Author: Brian Feroldi | December 28, 2018
Much can be learned from our own missteps
Every investor makes mistakes. It’s simply part of the process. That’s why smart investors regularly comb through their own investing history in search of recurring mistakes. By identifying your past blunders you can learn from them and avoid making them again in the future.
I recently looked back at my own investing history and found it to be highly educational. Here's a review of the five biggest investing mistakes that I’ve ever made and the lessons that I've learned from each of them.
1. Buying penny stocks
I didn’t have a lot of money when I was just starting out so I assumed that penny stocks were my best bet. My reasoning was that I could buy hundreds of shares of stocks that traded for under $1 but only a handful of them if they traded for more than $100.
I couldn’t tell you anything about the companies that I was purchasing beyond the share price. Did they have cash in the bank? A good management team? Good growth prospects? I literally couldn’t answer any of those questions. My decision making process was based solely on the price of a single share.
Predictably, almost every stock that I bought immediately went down by at least 25%. After losing so much so quickly, I ended up abandoning this strategy within just a few months.
Losing money so quickly was very painful but it taught me a valuable lesson: It doesn’t matter how many shares of a stock you own; what matters is how much capital you have invested in any given company and the quality of the business that you buy. The price of a single share is completely irrelevant.
2. Buying high-yield stocks
When I first learned about dividends I became extremely excited. I was thrilled with the idea that the companies that I owned would send me cash on a regular basis. Better yet, a simple stock screening tool showed that some companies boasted dividend yields of 15%, 18%, and even 22%! I figured that buying and holding them would be a no-lose situation.
I quickly learned that my instincts were dead wrong yet again. Most of the high-yield stocks that I purchased were in trouble and couldn’t afford their overly-generous dividend payments. Many of them ended up cutting the dividend in order to hoard cash. That eliminated my income stream.
To make matters worse, their share prices declined sharply after they announced their dividends would be cut. It was a horrendous double-whammy.
That painful lesson taught me that a high yield is actually a warning sign that the underlying business is probably in trouble.
While I no longer invest just for dividends I make sure to put any potential stock through a rigorous test to ensure that its dividend is easily sustainable. If it fails that test then I simply ignore it and move on.
3. Selling too soon
“Buy low, sell high” and “you never get hurt taking a profit” are two investing maxims that I heard over and over again when I was first starting out. These sayings taught me that the best way to make big money in the markets was to sell stocks quickly after you saw a return on your investment.
A look back at my own investing history shows that I sold Altria Group at $18, PayChex at $25, Insulet at $17, Microsoft at $24, Ebix at $20, and SodaStream at $43. In each case I was up 25% or more from my entry price and wanted to book my profit.
If you’ve studied any of these companies over the last few years then you know that in every single case the share price continued to move up and left my selling price in the dust. It turns out that I would be much better off today had I simply decided to never sell.
The big lesson here is that winners tend to keep on winning. If you’ve purchased a great business then you shouldn’t be in a rush to lock in a profit just because it has gone up. The greatest growth stocks continually make new highs so more often than not the best move is to do nothing.
I’ve since learned to become extremely reluctant to sell a great business even if I’ve already made a bundle.
4. Using leverage
I’d always heard that using options were risky. After educating myself about them I found out that they can actually be used to both amplify and reduce risk. It just depends on how you use them.
I started to dabble with them and, unfortunately, had a lot of early success. I say “unfortunately” because those early gains caused me to get cocky. That led me to make a dumb decision that came with a five-figure price tag.
In 2014, I became very bullish on an energy pipeline company called Kinder Morgan. The company made money by moving oil and gas from one place to another, not from the price of the commodity itself. Its revenue was protected by take-or-pay contracts, so I figured the business was very low risk. When its management team promised 10% dividend growth for the foreseeable future I believed them and bought the stock.
I become so bullish on the business that I added in a very bullish options strategy called a synthetic long to supplement my stock position. If the stock continued to rise then I would have made a killing.
If you’ve followed oil and gas prices over the last few years then you know what happened next. Energy prices plunged and Kinder Morgan’s customers suddenly couldn’t pay their bills. Kinder Morgan’s contracts didn’t matter at all; what mattered most was that everything in the oil and gas industry was getting killed.
Kinder Morgan’s stock ended up dropping by more than 60% from its all time high. My use of leverage greatly magnified my losses. I’m still underwater on this position today even though Kinder Morgan’s stock has recovered a bit from its lows.
5. Getting scared away by valuation
Of all the investing lessons that I've learned the hard way, this one has been the most costly by far.
In 2006, I worked for a company that chose salesforce.com as its customer relationship management software vendor. Our company quickly became heavily dependent on salesforce.com for nearly all of our commercial functions (marketing, customer support, sales). I eventually realized that our commercial team would literally stop functioning if salesforce.com ever went down.
I was so impressed with the company’s platform that I looked into buying the company’s stock. However, I quickly dismissed the idea because its price-to-earnings ratio was over 100. I wrote off the company as "too expensive” and moved on.
Salesforce.com's stock is currently up more than 1,500% from when I decided to take a pass. I would have minted myself a tidy fortune had I been able to look past its short-term valuation and just buy a few shares.
I wish I could say that I learned this lesson quickly but I repeated it numerous times. I balked at buying many of the greatest businesses of my lifetime -- Amazon.com, Intuitive Surgical, Netflix, and Alphabet -- simply because I didn't like the valuation.
Thankfully, in 2010 Motley Fool co-founder David Gardner finally convinced me that you should never let valuation alone keep you away from investing in great growth companies. I went on to purchase all of those businesses and have earned multi-bagger returns on each of them.
The key takeaway here is that you should never let valuation alone keep you from investing in a great business that you believe in. If I had only learned this lesson earlier in my life then I'd be far richer today.
Learn from my mistakes
In order to keep myself from making all of these mistakes a second time I’ve developed a detailed checklist that I use to evaluate any potential investment. I simply buy shares of companies that get high marks and avoid those that do not. This helps me to stay focused on the factors that I believe matter most and look past the valuation and share price.
I also regularly write in an investing journal so I can keep track of my thoughts and feelings before I make any buy or sell decisions. That way I document my mistakes as I make them and adjust my investing process accordingly.
Making use of these simple tools has made all of the difference in the world to my investment process. My accuracy rate is higher and my returns are much better, too.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Brian Feroldi owns shares of Alphabet (A and C shares), Amazon, Intuitive Surgical, and Netflix and has the following options: short January 2020 $30 puts on Kinder Morgan and short January 2020 $27 puts on Kinder Morgan. The Motley Fool owns shares of and recommends Alphabet (A and C shares), Amazon, Intuitive Surgical, Kinder Morgan, Netflix, and Salesforce.com. The Motley Fool owns shares of SodaStream. The Motley Fool recommends Insulet. The Motley Fool has a disclosure policy.