The Top 5 Ways to Lose Money Investing

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.

Two examples: Netflix (Nasdaq: NFLX  ) has warehouses with DVDs and mails them to people that pay a monthly fee. Waste Management (NYSE: WM  ) collects trash and recycling. It's that simple.

2. Speculating
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.

Dan Dzombak owns shares of Philip Morris and recommends you read The Best Investment Advice You Will Ever Get If You Have Under $100k. His musings and articles he finds interesting can be found on his Twitter: @DanDzombak.

Berkshire Hathaway and Waste Management are Motley Fool Inside Value picks. Baidu is a Motley Fool Rule Breakers recommendation. Berkshire Hathaway and Netflix are Motley Fool Stock Advisor choices. Philip Morris International is a Motley Fool Global Gains recommendation. Waste Management is a Motley Fool Income Investor selection. Motley Fool Options has recommended a write covered straddle position on Waste Management. The Fool owns shares of Annaly Capital Management, Berkshire Hathaway, and Philip Morris International. Try any of our Foolish newsletter services free for 30 days.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.


Read/Post Comments (24) | Recommend This Article (79)

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 October 11, 2010, at 3:45 PM, Vineconimcs wrote:

    I would not dispute any of the advice, have purchased Annally capital about a month ago. Prefer the Motley fool to many others, as it appears from the articles, the fools do not necessarily agree with one another, kinda refreshing..

  • Report this Comment On October 11, 2010, at 4:17 PM, EllenBrandtPhD wrote:

    What a ridiculous, illogical, and totally gratuitous mention of NLY and CIM!

    Shame on you, Motley!

    CIM's astute and careful management does not raise a dividend by over 6 percent lightly or frivolously.

    I expect CIM to beat consensus very nicely in about two weeks now. Although the analyst rankings are already very strong, I believe the three holdouts at Hold out of nine are going to have to upgrade to Buy or better.

    And the incessant propaganda barrage by a tiny but vocal contingent of shorts is out-of-your-mind Bullish for the stock, as its couldn't-be-longer- nor-stronger vast majority of Big Institution holders understands.

  • Report this Comment On October 11, 2010, at 5:39 PM, marcjones281 wrote:

    It's great how everyone's comments are about Annaly and not the article. Good lessons!

  • Report this Comment On October 11, 2010, at 6:12 PM, Glycomix wrote:

    I agree with you. My problem is knowing how to evaluate an investment; Motley seems to use two ways.

    1. Technical Indicators: such as PE (stock value: price/performance), ROE and ROI and profit margin (How well they're using the money they have to get a return, and how much they're making); debt/net income levels (High debt loads can lead to bankruptcy in a down market as it did with Chrysler and GM); and Free cash flow (money that they can use for discretionary purposes like rewarding investors). Free cash flow (to pay dividends to reward investors, companies need to have uncommitted funds).

    The usefulness of these are that they may show when the company is having trouble, or when the company is overvalued.

    Warren Buffet has a technique in which he uses the financial statements to identify competitive values. What does this company do that makes them worth significantly much more than their price.

    I agree with you about BAIDU, but I'm unsure of when

    David Gardiner likes, FFIV and recommended it, but I'm unsure of it's value other than being a "

    2. The COMPETITIVE ADVANTAGE: of the company and why they are able to beat the competition. this is where Dave and Tom and the "Fools" establishment spend time interviewing the management of the companies to see how good they are. The focus here is How and what could cause them to lose that advantage.

    For example, Netflix is known for its ability to suggest new videos based on your history. You could easily set up a family movie-night (even when everyone isn't available) by setting up a order based on each person's order history. That makes it easier when you get everyone to agree on the idea of a movie, but can't get consensus. It's hard to consult with everyone considering that families are so busy with teams or lessons in different areas: soccer practice, tennis class, ballet classes; cheerleader practice, football practice (it doesn't compete with soccer).

    In any case. I've been informed that there are certain statistics will tell you if Netflix is in trouble. PE seems to be high there as it is with BAIDU. Being on Cramer's "hotlist seems to have helped them. Cramer seems to be using his show to build up his business, "The street".

