Top Ten Investing Lessons

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By Gordon66
August 24, 2001

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

In honor of my 1000th post, I'd like to share some key investing lessons I've learned (or had reinforced) over the 30 months I've been following the boards here at TMF. Over this time period my relative investing performance (which wasn't too bad to begin with) has improved quite a bit. I don't think that's a coincidence.

So, here are they are, my top 10 investing lessons. Because lessons 8, 9 and 10 are quite long I'm putting those in separate posts.

Lesson #1: You can get better analysis from amateurs on good quality TMF board than from the best paid professional analysts and journalists.

Of course everyone knows that most analysts employed by financial institutions should be ignored due to conflicts of interest. But what amazes me is that the best analyses from journalists, and I've read many that were excellent, pale beside the best analyses I've read by posters here at TMF. Here are a few examples from the scores of posts I could have highlighted.

Cal8 on Krispy Kreme (KKD)

Dilemma on Hot Topic (HOTT)

RJMason on Amazon (AMZN)

But you have to be able to spot who these top quality posters are:

-- Are they unfailingly rational in their arguments?
-- Do they generously support their arguments with facts and examples?
-- Do they conscientiously respond to challenges to their arguments?
-- When they make an error are they quick to admit it?
-- Do they have a track record of having giving good advice?

Lesson #2: Don't be too proud to be a copycat.

I don't spend hours examining SEC reports and digging into the financial details of the stocks I trade (though I do spend some time doing this). I don't go to share holder meetings, listen to conferences calls, make store visits, etc. I don't spend much time on technical analysis. However, there are certain posters here at TMF that spend a great deal of time doing these things then generously share what they have learned. And over time I've grown to pay more and more attention to the the stock picks of such posters--if their general investment philosophy agrees with mine--when making my own investment decisions. That because we agree on what makes a stock good, and they happen to know much more than me about how well certain stocks actually meet the criteria of "being good".

Lesson #3: Be like a good poker player.

It has been said that the best poker players pay more attention to the other players than to their own cards. I expect that is a slight exaggeration, but the point is, if you play your own cards strictly by the odds and assume the other players are doing likewise, that will only lead to modest success, because you aren't going to be getting any more good hands, on average, than the other players. The big winnings are to be had by learning kinds of mistakes the other players are making and then exploiting those mistakes. Likewise in the market. Trading stocks strictly based on what you think about the stock is like playing just your own cards by the odds. You can improve your performance by looking at the other players. So when you're about to invest, go visit the TMF board for the stock. There will always be bulls and bears, but which is better informed and makes better arguments? This gives you a nice little window into what is driving the price of a stock. If there are many poorly informed bulls and many well-informed bears, that is a good sign that the stock is being driven by hype. If there is a cadre of rational, well-informed bulls and only a sprinkling of poorly informed bears, you may just have found yourself an undiscovered gem. And look at what the institutions are doing. Institutions can and do play games with stocks. Also, it wouldn't hurt to learn a bit about technical analysis, the formal discipline devoted to watching what the other players are doing. (Thanks to RAKEN for inspiring this lesson.)

Lesson #4: Be like a reed in the wind.

As the fashions driving stock valuations change, be willing to modify your philosophy at least a bit to fit with the times. If you are a value investor at heart, don't keep banging your head against the wall as that style falls increasingly out of favor in 1998-1999. Reduce your exposure a bit or at least resist the urge to "double down" on your holdings. Maybe even allocate a little of your portfolio to judiciously ride the tech stock wave but always with an eye on the exit. And when the bubble is clearly bursting, even if you ordinarily would never consider shorting, maybe put a little bit in hedge fund anyway. And when you see small stocks with low relative P/Es and PEGs starting to make a come back, as they started doing about six months ago, it wouldn't hurt to put some of your port in such stocks even if you consider yourself a "blue chip" investor. Such tweaking could easily improve your performance by a couple percentage points a year, and over time, that will make huge difference in your total returns. (Note: this argument mainly pertains to tax advantaged accounts. Having your stake cut by taxes probably outweighs the benefits of this kind of tweaking.) (Thanks to ionman for inspiring this lesson.)

