You Might Be a Bad Investor

I don't mean to insult you. I'm thinking only of your best interests. It's just that, if you're a bad investor, you should maybe get out of the self-directed investing business.

It's nothing personal. I'd consider the managers of the American Heritage fund (AHERX) bad investors, too. It lost only 1.4% in 2007, after losing 11.3% in 2006, and 32.3% in 2005 -- you get the idea. Despite holding large stakes in respectable names like Microsoft (Nasdaq: MSFT  ) , Intel (Nasdaq: INTC  ) , EMC (NYSE: EMC  ) , and Flextronics (Nasdaq: FLEX  ) , it currently ranks dead-last in its category. Worse, its 10-year annualized return is negative 23%!

But let's get back to you, shall we? Here are signs that you might be a bad investor:

You consistently underperform the market
Do you know how well your portfolio is doing relative to the market as a whole? How did it perform last year? The one before that? In the years since you started it?

If you don't know, that's a red flag. Our goal as investors should always be to beat the market, because a passive index fund would get us market-matching returns without any time and effort, and with minimal expenses.

And if your portfolio has averaged only 7% a year over the past five years, when the S&P 500 has averaged more than 10%, well, you might consider one of those index funds.

You equate value with price
Let's look at two stocks: Goldman Sachs (NYSE: GS  ) and Brocade Communications (Nasdaq: BRCD  ) . Which one is more attractive?

If you think Goldman is the more "expensive" of the two because it trades for $177 per share ... well, see the point above about index funds. A stock's price is not the same thing as a stock's value. For instance, here's how the two stack up on a few valuation metrics:

Company

Stock Price

Price-to-Earnings (TTM)

Price-to-Sales

Price-to-Book

PEG

Goldman Sachs

$177.20

8.3

1.7

1.8

0.9

Brocade Communications

$7.70

48.4

2.1

2.3

1.1

Data from Yahoo! Finance as of May 22, 2008.
TTM = trailing 12 months.

According to this admittedly simplistic exercise, Goldman actually appears to be the "cheaper" stock. Of course, comparing Goldman with Brocade isn't totally fair, because they have very different business models, and they're not in the same industry. But -- apologies to Jeff Foxworthy -- this exercise should tell you that if you equate price with value ... you might be a bad investor.

You don't know much about your holdings
Do you know how the companies you've invested in make their money? If not, you likely won't be able to think about them -- or value them -- in context.

For example, there are some companies I will not ever own simply because I can't understand them. Warren Buffett has said as much about technology companies. That sentiment looked dumb while the Internet bubble inflated, but downright brilliant when it popped.

On the flip side, I do understand -- and own shares of -- a business called Intuitive Surgical (Nasdaq: ISRG  ) . It makes robotic machines to aid surgeons, permitting them to execute very fine maneuvers using a robot. It also makes money by selling tools for the robot to use.

Peter Lynch famously wrote that you should "never invest in any idea you cannot illustrate with a crayon." That's because if you don't know exactly how a company makes its money, you won't be able to tell when -- or why -- it's stopped making money.

You're impatient for returns
Jumping in and out of stocks quickly undercuts you in several ways. For starters, the transaction costs add up quickly; those commissions will be lining the pockets of a brokerage rather than compounding for your retirement. Second, it sticks you with short-term gains (if not losses), which are taxed at your ordinary income rate, not at the preferred -- and much lower -- long-term rate.

The final nail in the coffin is that constant trading doesn't give solid companies a chance to flourish over the course of many quarters. While so much Wall Street thinking is quarter-to-quarter, as a retail investor, you can look years into the future to see where a business will be going.

You CAN become a good investor!
Many of us have been bad investors at one time or another -- especially in the beginning, when we were learning how to invest intelligently. Reading widely and partnering with other interested investors can help you learn how to invest for the long term and how to beat the market.

Another way to learn is to track -- and invest with -- proven investors. Many mutual funds are run by talented investors who will not only make you money, they'll teach you by example what to buy and what to sell, and when.

Our Motley Fool Champion Funds newsletter is a great source for finding those stellar investors and the mutual funds they manage. Its recommendations are beating the market 24% to 6%. Want to think about it? A 30-day free trial will give you access to all of our past issues.

Longtime Fool contributor Selena Maranjian owns shares of Microsoft and Intuitive Surgical. Intel and Microsoft are Motley Fool Inside Value recommendations. Intuitive Surgical is a Motley Fool Rule Breakers recommendation. The Motley Fool's disclosure policy is a very good investment indeed.


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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 May 24, 2008, at 9:01 PM, provastro wrote:

    Well done Selena! A nice article that's a wake up call for all of us who think we know about investing but don't have the basic facts about our investing performance at our fingertips.

  • Report this Comment On May 26, 2008, at 8:56 AM, TMFSelena wrote:

    Thanks, provastro!

    Selena

  • Report this Comment On May 30, 2008, at 1:28 PM, robets1974 wrote:

    True, true!

    Especially when you just started investing.

    IF you could find a GOOD mutual fund, it will be a better way to start.

    For those who wants nice return and learning about stocks in same time, mutual funds are great.

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