    The competence and abilities of the management vs excellent or poor stock companies. The Motley Fool's writers spend a much time here on how important a company's leadership is.

  • Report this Comment On October 11, 2010, at 7:21 PM, MegaEurope wrote:

    Wow, that Businessweek story about I-banks ripping retirees' faces off is crazy. "Buyers are compensated fairly for the risk they take on and don't need to know the details of how derivatives work to evaluate the securities, says Keith Styrcula, chairman of the Structured Products Assn., a trade group."

    Whaaa????

  • Report this Comment On October 11, 2010, at 10:36 PM, TMFDanDzombak wrote:

    @MegaEurope Exactly the reaction I had!

  • Report this Comment On October 12, 2010, at 6:33 AM, afamiii wrote:

    Too much text book investing from journalists and investing youngsters.

    Your Lesson 1. Invest in what you understand. Most of us only think we understand what we are buying, this is OK when everything is trending positively (i.e. earnings, RoE AND price.) But when your company issues a bad quarterly report, or when its price moves in a scary fashion? Which moves me into your lesson 2.

    Your Lesson 2. When the price tanks 50% is it possible that you only think you understand, whilst others understand better. Hmmm. Do you hold on whilst it losses another 50% (i.e. your 75% down.)

    Your Lesson 3. Management incentives? How many Berkshires are there? In reality few S&P 500 companies have significant owner management. Avoiding those that don't means avoiding most large companies.

    Your Lesson 4. Valuation. I subscribe to this one. But I wouldn't put much trust in PE. Some companies are cheap with a PE of 80 and some are too dear at a PE of 8. I guess I need to go back to Lesson 1.

    Your Lesson 5. When Berkshire put 40% of fund assets into American Express he certainly hadn't read this one. Maybe again it is linked to lesson 1. The more stocks you have the less you will understand each one.

    The real way to loose money in the market is.

    1. Not having developed your knowledge and expertise to a very high level (including business, fundamenta, technical and psychological analysis - as well as having studied at least a few very successful investors.)

    2. Not having developed a sound philosophy of the market and tested strategy that fits your personality and level of expertise and guides you on what to buy, what price to pay, when to buy, how you will monitor your investments, how you will find investment opportunities, how much you will buy, how you will recognise you have made a mistake, what you will do about it, how and when you will take profits.

    3. Not developing enough emotional fortitude to stick to your tested strategy, when the market feels scary.

    In short there are no easy rules to investment success, just some simple ones, hard grunt and discipline.

  • Report this Comment On October 12, 2010, at 7:27 AM, BearishKW wrote:

    While all of these reasons are good ways to lose money...in many circumstances, staying away from them means lost opportunities.

  • Report this Comment On October 12, 2010, at 8:35 AM, gimponthego wrote:

    Dan, I agree with the statement "never invest more than 50% of company stock" in your 401k and / or private stash. When the company I was with from the ground floor went public, we were all offered as many shares as we could afford..with no commission. I borrowed from relatives, used my savings and bought 1000 shares. Every month, I'd put 100% company stock in my 401k and added same to my bank as the years went by.

    This is 1 exception to the rule I'm aware of. There are probably others. I was proud of what we were doing and I was proud to be a part of it.

    When I retired at 50 in the late '90's do to health reasons, CCU was trading at 89+ at the end of the quarter I left.

    Just pointing out that while the axiom you mention is carved in granite for good reason, there are exceptions to the rule. Thanks, Johnny / San Antonio

  • Report this Comment On October 12, 2010, at 10:34 AM, TMFDanDzombak wrote:

    @afamiii I agree with your conclusion "In short there are no easy rules to investment success, just some simple ones, hard grunt and discipline."

    on 2: If PM was 75% down I'd be buying in droves

    on 3: While there aren't many Berkshires out there if you find management that is incentivized in a way that aligns them with shareholders (rolling ROIC, EVA Momentum, rolling FCF) as opposed to just being incentivized by revenue goals you will be better off

    On 4. Agreed

    On 5. Definitely linked to lesson 1

  • Report this Comment On October 12, 2010, at 10:37 AM, TMFDanDzombak wrote:

    @BearishKW If you don't have a good process, over time you won't have good outcomes.

