September 2021 Newsletter – Eight Common Investor Mistakes

In the book, Winning with Stocks, author Michael Thomsett lays out 8 mistakes he feels that most investors end up making and how to avoid the same. Rather than copy paste the same, I felt I shall try to explain the mistakes from my own experience. 

Mistake #1: Investing with more risk than you can afford

This is the number one account killer I have come across in my career as a stock broker. Clients overestimate their ability to take risks and end up taking way too high a risk which when things go wrong generally ends up with the account losing 100% of the capital. 

Once upon a time, exchanges in India used to follow a weekly settlement schedule. While BSE operated a settlement from Monday to Friday, it was Wednesday to Tuesday for NSE. This meant that you could buy a stock on say Wednesday and square off the same on Tuesday without making the full payment. Think of it as an extension of today’s intraday exposure brokers allow with minimum margins. 

In those days, margins were barely collected by brokers. Trust was the key. This meant that most clients were able to access pretty large exposure without putting down any real money. In regional stock exchanges, we had a way to carry forward this to the next settlement by a process called Badla and in this way, a client could carry over a position while paying off only the marked-to-market difference (if it was negative).

Given the nice brokerage (plus many brokers padded the prices in addition), both clients and brokers were happy but this meant rampant speculation and accompanied by failures – both of clients and many a time of the broker himself.

Badla is long gone but leverage has not. Derivatives have replaced Badla. While you could carry forward just 100 shares of most shares in the good old days, these days one carries a much higher quantity and one that can make or break a lot of traders’ accounts.

Leverage for most traders ends up badly. Yes, there are always the occasional winners who seem to have made much more thanks to the ability to leverage his minimal capital but out and out, it’s a losers game for most. Yet, the attraction never fades.

Mistake #2: Chasing Income but forgetting Cash Flow

At the first glance, both seem to be the same thing. Income is nothing but Cash Flow. Only when one looks at Cash Flow as negative (outflow vs inflow) does this start to make better sense.

A friend has built up an enviable portfolio of real estate assets which has not only gone up in value since his purchase but also for a long time provided him a good cash flow that took care of his other requirements. That is until Corona hit and his income evaporated. 

While there are many reasons why investors are generally fascinated with Real Estate, one big reason is the ability to generate a continuous stream of income. In many ways, this is the same attraction that drives investors to dividend yielding stocks.

Recently a question that was asked to me was the point of asset allocation. If one were able to hold onto their behavior when markets were bad, does it really make sense to have an allocation to debt with interest rates being so low.

The upside of equity combined with the recency bias of a bull market makes us forget that the risk of 100% equity is not that of equity falling but falling and then one losing one’s source of income. 

But as Warren Buffett says

“We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits”.

An allocation to debt in the asset allocation mix not just ensures a smoother equity curve but also something that can be dipped into during the bad times. Whoever said Cash is King isn’t entirely wrong.

Mistake #3: Limiting your investment horizon

What should be an ideal portfolio of assets. Should one limit oneself to Stocks or deal with Commodities, Forex not to mention Real Estate. What about Country Bias – should one restrict oneself to one’s own country or be spread across multiple countries to take benefit of both diversification of country as well as being hedged versus the Rupee.

An ideal portfolio is one that has the lowest correlation between the assets themselves. Most discussions on diversification tend to discuss how many stocks are good for being diversified. But given that most stocks have very high correlation between each other, is that really true diversification.

True diversification revolves around having assets that at best have negative correlation between themselves or at worst a low correlation. One of the reasons for the fascination with Gold for instance has been its low correlation to equities. 

Since the introduction of Gold Bees, the 200 day correlation between Gold Bees and Nifty has moved between a max of 0.87 and a min of -0.93 with average being -0.03. This year for instance, Gold has moved down by 7 odd percent while Nifty has moved up by 28 percent. 

International diversification is gaining a lot more acceptance these days thanks to the massive moves in US Equities and products launched by Indian AMC’s. While country bias is removed, this doesn’t provide true diversification since equities in India tend to move the way they move in the US. In fact, there are very few countries whose fortunes aren’t in some way linked to the performance of the US markets. What International diversification provides at best is a hedge against the Rupee.

A better diversification can be achieved by investing in Trend Following programs. Unfortunately in India, we don’t have any CTA style funds. While there are advisories that provide trade ideas based on trend following, they are very limited in nature and require constant personal interventions. 

Real Estate is a massively large diversifier and one with low correlation to equities. A right amount of Real Estate in the portfolio can work wonders during good times and bad. Debt Mutual Funds are another way to diversify. Both of these also tend to be the biggest driver of returns for most investors. 

Personally though, I believe in Charlie Munger’s idea of having everything invested in a single basket and watching the basket carefully. While this means a higher level of volatility, my belief is that if I can keep my head when things aren’t working out, when they work out it really works wonders.

Mistake #4: Overlooking the Essential Research

As investors, it’s easy to get swayed by the current trends. Buy First; Research Later is something most tend to do though once a certain asset or stock has been bought, does it even require any more research.

