If you read about the executive culture at companies like Lehman Brothers, Bear Stearns, and Citigroup (NYSE: C  ) , you'll find that hubris and undue self-confidence were huge causes of their downfalls.

Before making an investment, one of the smartest things you can do is find someone who thinks you're absolutely nuts, and hear them out with an open mind.

4. Follow the herd
At every second of every day in every market, there's a trend du jour. Sometimes its megabullish. Sometimes it's end-of-the-world bearish. Sometimes it's oil. Sometimes it's gold. Sometimes it's Twilight and Miley Cyrus. In any case, if it's extremely popular, it's probably dangerous. One of the most ironclad rules of the world is that an investment's future return is inversely correlated to its current popularity.

Take gold right now. Bullish investors are throwing out forecasts of $2,000, $5,000, even $8,000 an ounce. I have no idea whether they're right (nor do they), but it wouldn't surprise me. Markets do extraordinary things. But I will guarantee with 100% certainty that most gold investors will end up losing big time. Why? Because most will pile in near the top, right at the peak of exuberance. That's when investing feels the best. That's when your bullish thoughts have been vindicated. That's when everyone you know is buying. That's when you know you can't be wrong. But it's a false sense of security, and it always ends in tears. This history of bubbles proves this over and over and over again.

5. Assume you're invincible
Tell yourself you're the next Warren Buffett. Tell yourself you're a genius. Assume your predictions can't be off, and that you're the seer of all things financial. Set up your portfolio so that every one of your assumptions must come true, but take comfort in knowing that being wrong is doubtful. Assume markets are predictable and move in clear, coherent ways. Brag a lot. Look in the mirror constantly. You'll become a terrible investor in no time flat.

6. Have a concentrated portfolio
Warren Buffett has said, "Diversification is a protection against ignorance." This is true if you're Warren Buffett, but potentially lethal for investors with less aptitude, or those who take his comment to the extreme.

Now, not everyone should be in broad index funds that mimic the market. Individual investors can find good stocks -- that's what The Motley Fool is all about.

But overconfidence, combined with a manic market, combined with overallocation, is a brutal trifecta. Factors beyond of your control or above your understanding can, and will, bodyslam what look like great investments. General Electric (NYSE: GE  ) is a good example. Before 2008, most people equated GE with the most conservative, tried-and-true blue chip that Grandma could hold forever. Ditto for AIG (NYSE: AIG  ) . Then the financial crisis hit, AIG blew up, and GE fell nearly 90%. Bad things happen to good companies, and investors with extreme concentration in any investment are setting themselves up for misery.

7. Don't invest
Stay in cash your entire life because you're afraid of the market. This is the easiest way to become a terrible investor and watch your purchasing power slowly vanish before your eyes.

Moving on
Becoming a terrible investor is easy. Learning from your mistakes is the hard part -- the part that our Motley Fool Stock Advisor newsletter focuses on relentlessly. Learning and adapting from its past mistakes has made Stock Advisor hugely successful, with the average recommendation outperforming the market by more than 52 percentage points since inception in 2002. If you'd like more information, click here for a free 30-day trial. There's no obligation to subscribe.

Fool contributor Morgan Housel owns shares of Berkshire Hathaway. Google is a Motley Fool Rule Breakers recommendation. Apple and Berkshire Hathaway are Motley Fool Stock Advisor picks. Berkshire Hathaway is a Motley Fool Inside Value pick. The Fool owns shares of Berkshire Hathaway, and has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (65)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 26, 2009, at 11:51 AM, megabuc wrote:

    IT IS ONE THING TO BE A TERRIBLE INVESTOR, BUT it is a totally different thing to be a LOLLIPOP INVESTOR. The facts are any investor that puts their hard worked in CITIBANK STOCK IS A TOTAL SUCKER. Citibank has been nationalized by the Fed and is being taken apart and sold off so the GOV CAN GET THEIR MONEY... THE SHAREHOLDER OR LOLLIPOP WILL ONLY GET THE STICK OR SHAFT. ONCE THE WORLDS BIGGEST BANK UNTIL THE CLOWNS TOOK CONTROL AND CRASHED BURNED IT AND THEMSELVES. THE PRINCE DID NOT REED BETWEEN THE LINES AS THE WILD SAND WILL LEAVE WITH A PAN IN HAND BROKE. Time of your life kid... HAHAHAHAHAHAHA HAHAHAHAHAHA AAAAAAAAAaaaaaaaa aaaaaaaaaaaaaaaa.

