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Learning to Invest / My Dumbest Investment


Subject:  Cap Preservation - commissions, fin planning fee Date:  10/12/2006  4:42 PM
Author:  yattaboy Number:  2320 of 4353

First, congrat's to anyone willing to tell the world what they've done wrong. That's the first step to improving your investment abilities!

I will focus not on specific stocks, but other ways of wasting your hard earned money.

Warren Buffet recently estimated that ~35% of all profits earned by investors, traders, speculators, etc are squandered to fees. I could have written that same piece of advice.

Scenario 1 - Mutual Fund Fees

When I first delved into mutual funds in the early 1990's, I had picked some pretty good mid-cap growth/dividend funds on my own for my IRA, but couldn't help noticing the big, financial firm down the street with a highly recognizable blue logo, who's first name begins with Merrill. Convinced I was missing out, I eventually swapped most of my funds into a newly created IRA with them, happily paying the front-end fees for a bunch of funds I knew nothing about but whom my advisor, a friendly guy about my age, seemed so positive about.

Long story short: By summer of 2002, I had lost approx 50% of the value I put into my IRA, and had paid front end fees for the pleasure of doing so. I compared the NAV price at that time for the funds I had initially picked on my own...if I have kept the money in 'my funds' that I picked in the early 90's, I would have earned a positive net return over the holding period, and have paid no fees.

Summary: If you feel confident of your own research, and have at least some positive returns, and are comfortable with making investment decisions on your own, trust yourself. You are smarter than you think.

Scenario 2 - Option Contracts, Stocks, and Commissions

Fresh out of an expensive option training program, I funded a new account with $5900 in May 2003. In one year's time, I had miraculously turned that into...$300. Yes, almost a 100% loss. But here's the real point: About 2 years later, I was analyzing my trades (another fantastic piece of advice...I'll save that for another post). I found that I spent $1,400 on COMMISSIONS. Ugh. I had tried many different trade models and stocks, so my trading was more excessive than at any time of my life, but the essential fact is, nearly 1/4 of my entire portfolio was killed by commissions. I was stunned. Most friends and co-workers consider me the local stock guru...believe me, I don't think or want that to go to my head. But I do enjoy investing, and do consider myself knowledable. Yet I fell into this trap. Fees creep up on you. They creep very slowly, like the hands of a clock. But after 'a few hours', sure enough the clock's hands have moved. There's a reason brokerage ad's are in your face everywhere -- there's huge money behind it. And we are the ones making that possible.

I have since learned much about options by the way, and they have a very useful place, but you must learn more than theoretical trades. (i.e. have a system, set loss and gain limits, then ABSOLUTELY follow them - that is so very much harder to do than it sounds). If options interest you, by all means, look into them, but watch commissions, and watch how much you spend on training. I took an expensive course for two days, taught by ex-CBOE traders, which cost $3K. I was probably worth it for their inside advice, but it's no panacea to success. Your own discipline is. But I digress.

Summary: Don't ever laugh at $20, 10, 8, 4.95 commission rates. They add up, especially in larger share batches, limit orders, etc. So do other ancillary costs like training, wireless internet, software, subscriptions, etc. Don't get me wrong. As an independent investor, you need to pay for most if not all of these things, but account for it. For many people, buying a no-load index fund and forgetting it may sound boring, but it has none of these costs eating away monthly at your returns.

Scenario 3 - Do not lose money, follow rules of a system

I have three portfolios: One has stocks picked via IBD CANSLIM, one is for option trading via thinkorswim (great software - and free!), and the other is value investing, ala Buffet, Benjamin Graham, and Motley Fool's own Hidden Gems. Guess which has been the best performing style of investing for me?

If you picked value investing, yep, that's it. By far. I've met some rich option traders, and I think CANSLIM is excellent, and both will forever by systems I use, but for the last 4 years, every awesome gain I've had has come from simply looking for companies that make extra cash, day in/day out, year in/year out, and buy them when Wall Street loses favor with a certain industry. The premise of value investing is to buy at a bargain price, and with a margin of safety, and hold forever. In my experience, it usually doesn't take long for Wall Street to wake up to the under valuation. I've made anything from 25 - 800% gains in 6 months to 1 year per stock. Compound those kind of gains for a few years and see what happens.

