4 Ways to Avoid Stupid Investing

A headline in The Wall Street Journal last week pronounced that hedge fund manager and former university lecturer Alberto Micalizzi had fallen from grace. With his fund suffering huge losses in 2008, Micalizzi bought worthless corporate bonds either unknowingly or in an attempt to cover up the deficit. Either way, you have a really smart guy with all the right credentials who failed miserably at managing money.

This reminded me of the fall of Long-Term Capital Management in 1998. In case you don't remember, LTCM was another hedge fund made up of several people whose IQs would undoubtedly qualify as genius. A couple of them won the Nobel Prize for economics. One had served as the vice chairman of the Federal Reserve. Most had previously been successful Wall Street bond traders. There was no fraud at LTCM, just sheer incompetence that lost over $4 billion in a handful of months.

After the last recession there was a lot of talk about Wall Street versus Main Street and how the small investor couldn't compete. Since then, we've heard how the stock market is "rigged" by high-frequency traders. With all these factors working against you, you might wonder how you could possibly handle your own investments when smart, connected professionals fail so spectacularly.

The key is not in being clever, but, as Berkshire Hathaway vice chairman Charlie Munger would say, not being stupid. While all those unsuccessful hedge fund managers are unquestionably intelligent, they did some really dumb things. In the spirit of not being stupid, below are some things to think about as you determine the best way to allocate your own capital.

1. Don't turn down free money
First, if your company offers a 401(k) match and you're not taking full advantage of it, then you're being...less than smart. For instance, if your employer matches $0.50 on the dollar up to 6% of your salary, then you'd better invest at least 6% (and preferably more). Otherwise, you're turning down an instant 50% return on your money. A 401(k) match is like getting paid simply to invest in your own future. Who doesn't like free money?

2. Don't shell out fee money
Another way to avoid being unwise is to avoid fees, or at least minimize them whenever possible. If you invest in mutual funds, find those that cost the least. These are usually funds that make less frequent trades, as buying and selling add transactional costs. If you invest in individual securities, then your own trades should be infrequent -- first, because of the costs involved, and second, because you can't predict what the market will do over the short term. What can be predicted is that over long periods of time, the stock market rises.

3. Don't trade stocks. Invest in businesses.
Earlier this summer I met a nice retired gentleman who seemed to have done quite well for himself in business. He lived in an upscale neighborhood next to the beach. As we talked, I discovered he had owned at least two manufacturing plants in a couple of different states. He said he now spends his time investing in stocks which he holds for "at least two weeks." I can't say for sure, but I'd be willing to bet that as a businessman, he wasn't buying and selling factories every two weeks.

This leads us to the third way to avoid the predicaments of failed hedge fund managers: Approach investing like a businessman. Value investment guru Ben Graham said it best when he said that "investment is most intelligent when it is most businesslike." That means doing research, buying strong companies that are managed well, and then giving them the time to succeed. If you're not up for the research, you can simply buy a large group of companies via a low-cost index fund or exchange-traded fund. Either way can work, depending on how much effort you want to put forth. The key is letting time and compounding work in your favor.

4. Don't let emotions get the best of you
Finally, keep in mind that emotional intelligence is far more valuable in long-term investing than your ability to calculate a discounted cash flow or define "weighted average cost of capital." Temperament is more important than intellect. Investors who lost their heads during the Global Financial Crisis sold off their investments at huge losses. Meanwhile, more savvy investors recognized a once-in-a-generation buying opportunity and enjoyed massive returns for the next several years.

To be a successful investor, you don't need above-average mental capacity. You simply have to avoid being stupid.

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