Via Negativa

“All I want to know is where I’m going to die, so I’ll never go there” - Charlie Munger

While a lot of readers may think about what they should do to be a successful investor, it is often helpful to also think about what not to do. Loss aversion is a more important focus as a value investor than chasing return and avoiding mistakes can be a key driver of successful long term compounding. Avoid the losers and the winners will take care of themselves.

In this post I will walk through some of the most common investing mistakes that we have observed and explore the incorrect thinking and psychological biases behind them. 

1. Taking on Leverage

As always, I will take this opportunity to caution investors on the use of leverage when investing. Particularly in highly volatile assets like Sri Lankan Equities. Especially when others are also leveraged creating the risk of a daisy chain of margin calls. An unleveraged investor has unlimited holding power and can weather any storm. This is a huge advantage.

One of the most important rules of investing is to never be a forced buyer or seller. (The inverse: Try to buy from forced sellers and sell to forced buyers is also a good rule of thumb). Leverage makes you a forced seller at the worst possible time - when stocks are cheap. More about how we think about leverage can be found here.

2. Short Term Thinking

Time in the market beats timing the market. Markets have become faster, noisier and more short term than ever. Constant news updates (in a particularly fast changing world) create a need for action and desire for results.  Investor impatience comes in many forms.

Many invest seeking immediate near term gains often within weeks or months. When these gains do not materialise, they switch investments or exit the market. Such investors also have little tolerance for short term losses, and quickly exit investments at a loss instead of holding on. This short termism is a common symptom of investors who lack conviction in their thesis, and are searching for a quick and easy buck.

The other form of short-termism is related to the obsessive focus on near term high frequency data points (quarterly earnings, monthly GDP data and so on). Investors can often over focus on these near term data points and miss the bigger picture. 

Selling a wonderful business just because the price has been stagnant for a few months, or they had a weak quarterly earnings report is rarely the right thing to do. Investing is a long game and patience and a long term investment horizon are an easy way to outperform others.

3. Investing With Money Earmarked for Other Uses

We often come across participants who have a temporary cash windfall that they chose to put into the market. For instance after selling a property or vehicle prior to buying their next property or vehicle. These investors usually have a very short time horizon, often measured in weeks or months, and have limited control over when they enter and exit the market.

In the near term the market is unpredictable. Hence putting funds in the stock market that you will need to pull out in a short period of time is not investing, it is gambling. Our general view is one needs to be comfortable locking up the funds for at least five years, but ideally much longer. Funds earmarked for near term expenses (such as holidays or education), or emergency funds should not be in the market but in places they are safe and liquid. Bank deposits are ideal. 

4. Buying Dips (Just Because They Are Dips)

Some investors often buy shares that have fallen sharply, in anticipation of a near term reversal. This is a common misconception in value investing. While the goal is to buy cheap shares, a stock that has fallen in price is not necessarily cheap. The company may have been massively overvalued and just started correcting, or it may be a business in perpetual decline. Either way, regardless of how far a share has fallen, there may be further losses ahead.

Shares which have dropped in price are often a fertile hunting ground for investment opportunities, but the investment decision should be based on the merits of the business and the gap between market price and fair value, not just because the share price has dipped.

5. Waiting to Break Even

Making mistakes as an investor is common. If we are right more than 70% of the time, we would consider it a good result. The key to successful portfolio management is managing these mistakes. Hence, when your investment thesis is disproven, a rapid exit of a position is key.

However, investors often hold on to investments that have lost money, waiting for them to return to their breakeven point prior to selling. We think this is a highly flawed way of thinking for several reasons.

Firstly, the future price of a share has nothing to do with your entry point. There is absolutely no guarantee that the share will ever return to where you bought it. It may bleed all the way to zero, or it may stagnate at a low price for decades.

Second, there is a significant opportunity cost in being invested in an unattractive security. As you wait for the share to recover (if it ever does), the other investments in your portfolio may be performing very well and the funds could have been invested in those.

Third, several other investors may have invested based on the same thesis as you. If the thesis is disproven, their selling will move the price lower. It is thus best to be the first out. 

An even more dangerous version of this is the concept of “averaging down” where an investor puts new funds in to buy even more of a share as it drops, to lower their average purchase price.

If, upon a close review of the investment, the investor is sure his thesis still holds, and the opportunity is now even more attractive, it is reasonable to buy more of a share. However this should never be done just because the share price has dropped. A falling share price is a warning signal that you might be wrong, and such warnings should be treated with respect.  

Fighting one’s ego to accept mistakes and sell an investment at a loss is painful. It requires significant discipline to do so and is a key differentiating factor for great investors. 

6. Selling to Realise a Profit. 

As a corollary to the above, investors often sell a share to realise a profit, missing out on significant future gains in the process. While it may seem great to sell a share after realising a 20% gain in a few months, several shares in the CSE have returned over 200% over the last two years. Selling early would have led to a significant opportunity cost in missed gains. 

