In a commencement address years ago, Berkshire Hathaway co-chairman Charlie Munger evoked the late Johnny Carson, noting that Carson "couldn't tell the graduating class how to be happy, but he could tell them from personal experience how to guarantee misery."
This theme -- studying failure rather than success -- is common for Munger. His past talks have recommended avoiding cocaine, "AIDS situations," venereal disease, ingesting chemicals, and racing trains to the track as ways to gain happiness. All great advice, but of little use here.
Investors are inundated with advice on how to effortlessly become wealthy and successful. Much of it is nonsense. Studying what makes investors fail miserably will likely be far more informative, prescient, and timeless.
In no order of importance, here are seven things you can do to guarantee you'll become a terrible investor.
1. Use lots of leverage
Mae West said, "Too much of a good thing can be wonderful." Some investors look at her advice and think, hey, if I've found a great investment, why not leverage up and get two, three, or four times the goodness?
I'll go out on a limb and say that the only individual investors who consistently profit with leverage do so through pure chance.
For one thing, margin debt (money borrowed from a broker to buy investments) comes with a very high cost of capital -- typically 7%-10% -- which, not surprisingly, is at or above the average market return.
Second, margin holds you hostage to time and temperament. If you leverage a margin account 2-to-1, a 50% drop will wipe you out. Game over. Insert more quarters. And as we learned over the past two years, even high-profile names like UnitedHealth
2. Hire a commissioned advisor
A good friend used to invest on her own. But after she lost interest, she hired a commissioned advisor instead. That's an admirable step in humility, but a dangerous one nonetheless.
She asked me to look at her new, post-advisor portfolio. Not surprisingly, it now consists exclusively of front-end-loaded mutual funds. Some of the funds command front-end fees (akin to cover charges at bars) of nearly 6%, on top of annual management fees of 1%-2%. More sickeningly, most of the funds were essentially market-tracking funds that an ETF could achieve for a negligible fee.
The only person who wins in this situation is the broker. To quote Munger again, "Most stockbrokers are a disaster waiting to happen."
3. Surround yourself with people who agree with you
Munger likes to emphasize the work method of Charles Darwin, who spent a better part of his life trying to prove himself wrong. As Munger notes, "He always gave priority attention to evidence tending to disconfirm whatever cherished and hard-won theory he already had." Most investors can't say the same.
If you want to guarantee you'll lean precisely nothing, converse with people who share your same views and agree with everything you say. That'll do it. If you read about the executive culture at companies like Lehman Brothers, Bear Stearns, and Bank of America
Before making an investment, one of the smartest things you can do is find someone who thinks you're absolutely nuts, and hear him or her out with an open mind.
4. Follow the herd
At every second of every day in every market, there's a trend du jour. Sometimes it's megabullish. Sometimes it's end-of-the-world bearish. Sometimes it's oil. Sometimes it's gold. Sometimes it's Twilight and Miley Cyrus. In any case, if it's extremely popular, it's probably dangerous. One of the most ironclad rules of the world is that an investment's future return is inversely correlated to its current popularity.
Take gold right now. Bullish investors are throwing out forecasts of $2,000, $5,000, even $8,000 an ounce. I have no idea whether they're right (nor do they), but it wouldn't surprise me. Markets do extraordinary things.
But I will guarantee with 100% certainty that most gold investors will end up losing big time. Why? Because most will pile in near the top, right at the peak of exuberance.
That's when investing feels the best. That's when your bullish thoughts have been vindicated. That's when everyone you know is buying. That's when you know you can't be wrong. But it's a false sense of security, and it always ends in tears. The history of bubbles proves this over and over and over again.
5. Assume you're invincible
Tell yourself you're the next Warren Buffett. Tell yourself you're a genius. Assume your predictions can't be off, and that you're the seer of all things financial. Set up your portfolio so that every one of your assumptions must come true, but take comfort in knowing that being wrong is doubtful. Assume markets are predictable and move in clear, coherent ways. Brag a lot. Look in the mirror constantly. You'll become a terrible investor in no time flat.
6. Have a concentrated portfolio
Warren Buffett has said, "Diversification is a protection against ignorance." This is true if you're Warren Buffett, but potentially lethal for investors with less aptitude or those who take his comment to the extreme.
Now, not everyone should be in broad index funds that mimic the market. Individual investors can find good stocks -- that's what The Motley Fool is all about.
But overconfidence, combined with a manic market, combined with overallocation, is a brutal trifecta. Factors beyond your control or above your understanding can, and will, bodyslam what look like great investments.
AT&T
Bad things happen to good companies, and investors with extreme concentration in any investment are setting themselves up for misery.
7. Don't invest
Stay in cash your entire life because you're afraid of the market. This is the easiest way to become a terrible investor and watch your purchasing power slowly vanish before your eyes.
Moving on
Becoming a terrible investor is easy. Learning from your mistakes is the hard part -- the part that our Motley Fool Stock Advisor newsletter focuses on relentlessly. Learning and adapting from its past mistakes has made Stock Advisor hugely successful, with the average recommendation outperforming the market by more than 52 percentage points since inception in 2002. If you'd like more information, click here for a free 30-day trial. There's no obligation to subscribe.
This article was first published Dec. 26, 2009. It has been updated.
Fool contributor Morgan Housel owns shares of Berkshire Hathaway. Berkshire Hathaway, Microsoft, and UnitedHealth Group are Motley Fool Inside Value recommendations. Berkshire Hathaway, Ford Motor, and UnitedHealth Group are Motley Fool Stock Advisor choices. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Berkshire Hathaway and UnitedHealth Group, and has a disclosure policy.
