Chapter 10

The Financial Death Wish

I doubt that anyone will consider “buy low, sell high” to be a brilliantly controversial idea. It's self-evident, isn't it? Who would do otherwise? Most investors, that's who, because most stock market investors lose money in the markets, even in bull markets. It's an almost universal phenomenon. Most investors have done it at least some of the time. What they don't know is why they did such a dumb thing. There are several definable and avoidable reasons:

• Ignorant timing: Investors usually have no clue as to real intrinsic value, so they do the stupid thing described in Chapter 8—they pay too much for an overvalued stock because it's “hot” or in the news (which means the pros have already bought), and then when it inevitably returns to a more realistic valuation, they get discouraged and sell out for less than what they paid for it, so they bought high and sold low. They don't realize that profit is predetermined at the time you buy, much more than when you sell. If you don't buy right, the odds are you will sell low.
• Emotions: Emotions are usually a huge factor in stock losses. Investors who make unemotional decisions are rare (if they do, they're usually hardened professionals), and the emotions that can distort judgment are legion: enthusiasm, the desire to not be left out (otherwise known as herd mentality), ego, and the ever popular fear and greed.
• Bad luck: Sometimes you buy just before some unforeseen piece of bad news hits and the stock tanks. That's not your fault, but it can be an opportunity in disguise that you will probably miss.

Let's look at these mistakes one at a time.

IGNORANT TIMING

I called this ignorant rather than bad for a reason. It usually happens because you haven't taken the time and trouble to do your homework, starting with a study of the price history of the company and a careful examination of historical valuation ratios (price/earnings, price/sales, etc.), both for the company and its industry group. Even a good company is a lousy investment if it costs too much, as is even the strongest company in a weak industry group. If the price is out of whack with historical values, you are just about to buy high, sell low.

Emotions are the investor's worst enemy, because they skew judgment, often in ways that you aren't even aware of. Let's look at a few reasons why:

• Love. I don't know how many times I have had an investor defend a decision to hold onto a losing stock position by saying, “But I love this company!” I can assure you that the company doesn't return your affection. A stock is not a spouse, a child, or a puppy, it's an inanimate thing, and you should be as unemotional and impersonal toward it as it is to you. Go back and read Chapter 9 again.
• Ego. This usually manifests when all the objective data say it's time to sell, but you hang on while the losses mount, not willing to admit you made a mistake. Sometimes selling at a small loss seems like a personal insult: “I'll be damned if I'm going to let this stock tell me what to do.” Ruff's First Law of Limiting Losses is, “He who refuses to take small losses will take big losses,” and ego is the main reason why you don't face unpleasant reality and cut your losses. This principle really won't prevent a loss, but it will avoid big losses.
• Fear and greed. We will talk about these two emotions together because they are the two sides of the problem that go together. We fear we will be left out, so we buy after a run-up. We fear we won't think of ourselves as smart if we don't get on board. Greed causes us to hang on too long and ride a stock over the top and down the far slope, for we fear we will leave some money on the table. Fear of loss will also cause us to unload before a promising company has had a chance to prove itself, even if the fundamentals are still promising.
• Enthusiasm. This admirable quality is one emotion no investor can afford to indulge when making buy, sell, or hold decisions. It's usually what sucks you into the herd mentality. During the late, lamented dot-com bubble, I heard enthusiasm from individual investors, from stock analysts on CNBC, and from economists touting the new economy and telling us how the old standards no longer apply. Enthusiasm sucks unsophisticated investors into doomed start-ups because they are excited about a new widget that will revolutionize something or other. Enthusiasts emotionally buy into the story, but objective realists ignore the enthusiasts. They want to know if the management team has the skills, knowledge, and balance to turn a great idea into a real company. They want to know if the company will have enough cash to make the necessary capital expenditures, do the market research, and then drive the company to success. They want to see the business plan to determine if the founders and management have really thought through the process of turning a great idea into a great company (see Chapters 17 and 18).

BAD LUCK

We all experience some bad luck from time to time, but smart investors insulate themselves from potential bad breaks so they are minimized. How?

• They diversify broadly. I had very little sympathy for the Enron employees who were caught in the sudden collapse of their employer. I watched a parade of them on the TV news as they told their sad stories about how their entire 401(k)s were invested in Enron stock, so their whole future retirement was wiped out overnight. If they had diversified, they would have been hurt but they wouldn't have been wiped out. Investors should look at their portfolio like the portfolio manager of a mutual fund looks at his or hers. Even the best are wrong about 30 percent of the time, and the managers know it. They prune out the losers without a backward glance, unlike a lot of investors who watch a stock more closely after they sell it than they did when they owned it, just to see if they made a mistake. It is unlikely that bad luck will sink your whole portfolio at once if you are broadly diversified. But broad diversification is more than meets the eye. If your diversification is across a narrow spectrum of related investments, like industry groups that will be affected by the same forces in the same direction, that is not diversification, it's what Robert Kiyosaki calls “de-worsification.” Real diversification might look like this: some income-producing real estate, some gold and silver or gold-mining stocks, some commodities, some land, some undervalued, dividend-producing stocks, a few promising start-ups using the guidelines in Chapter 18, and some T-bonds or foreign bonds and stocks. It is unlikely that they would all go south in a bear market or be crushed by the reprehensible actions of the management of one company, such as Enron.
• They buy shares of only a single mutual fund. This is one way to de-worsify. You should divvy up your money between several different types of mutual funds, such as a growth fund, a financial institutions fund, an oil fund, a real estate investment trust (REIT), and a gold fund. That might work and spread the risk.
• They turn lemons into lemonade. If bad luck hits one of their investments and it crashes and burns overnight, they reevaluate it and see if they haven't been presented with a chance to buy real value at a big discount. The only reason stocks are cheap is because potential buyers are pessimistic about the future of the company or the market and are selling. The only cheap stocks are out-of-favor stocks, so your piece of bad luck can be a new opportunity in disguise. As Baron Rothschild said, “The time to buy is when the blood is running in the streets.” That's a great concept as long as you can determine whether or not the blood is flowing from a mortal wound. But if you diversify over several companies, the odds are that the bad decisions will be more than balanced out by the good ones, especially if you quickly prune the bad decisions from your portfolio as things become clearer.