Why I'm Down More than 85%, and How You Can Avoid My Mistakes

As any member of Alcoholics Anonymous knows, the first step to setting out on the proper path is admitting your weakness. In that spirit, I'm writing about my biggest mistake during the bear market. Here. Publicly. For the whole world to see.

After all, if legendary investor Peter Lynch of Fidelity Magellan fame could publicly admit to holding AIG and Fannie Mae at the end of 2008, what does an analyst like me have to lose?

I hope two things come of my story:

1. Someone, somewhere out there learns something from my mistakes.
   
   
2. Having studied psychological commitment and consistency in Dr. Robert Cialdini's classic work Influence: The Psychology of Persuasion, I hope that my public commitment to avoid repeating these mistakes prevents me from falling victim to them again.

Mea culpa
My greatest investing failure of the past year has been my investment in Allied Irish Banks. To date, I'm down 86% (not long ago, I was down more than 90%, but the stock has inched upward).

That's more of a loss than even those suffered by investors in companies like Blockbuster (NYSE: BBI  ) , Discovery Laboratories (Nasdaq: DSCO  ) , Western Refining (NYSE: WNR  ) , and Xenoport (Nasdaq: XNPT  ) over the past year!

Yet painful though that loss is, seeing how avoidable this was in hindsight hurts even more.

Perhaps the only comforting thought can be found in Warren Buffett's 2008 Berkshire Hathaway annual report. Buffett writes that he also suffered a significant loss by investing in Irish banks. Some have speculated that AIB was among them. If so, at least I was fooled alongside a much better investor.

Following the crowd
I first went wrong in falling prey to social proof. I put too much weight on the research, opinions, and actions of others, without thinking through my investment decision for myself and deciding whether it made sense in my portfolio.

Before my purchase of Allied Irish Banks, it had been recommended in our Global Gains newsletter service and purchased by the team heading up our real-money Million Dollar Portfolio service. Advisors in both services wrote that the stock was trading with low historical and relative multiples, a very attractive dividend yield, and a significantly undervalued price.

While they made compelling arguments, I failed to carefully evaluate whether I agreed with their assessments. And I became even more hooked as these fellow analysts began purchasing Allied Irish Banks for their personal portfolios.

As a result, I also began to give in to confirmation bias -- where I sought out opinions that further confirmed my buy decision, rather than seeking a contrarian opinion that might indicate danger ahead.

Seth Jayson, co-advisor of our Motley Fool Hidden Gems newsletter service, recently shared with me that confirmation bias is one of the most common predispositions investors face. He explained that truly great investors develop an ability to honestly look at both sides of an investment thesis.

Anchoring in loose sand
As if those errors weren't enough, I also became anchored to the price at which each service recommended the stock. I fixated on those price points; in my mind, anything lower than their entry prices became a clear bargain.

So when Allied Irish Banks fell another 50% from the most recently recommended price, the stock became twice as attractive to me, as did the doubled dividend.

These mistakes fed off each other, collectively persuading me to overlook my normal investment process. I took shortcuts. I failed to perform as much research as I typically do. I fell in love with the stock, viewing it as mostly upside, without truly understanding the risks and pressure points. And I didn't even consider the possibility of a suspended dividend (which later came true).

The company -- which, hurt by the falling Irish economy, needed to boost its construction and development loan reserves -- was much more complicated than I originally thought. Andy Cross, also co-advisor at Hidden Gems, recommended to me that investments should always pass what he calls "Einstein's razor," which dictates that an investment thesis "should be made as simple as possible, but no simpler." The complexity of Allied Irish Banks forced me to look to other investors, bypassing my own investment process.

Lessons learned
The key takeaways from my mistakes, then, are:

1. While it can be helpful to look at the opinions of others, you still need to carefully consider whether you agree with their investment theses. Even if Allied Irish Banks had risen 86%, it still would have been a mistake for me to buy it, because I hadn't sufficiently examined the reasons for owning it. You must be able to distance yourself from the positions of people you respect.
   
   
2. It's much better to leave a stock's price history out of your analysis, so that you're not tricked into a value trap. Companies can, and often do, change. OceanFreight (Nasdaq: OCNF  ) might have seemed like a bargain at the start of 2009, when it was down more than 50% from the previous year. But it doesn't seem like it would have been wise to buy it -- the stock is down more than 20% over the past 12 months. Pure Bioscience (Nasdaq: PURE  ) and Verenium (Nasdaq: VRNM  ) shared a similar fate. 
   
   
3. It's best to simply bypass investments that are too complex, or that you're not certain you solidly understand.

These takeaways -- and countless other investor psychology topics -- are heavily studied by Hidden Gems advisors Seth Jayson and Andy Cross as they seek out the world's top small-cap companies. That has now become an even higher priority for them as they construct a real-money portfolio of their best small-cap ideas for our Hidden Gems newsletter service.

Not only can you see their buy guidance right now, but they're also offering you the chance to read their research so you can see if you agree with their analysis. Click here for a free guest pass -- there's no obligation to subscribe.

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This article was originally published April 14, 2009. It has been updated.

Adam J. Wiederman owns shares of Allied Irish Banks. The Motley Fool owns shares of Berkshire Hathaway, an Inside Value and a Stock Advisor recommendation. The Motley Fool's disclosure policy likes to learn from its mistakes.