It is heart-wrenching when you hear stories of investors losing their life savings for avoidable reasons. A recent story in Bloomberg BusinessWeek about Leona Miller, an 84-year-old retired beautician who invested in derivatives, got me thinking of ways people lose money in stocks and how to avoid them.
1. Investing in a product or business you don't understand
Leona Miller bought a structured note called a "reverse convertible note with a knock-in put option tied to Merck stock." Even I was unsure what this meant, and this is one of the more basic structured notes.
Leona collected a 9% coupon and the right to receive her initial capital back at maturity. However, if at any time Merck fell below a certain level (called the "knock-in" level), instead of giving Leona her money back, the bank could give her a predetermined number of shares of Merck. As long as Merck's stock didn't fall, Leona collected her 9%.
If Merck did fall, she would lose huge amounts of money. As you might expect, Merck's price fell below the "knock-in" price, and Leona was left holding stock worth 30% less than her initial investment. I am hard-pressed to believe any amateur investor could fully understand exactly what a "reverse convertible note with a knock-in put option" is. By investing in products you don't understand, you are setting yourself up for disaster.
Peter Lynch has said to invest in businesses and products you understand. Leona's broker wrote that she was familiar with Merck as they manufactured one of her medications. Baloney!
Many people own mortgages and are having trouble paying them off, but that doesn't mean they should go out and invest in Annaly Capital Management (NYSE: NLY ) or Chimera Investments (NYSE: CIM ) , which are real-estate investment trusts (REITs) that specialize in buying up mortgage-backed securities and assessing the risk inherent in residential real estate.
If you don't have an understanding of how a business truly works, don't invest in it! There are many simple businesses out there that anyone can understand.
If the price of a stock you own drops by 50% tomorrow, do you like the stock more? If not, you are speculating. For example, if Philip Morris (NYSE: PM ) drops by half tomorrow, Godsend! It's a financially sound business with recurring revenues and a strong brand. I would love to be able to buy shares at $25 compared to the $50 per share you can get them for today.
3. Ignoring incentives
If you give someone incentives they will game them, meaning they will do what is in their best interest.
Regular investors, you would never ask a used car salesman if you need another car, or a life insurance salesman if you need more life insurance, so why would you ask a stock broker for advice on stocks? They don't have a professional obligation to put your interests before theirs, what's known as a fiduciary responsibility. If you are looking for advice, seek out a reputable financial advisor and double check they aren't merely brokers under a different name. Make sure they put your interests first and aren't being paid extra based on what funds and products you choose.
Stock pickers, if management is paid and incentivized based on revenue goals or share price goals, management will game them. Be wary of investing in companies with perverse management incentives, and recognize how management will likely game their incentives. Invest in companies in which management owns a considerable stake and how your interests and management's interests are aligned. The best example is Berkshire Hathaway (NYSE: BRK-B ) , whose management team of Warren Buffett and Charlie Munger own a combined 24% of the company's stock.
4. Ignoring valuation
Buying outrageously priced companies is setting yourself up for disaster. Investors' memories are very short; does anyone remember the tech stock crash? Baidu (Nasdaq: BIDU ) is trading at 100 times earnings. If you want to earn 10% on your money annually, the company must grow its earnings 30% a year for 10 years! One misstep and Baidu will be crushed. Buying a stock hoping to sell it to the next sucker that comes along is a fool's game; buy undervalued companies.
5. Putting all your eggs in one basket
When I meet people who have 50% or more of their portfolio in their company's stock I shudder. While they may "know" their company will do well, if something goes wrong they can be walloped by losing their jobs at the same time their portfolios take a dive. Anyone who worked at Lehman, Enron, etc., can attest to this.
This list could be much longer, but five is good enough for now (No. 6 would be paying high fees). As Warren Buffett once said, "An investor needs to do very little right as long as he or she avoids big mistakes." Avoid these mistakes and prosper.
If you'd like some individual stock ideas, click here for a free report on some companies you can understand.