Lesson #5: Don't "double down" until a stock looks cheap to value investors.

Everyone has done it. You buy a stock and then it starts tanking badly. You want to "undo" your mistake of buying at the wrong time by buying more "on sale". The problem with this logic is that there are two basic kinds of investors in the world, momentum investors and value investors. Once the stock starts tanking badly the momentum investors flee, and this leaves the fate of the stock in the hands of value investors. If you bought a stock when it was pretty cheap by conventional standards, it may not have far to fall before the value investors step in and put a floor under the stock. But if you bought a stock that was hideously expensive to begin with in the eyes of value investors, for all purposes there is no floor for that issue. You may just find yourself doubling down to zero. (Thanks to cal8 for inspiring this lesson.)

Lesson #6: Don't be afraid of the numbers.

Every time you make a decision to invest in a stock for the long term you are making an implicit forecast. You are forecasting that the intrinsic value of the stock exceeds its current price. Therefore, it is a good idea to run a few numbers to verify the plausibility of your forecast. There are many ways to do this. The most "accurate" is to do a DCF (discounted cash flow) analysis that extends into perpetuity. But as a wise person once said "don't measure with calipers what you're going to mark with chalk and cut with an axe".

Fortunately there are other rough analyses you can do. And the more generously valued a stock seems now by conventional ratios, the more crucial it is to assess the plausibility of your implicit forecast. One of my favorites is to pick a medium term time horizon (say 3-5 years) and project some scenarios for earnings per share at the end of that period. Then identify a likely range of terminal P/Es. That will give you range of future plausible stock prices. Then pick a discount rate and back into the current implied "reasonable" price range and compare that to the actual current price. (Note, you will want to adjust the E in P/E for unusual circumstances.) A nice example of this style of analysis can be found in TMFBuster's analysis of Amazon over a year ago.

For longer horizons (10-20 years) I like to identify comparable companies of yore ("comps") and say: "what if my target company, which I consider to be the next "X", were to actually perform like "X" did during a similar stage of development? Would it be under or overvalued given its present valuation? An example of this sort of analysis can be found in my response to a post by ejandresen over on the Krispy Kreme board.

If you don't feel comfortable with doing these sorts of numerical analyses, then you probably should avoid stocks with a high P/E or PEG, because you'll have no way of know whether or not you may be wildly overpaying for the stock.

Lesson #7: It is possible to spot a large stock market bubble contemporaneously.

If you read A Random Walk Down Wall Street by Burton Malkiel you will see him document many investing bubbles of the past. Abstracting from those examples and considering the internet bubble, here are five signs to look for when trying to identify a general market bubble:

(1) a radically new technology or concept that has caught the public fancy,
(2) share prices that go up many fold in a short period of time even in the absence of any significant news affecting the fundamental value of the shares,
(3) a growing fascination with investment among retail investors,
(4) valuations that seem patently absurd by conventional standards,
(5) the invention of entirely new and untested valuation models by market analysis in order to justify their stock recommendations.

And when it seems like you are in the midst of a huge bubble, what should you do? The adventurous might consider shorting stocks, though that is very dangerous. For most people you'd do better to just take some defensive measures, such as eliminating any margin debt you might have and exiting individual stocks you might own that have extremely high multiples. Not just apparent bubble stocks, but even "blue chips" bearing ratios far outside their historical norms (e.g., Cisco (CSCO) with a P/E of 200, as it had at one point last year).

Sure, a giant bubble may only come around about once every other decade, but I expect that if you can manage to have even one less pulverization of your portfolio over your lifetime then your total lifetime returns will be noticeably improved.

Lesson #8: Beware the "base rate" fallacy.

Lesson #9: A little knowledge�of a theory�is a dangerous thing.

Lesson #10: The EMT does not spare you from wildly over paying for a stock

So that's all ten lessons. Many thanks to the members of the TMF community (some of which are mentioned about, and many more that are not) that have assisted in my never-ending process of learning about how to invest.