But there's one other huge advantage of value investing. Did you see it in the title of this post? CAPITAL PRESERVATION. If you buy at a bargain, and try to find some additional margin of safety (i.e. lots of cash and little debt on the balance sheet is one example, or expensive barriers to entry is another, referred to as a 'moat' by Morningstar), you are protecting your downside. This is critical.

If you invest $10,000, and it drops to $5,000, you've just lost 50% on your investment. Congratulations. If you want to make the money back, you need to earn a 50%...ah!, no, you need TO MAKE A 100% GAIN on your revised starting balance of $5,000. It's much easier to make a 50% loss than a 100% gain!! For most casual investors, that will take years. For a very good investor, it may only take months, but if you're that good, think what you could have done with the money had you not lost it in the first place?

If you invest $10,000, it then goes up to $12,000, and finally goes down to $8,000, how much money did you lose?? There are several answers:

a. You haven't sold it yet. You've lost nothing.
b. You've lost $2,000, as $10,000 is your cost basis.
c. You've lost $4,000, the difference between the high and current low.

While there's no absolutely correct answer, the answer that best fits my investment systems is "c". If my stock went to $12 grand, and I didn't take profits, then watched it all disappear, I feel I've lost money. In reality, you might have a trailing stop or put option to hedge. Those have their own disadvantages, and would probably not save your whole paper gain of $2,000, but I can guarantee you that I would not be holding that stock down to $8,000 either. I've lived through all three answers, so my opinion isn't hypothetical. In pure value investing, it should be said that you WOULD hold the stock down to $8,000, and indeed hold it forever because if you've done your homework, you still know the stock is undervalued over the long term at even $12,000. Bluntly, I am trying to time the market using fundamentals and technical (charting) analysis, possibly to my peril, so I do not engage in pure value investing, in the sense of the holding period. The key here is to understand what the rules of the system you are using tell you to do. Rules are typically explained in the books, publications, websites, etc from the authors of the system.

When I look back at some old statements, and see, for example, JCP(enney) at $20/sh, or MCD(onalds) at $21/sh, and now see those today at $68 and $45 something per share, I just cringe. I lost money at the time on those trades. It's interesting to note that if I had bought and held, I'd be sitting on 200-300% gains in 3 years. Both were and are larger companies, good sales, lots of cash, but at the time were improving aspects to their businesses to make better returns, and were valued lower, all at a time when Wall Street wasn't interested. But they've had some ups and downs since then. How many people would have the patience to perservere and wait the last 3 years for those gains? But if you did, you were rewarded.

BTW, after applauding IBD and thinkorswim, I really should say that Hidden Gems has simply been fantastic. Past performance is no assurance of future, but I made back the cost of subscribing in days, and have made an overall, medium-double digit return in about 1 1/2 years. If value investing interests you, I would recommend it. No, the Gartner's aren't paying me to say this. It's just true. I still pick many value stocks on my own, but HG will also be forever part of my investing methodology too. I've noticed there seems to be a 'Hidden Gem' effect, where after identifying picks, they start to show up on the radar of analysts, IBD, etc, creating a potential fast gain, although that's not the purpose to value investing.

Summary: Do not accept large losses. The rate of return % needed to recoup a loss is larger than the % of the loss itself. You can pick whatever investment or trading method you like, but having a margin of safety, hedging, or insurance of some kind to protect your capital is crucial to success. Yes, really. Crucial. And by extension, you therefore need to take profits at some predetermined level. Every system is different. Buffet buys and holds forever, but over the years he still had to take profits sometimes (to buy a new set of loafers, cans of baked beans, all the things a billionaire from Nebraska would need). Day traders take 2 or 3% profits. CAN SLIM has 7-8% loss limits. Every system has thresholds.

Well, there's a few ideas. There are many investment systems, so hopefully I haven't cursed you into looking at too many different styles. Never confuse the rules between different systems, should you decide to use two or more like I am...that's easier to do than it sounds.

I seem to have a hard time writing short posts, and I cheated by writing about different scenarios rather than one bad trade with a eureka-moment of what I did wrong. But if I can save someone a few thousand bucks, then hopefully this was worth your time!
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