Selling to realise a profit is another example of a trading decision made based purely on price, instead of a more holistic look at the share to determine risk adjusted reward. 

How much of a gain or loss you have made is irrelevant to the decision on whether to buy, hold or sell a share. The only criteria for this decision is the anticipated risk adjusted return, and how that compares to other opportunities in the market. If a share has a lower anticipated return than other opportunities of similar risk in the market, it should be sold for those. Regardless of whether the investor is realising a profit or a loss. 

7. Following the Herd

The market often disproportionately focuses on a few “darling” stocks with some topical news. These shares often see sudden surges in trading volume and often have rapidly rising share prices. They also often become the talk of the town, with everyone at the dinner party having an opinion on this new paradigm. The fear of missing out leads to investors following the crowd into these shares, without doing sufficient due diligence of their own. Often if everyone is talking about it, and the price has already risen sharply, it is probably too late and investors who follow the crowd are left holding the bag as the bubble deflates. 

In order to outperform, an investor, through his independent research, must have a conviction that the share is worth more than what the market is pricing it at. This is a high bar, set even higher for the hot stocks that the herd is chasing, which will thus be pricing in very optimistic scenarios already. We treat high herd optimism in our holdings to be a warning signal that such securities may be overvalued, and hence require closer monitoring for an exit. 

Opportunity lies in the unloved, the ignored and the misunderstood. The market tends to price in less rosy outcomes for such securities, creating the opportunity for the diligent investor to find the diamonds in the rough.

8. Not Doing the Work

Investing is a competitive field with talented and well resourced investors competing with you to find the limited opportunities available for attractive returns. Hence it is not easy. Due diligence takes time and effort. Investors often attempt to shortcut the process with superficial analysis of the available information or by relying on what others tell them to do. 

Such investors are relying more on luck than effort, and hence will have worse outcomes on average. The ability to outperform via superior due diligence is even higher in markets like Sri Lanka where a lack of sophistication means that readily available information is not always well priced in by the market, creating opportunities for diligent investors. If fewer people are doing the work, the reward is higher for them.

Investors who lack the time or knowledge to research investments in depth are better off investing in unit trusts where a fund manager will do it for them.

9. Focusing on Macro Over Micro

Many investors obsess over interest rates, inflation or geopolitical tension, and then ignore the fundamental shifts in the businesses they own. While the business cycle is an important driver of near term business performance and returns, a high quality business with competent management will be able to adapt to macroeconomic shocks and perform well over the long term. 

This is well illustrated by Sri Lanka in the last few years. We have weathered multiple economic shocks, starting with terror attacks, Covid, and finally an unprecedented economic shock. Yet many quality business are reporting record earnings with their share prices at all time highs. Anyone who panic sold due to these crisis would have missed out on extraordinary gains. 

Investors should carefully reconsider their investment thesis in the face of new macro information, but they should be mindful not to overtrade. 

10. Getting Diversification Wrong

Diversification is another complex subject for an investor, probably warranting its own blog post. Regardless of how convicted one is, an investor should never put all his eggs in a few stocks. Black swans and fraud risk mean it is key to have a diversified portfolio so that a few strikes of bad luck do not take you out of the game.

At the same time, overdiversification is also a common mistake. Your three highest conviction ideas will probably generate a better return than  your 50th top pick. Hence allocating capital to 50 shares will dilute your possible returns, for a negligible improvement in risk. 

It is also important to be invested in businesses that are uncorrelated with each other. For instance a portfolio of 20 banking and finance companies is actually not very diversified. 

How diversified one’s portfolio should be depends on multiple factors, including time horizon and risk appetite. We feel the ideal portfolio for us is around five to ten uncorrelated investments, with a minimum size of 5% and a maximum of 20% of our portfolio. There is no right answer for this, but there are plenty of wrong answers. 100 shares, with 1% each is too diversified. 2 shares with 50% each is not diversified enough. 

The Cardinal Sins of Investing

It is noteworthy that these mistakes often have very common underlying causes:

1. Placing oneself in a position where you end up as a forced buyer or seller.

2. Basing the decision on the price behaviour of a share, not the gap between price and value.

3. Basing the decision on what others say or do, instead of your own independent analysis.

4. Making decisions that placate your ego.

Avoid these cardinal sins and you will be indirectly avoiding several other mistakes not covered in this post. 

So What Should an Investor Do?

In theory, investing is simple: buy shares in well managed companies you understand well, at attractive valuations significantly above the market price, which justify the risk incurred. Re-evaluate these regularly to be sure that your investment thesis (i.e: Why the business is attractive, its future outlook, and valuation upside to price) holds. If the thesis no longer holds, sell immediately. Rinse and repeat, searching for five to ten attractive opportunities. Have a long term horizon and do not get disturbed by short term noise. 

In practice this is extremely difficult. The psychological pressures of taking a loss, having significant personal funds showing large swings in profit and loss, and dealing with complexity and uncertainty can be tough to manage. If you do not have the time, patience and psychological makeup to deal with these pressures, we absolutely recommend letting a professional manage your savings.