The toughest part about investing is that it involves predicting the future. That absolutely guarantees you won't get it perfectly right 100% of the time. It also means that at least every once in awhile, you'll buy an investment that moves in the wrong way.
But there's a difference between merely being wrong and being downright stupid. Being wrong is inevitable, but being stupid can be prevented. And in order to keep a resolution to invest smarter in 2011, in hopes of a brighter year, let me share with you some of my stupidest investing decisions and how you can avoid them. After all -- the only thing better than learning from your own mistakes is learning from someone else's.
First: Stop buying clearly damaged goods
It was obvious that the former General Motors (NYSE: GM) was dying as a public company years before it actually declared bankruptcy. Now, I'm not talking about today's reborn Wall Street darling GM, mind you, but rather the old, absolutely worthless version now known as Motors Liquidation. Still, I owned the old stock in the hopes of some sort of a miraculous recovery.
Likewise, it didn't take much insight to question valuations in the housing market and see that particular bubble before it burst. But I still owned class B shares of homebuilder Lennar (NYSE: LEN) and Alt-A (aka "liar loan") originator Impac Mortgage. Because, after all, the market wasn't all that concerned about what looked like a bubble at the time I bought, and who was I to disagree with the learned expertise of professional money managers?
Nobody gets every investment choice right all the time -- not even Warren Buffett. But if you can manage to avoid completely unforced errors of the type I've made far too often, you'll be doing yourself and your future net worth a great favor.
Next: Know and spread your risks
Even a seemingly healthy company can fall upon hard times. My wife bought shares of General Growth Properties (NYSE: GGP) after that company turned around a struggling local mall. At the time, the company looked financially stable for a REIT. Like many in its industry, though, it faced refinancing risk if it needed to renew maturing loans at a time of tight capital markets. And sure enough, it was forced to declare bankruptcy, although its stock didn't go to zero and has actually performed well since the company emerged from bankruptcy protection.
On a similar note, I held onto Bank of America (NYSE: BAC) stock throughout the financial crisis. It was strong enough to be a net acquirer of troubled businesses during that mess, and it clearly looked like it would survive. But even as the once-titanic bank stocks looked ever more like screaming bargains during the meltdown, I held off buying more of its stock or any other banks' shares, for that matter.
Sure, fellow banking giant Citigroup (NYSE: C) also looked like a survivor, albeit a more heavily damaged one than Bank of America. But in addition to Bank of America shares, I had already owned shares of Fifth Third Bank (Nasdaq: FITB), which also survived, and Washington Mutual, which didn't. I wasn't about to throw more money at a sick industry in the hopes that I'd be accurate in picking the survivors.
No matter what the company or industry, it makes no sense to risk too much money on any one investment. A company that goes bankrupt or an industry that radically downsizes will sting an investor's portfolio if that investor owns shares, but that sting need not be fatal. Key to assuring you can financially survive even when a stock you own doesn't is to not put too much of your money in any one investment.
Finally: Look for solid balance sheets
The risk of a surprise failure is especially large if the company relies heavily on debt, like REITs and banks so often do. After all, rising interest rates or a worsening risk profile can turn what had been a successful leverage play into an abject failure in the blink of an eye. When a company over-exposes itself to debt, its investors face magnified risks not only from the business' operations, but its financiers' mood swings, as well.
The importance of a clean balance sheet was again driven home to me recently when Life Partners Holdings (Nasdaq: LPHI) found itself on the front page of The Wall Street Journal. I had previously bought shares in the company not too long ago when the Journal wrote a devastating article questioning the very foundation of its operations -- the way it rates policies. In a heartbeat, what had looked like a terrific bargain transformed into a risky proposition.
Yet the company's shares remained largely intact, even after that very respected publication shed light on some rather questionable (though apparently legal) business practices. Why did Life Partners survive when the very rumor of a potential hiccup sent Bear Stearns into a death spiral? In large part, it's because Bear was leveraged to the hilt, while Life Partners carries no long term debt on its balance sheet.
The right way to be wrong
No investor is going to get it right 100% of the time. But there's a difference between a company's outlook deteriorating and an unforced error caused by an investor not paying attention to some very real (and obvious) warning signs.
My investing resolution for 2011 is to stop making those unforced errors. By understanding a company's operations, the market it competes in, and the financing choices it makes, I expect to do a far better job avoiding the very dumbest of my dumb mistakes.