  • Report this Comment On October 12, 2010, at 10:38 AM, TMFDanDzombak wrote:

    @gimponthego There will always be some for who this worked out well, in general however, it's not a good idea to invest even half of your retirement savings in your company's stock.

  • Report this Comment On October 12, 2010, at 4:50 PM, easyavenue wrote:

    Dan,

    Thanks for a good article. I think you make some excellent points beginners AND advanced investors need to be reminded of every time they trade.

    To other Commentors: The next time you see a course in Critical Thinking from your local Community College please take it!

    EA

  • Report this Comment On October 12, 2010, at 7:44 PM, TMFDanDzombak wrote:

    @easyavenue thanks!

  • Report this Comment On October 14, 2010, at 12:07 AM, 1caflash wrote:

    Your article makes a lot of sense. It's a shame Investing is not that simple. When Chimera does well, Its Management should invite Venerability to help Ring the Wall Street Bell. I'll watch with a Big Smile.

  • Report this Comment On October 14, 2010, at 12:35 AM, TMFDanDzombak wrote:

    @1caflash Thanks

  • Report this Comment On October 14, 2010, at 11:13 AM, marcjones281 wrote:

    Like most things in life, to be good at it you have to put in the work.

  • Report this Comment On October 14, 2010, at 1:42 PM, TMFDanDzombak wrote:

    @marcjones281 True

  • Report this Comment On October 14, 2010, at 4:23 PM, 1caflash wrote:

    Thank You, Dan! I'm a Baby Boomer who likes The Beach Boys, but "Wouldn't It Be Nice" if Investors thought Chimera was Undervalued for what this Company Gives Us, and took It into Rolling Stones' territory "Flight 505".

  • Report this Comment On October 15, 2010, at 1:45 PM, ManualShifter wrote:

    I agree with your warning about not putting too much of your portfolio in your own company stock. I know several people who spent most of their careers at Polaroid during the company's heyday of the 1960s through the 1980s. Polaroid's retirement plan was heavily incented to encourage purchase of its own company stock. When Polaroid went belly up (the first time) in 2001, many employees lost retirement plan value in the hundreds of thousands of dollars, and some lost millions.

  • Report this Comment On October 15, 2010, at 3:41 PM, TMFDanDzombak wrote:

    @ManualShifter Thanks for the story. Could not imagine what that would have been like.

  • Report this Comment On October 16, 2010, at 10:24 PM, underdone wrote:

    The derivative this woman bought probably saved her more money than investing in the stock market more directly.

    What she has ended up with is a lower income from Merc's dividend and a portfolio that is worth 30% less than before. A lot of people would love to be in that position.

    If she or her broker were a little more astute they could have used part of the 9% yield to buy a put at the strike where she was delivered and then her capital would be intact.

  • Report this Comment On October 17, 2010, at 2:09 AM, TMFDanDzombak wrote:

    @underdone She earned 9% by selling puts, buying puts would have cancelled out that income.

  • Report this Comment On October 24, 2010, at 7:31 AM, MFreader001 wrote:

    There is one 6th reason that may be added - not knowing how the system works.

    Nowadays the greater part of the cash flow is not circulating through the market as in the good old days. Money is created as debt by the banks and collected back (plus accrued interest) by the very same banks, and after distributing shameless bonuses it is returned on the market as loans (at shameless interest rates). The industry is out of the equation and the cash-flow circulating through the market is continuously running down.

    In the good old days if you were good enough, competitive enough, creative enough (including the case of a stock broker) there was a great chance to succeed. Nowadays you have absolutely no chance with such qualities.

    All that matters is how close you are to the fed and to the internal information exchanged in connection with the next naked short selling 'investment'. In the case of a bull market respectively is how much money can you induct from bonuses (when the market is left almost without money).

    This game is dishonorable from any point of view but the changing of its rules 'under the table' is outperforming everything else.

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