  • Report this Comment On December 26, 2009, at 1:43 PM, theHedgehog wrote:

    <i>The American WalMart mentality has resulted in many $10,000 ETrade accounts becoming $5000 ETrade accounts.</i>

    The two big mistakes that small traders make is cashing in at the bottom and buying in at the top. Next along the line is probably turning your investments over to a "professional" and turning your back while they move everything you have to front-end loaded funds of dubious value. But, hey, they got theirs!

    The successful "American WalMart mentality" investor bought a handful of index funds and just sits on them, regardless of what the economy is doing.

    <i>Charlie Munger's street cred? He knew Warren Buffet.</i>

    Actually, I believe that Mr. Buffett depends on Mr. Munger's advice to make his $billions.

  • Report this Comment On December 26, 2009, at 2:23 PM, Fool wrote:

    What is this, an ad or an article.

  • Report this Comment On December 26, 2009, at 3:14 PM, gslusher wrote:

    "Despite the bad rap...there are many high quality, decent, honest investment professionals out there who do right by their clients and actually make them money as well as preserve capital."

    Perhaps you didn't read the article or you just saw what you wanted to see. The author mentioned *COMMISSIONED* advisors. They should be avoided because they have a personal and/or company financial interest in WHAT they recommend. Instead, look for an advisor who works for a fee, but who does not sell anything.

    When my father died in 2004, the first advisor I consulteda about managing my inheritance worked with a major firm that had its own funds. After several meetings, he presented his recommendations: EVERY investment in the very complex portfolio was with a fund that his employer offered. He said that they were all "no-load," but I checked and they had a back-end load (fee if I wanted to take out any money) and high maintenance charges. He was also going to charge an annual fee for his services, as well. The total fees would have amounted to about 3% of my portfolio per year, assuming that I didn't sell anything. He also said that I should invest in REITs and that I should not pay off my 6.75% mortgage.

    I suspected a rat and consulted a fee-based advisor. His recommended only 2 funds, both in Vanguard with no load and low maintenance. He said that I should pay off the mortgage (I did). He called REITs "roach motels for money"--your money goes it but it doesn't come out.

    The fee-based advisor cost more up front, but he had no incentive to recommend any particular investment & did not sell anything. (He could help fill out forms, but would not get involved in any transactions.) He had been a stockbroker but quit because of ethical concerns. His firm told him to increase the churn, advising clients to change their portfolios, even if that would lose money for them.

  • Report this Comment On December 27, 2009, at 4:26 PM, accelerando wrote:

    More idiotic advice. These guys are becoming simply another arm of wall street with commonplace nonsense.

    Here is the best investment advice:

    Find the best companies -- the ones with the best managment, best products, best cash-flow, best development teams, best marketing, best business models and so forth.

    There are only a few in any given era (IBM, Wall-Mart, GE, Microsoft once fit the bill).

    Divide your money up among this very small group of very select companies. Do your homework and stay ontop of each of them -- when things change, get out completely and look for better companies.

    Or to put it another way. Buy companies. Not stocks. Stocks are just bits of electronic flotsam.

    This was WB's strategy and it should be yours.

  • Report this Comment On January 01, 2010, at 9:52 PM, DEInc wrote:

    If you invested $100,000 on Jan. 1, 2000, in the Vanguard index fund that tracks the Standard & Poor’s 500, you would have ended up with $89,072 by mid-December of 2009. Adjust that for inflation by putting it in January 2000 dollars and you’re left with $69,114.

    But that is not how most real people invest.

    They don’t pour everything they have into just one type of asset and then add nothing to it for 10 years. Instead, they buy stocks of all sorts, and bonds and perhaps other things, too.

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