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While having a conversation with my Grandfather, the other day, we started talking about investing. And quickly disagreed about mutual funds, and caring about the “market.”
Keep in mind I orignally wrote this for my uncle, so it may get a bit boring at times when I tried to explain things such as paying commisions to brokerages or cutting losses short.
Wasting money on high priced brokerages. Some brokerages charge over $50, for EACH trade. Others charge you depending on how much you buy, using percentages to figure out commissions. I think both of these ways, you get charged too much. Another way you get ripped off is when, the brokerage charges you too “manage” your portfolio. This is when they buy and sell all of the stocks in your portfolio, sort of like an overpriced mutual fund. The best brokerage to out your money in, is one that has low commissions (never put more than two percent of your investment into commissions), is online (online brokerages can't call you to try to tempt to buy or sell any equities using their high commissions, and one that does not have an account minimum (some brokerages charge you a fee if the value of your account goes under a certain amount.)
Ignoring Valuation Some companies may have very good management, such as Starbucks, or very good financial statements, such as the blue chips of 2000. Yahoo has great management, and solid fundamentals, but I would never recommend it, because it is destined to fall because it is so overvalued.
Using Valuation Alone Even upon finding a company whose stock price is absurdly undervalued, more cash per share then share price. A thorough investigation of the company is still required before purchasing. Like many financial analysts say, “cheap crap is still crap.”
Caring about the “Market.” One of the biggest mistakes individual investors can make is paying attention to where the “market” is going. It does not matter where the S&P 500 is going or where the Wilshire 5000 is going, it matters where each person's separate stocks are going. Analysts at the Motley Fool say that one of the biggest mistakes they made while choosing stocks, during the great bull market of the late nineties and early two thousands, was buying companies such as Yahoo!, eBay, and, because the companies fundamentals were exceptional, and they were shooting upward. The analysts made the mistake of buying these companies because they afraid of losing to the market in the short term. When if they would just paid attention to where those companies were going in the long term, and picked companies which would beat the market in the long term. They would have faired better during the market crash in 2000.
Ignoring a Company because It Has a High P/E. Many investors today lose money because they worry to much about a companies Price to Earnings ratio. The Price to Earnings ratio was popularized by Benjamin Graham, in his book The Intelligent Investor, when he wrote the book, for the first time sixty years ago, the P/E was a good way to evaluate a companies valuation. But today Accountants have found ways to “juice” a companies earnings to make them look like they have earned more than they really have. That's why I use a better way of quickly evaluating a companies valuation, the EV/FCF ratio. Free cash flow is a lot harder to fake then earnings.
Paying Attention to the Short Term. This mistake goes right with the fourth one. Investors who pay much attention to the short term end up committing another mistake, which is next on this list. Short term movements should not influence the decision of investors. Day Traders, and people who buy on momentum, and try to profit from short term movements, are the ones who usually lose all of their money, and end up complaining about social security when they retire.
Selling because of a Loss; Buying because of a Gain. Individual investors who sell on a short term loss or buy on a short term gain are the ones who sit next to the ones from #6 at the retirement home to complain about social security. If you think about it always selling on a loss and buying on a gain, will lose you money no matter what, when your company bursts upward, it might now be overvalued, so it needs to thoroughly evaluated to see if it shouldn't be sold for a gain. Selling on a loss will be covered in the next mistake.
Cutting Losses Short. Cutting losses short, is when an investor sets a percentage, such as 7%, where when the companies drops that far from the buying price the broker immediately sells it. As superinvestor Peter Lynch says, it seems like the stock that has a –10% limit always falls 10% before going up a few 100%. If you have thoroughly evaluated a company and are confident with its' long term prospects, selling on a loss , should be unacceptable. In fact whenever I buy a company, I do not put the full amount of cash into it that I would like, instead I out about 70% of that money into it, then hope for a short term loss, which will make the stock be even more undervalued, so I can put the remaining thirty percent into it. This process is called averaging down, the investor who brought this to the apex of it's success was John Neff.
Buying on Rumors, Tips and Opinions. The investors who use this investing style are the most ignorant of investors. These are the investors who bought Google a month ago when it was at $180, Google was already doubled it's intrinsic value when it IPOed at $80, but now it was more than double than that at $180, these investors have already lost eleven percent in a month, and they better be ready to lose about $130 more before it settles down.
Over Diversifying Over diversifying is what makes stale returns for investors. Although it camouflages any big looses, investors may have it also camouflages the big winners. Investors should never own more than fifteen stocks at once. Some investors worry about diversifying in industries, saying that if they too many of their eggs in one industry basket, they will take too big of a hit if that industry takes a hit as a whole. I say good! If that industry takes a hit then you can put more money into your undervalued stocks. There is also the issue of under diversifying. Never own less than eight stocks. As Peter Lynch says, out of every ten stocks you buy, six will behave as expected, two will behave worse than expected and two will behave better. Don't argue with Peter Lynch!
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