Research is tough. In fact, it may not be possible by investors to do the kind of research necessary owing to multiple limitations. But true research ideally starts with having a good philosophy and one I have found to be missing by a large number of investors.

Momentum is a hot product these days. Given that Portfolio Yoga runs an advisory with 2 portfolios focussed on Momentum, I get to talk to a lot of investors. It’s not really surprising to find that Momentum is new for a lot of folks which makes me wonder how the folks will behave when the trend turns around. 

Mutual Funds are bought when the strategy is reaping great rewards. When the returns start to fade, the fund manager is blamed for incompetence. How could he not see that the stocks he has bought are not Value Stocks but Value Traps was the constant refrain of one of the top fund managers in town but one who had been going through a very long period of underperformance.

Good research requires the underpinnings of a deep understanding of the philosophy. Every philosophy has its good and bad and only a keen insight into the workings allow one to develop a framework that works out in the long term. 

The thing about research though is that there is never an end to it. One can research a whole lifetime and still not be sure. The search for perfection never ends. Some compromise is always necessary.

I don’t consider myself a deep fundamental investor but when I wish to understand a company or a business, I have a checklist on things I wish to be sure upon before deciding whether it’s worth buying or not. This is not an exhaustive checklist but yet it covers a lot of ground where mistakes can be made. 

Refinement of any strategy is a continuous process. As new evidence comes along, one needs to change. We see this in other professional fields such as Medicine, Law among others. Finance is no different.  

Mistake #5: Buying and Selling at the wrong time

So much ink has been spent  on the Behavioral Gap that occurs due to investors buying at highs owing to the fear of missing out and selling at low owing to the fear of being invested and yet things hardly have changed.

In the last year, most investors I have spoken to have expressed a combination of both fears. Most want to get in and yet are afraid of what if markets decide to tank the moment they enter. Post the Covid crash, there have been umpteen analyses on how the economy may take years if not decades to recover. Markets moving higher was supposedly a trap and one which could crash any day soon. From the risk of a third wave to the Inflation risk in the US to the Evergrande mess in China, there is always something that looks scary. In hindsight, they are best a mosquito bite to an Elephant.

One of the reasons why Systematic Investing or basically Dollar Cost Averaging is gaining acceptance is because investors are finally figuring out that timing the market is exceptionally tough – not impossible but tough and in the long term, one may be better off spending the same time on other avenues than trying to time the markets.

The biggest grouse of advisors is how investors are more comfortable with respect to drawdowns in asset classes like Real Estate or Gold vs Equities. While there are several reasons that can explain this phenomenon, quickly try and remember the last time a non business newspaper had a headline – Investors lose 10 Lakh Crores as the Real Estate Market tumbles overnight. Never.

The biggest advantage of stock markets is the ability to instantly liquidate one’s assets and convert it to cash. Yet this advantage turns into a very big disadvantage since it allows one to make decisions based on the mood of the day without delving too deep. 

In most other fields, mistakes are eliminated by experience. In the stock markets, experience counts for zilch as even those with long experience may get swamped by fear and decide to cut one’s losses at the worst possible time.

Stanley Druckenmiller’s quote from his experience in the dot com bubble is worth a mention,

“I bought $6 billion worth of tech stocks, and in six weeks I had lost $3 billion in that one play. You asked me what I learned. I didn’t learn anything. I already knew that I wasn’t supposed to do that. I was just an emotional basket case and I couldn’t help myself. So maybe I learned not to do it again, but I already knew that.”

Of all the crashes one has observed or read about in history, the Corona crash and the rise has been the fastest. Yet, it has impacted different investors in different ways. While the new age investors seem not to be bothered with either the speed of the rise and the valuations, the old investor has been skeptical and more the rise, more skeptical he has become. The opportunity cost to such investors has been enormous.

As much as buying when markets are crashing and valuations are low is appealing in theory, execution is way harder for most including professionals. Every crash has been different. The Corona Crash for example was the fastest crash we had ever come across with analysts painting an even gloomier picture. The best investors were those who were able to stay put, very few could add significantly to their exposure during these times. Sometimes, just doing nothing as the 5 Star Advertisement says works out well.

Mistake #6: Assuming the Entry Price is the Starting Point

In behavioral economics, this is explained by a bias called Anchor Bias. When an investor buys a stock and the stock crashes, he promises himself that the moment the stock comes back to his buying price, he is getting out. This even though in the larger scheme of things, the entry price has nothing to do with whether to hold or sell. 

One of the biggest advantages of moving to a quantitative strategy is its ability to not be too bothered with the Entry / Exit Prices. This has a very huge implication since it overcomes our inability to sell a stock that is lower than where we got in while also willing to buy a stock way above where we once had sold.

An Example: In my personal Momentum Portfolio I entered Abbott India in July 2018 and exited more or less for the same price in April 2019. The stock once again came up as a Buy in July 2019 but by which time it had moved nearly 2000 rupees higher. Ignoring this stock for the single reason that I had sold it at a much lower rate would have cost me dear. 

Regardless of whether it’s a stock or a real estate investment or even Gold, it’s tough to forget our Buy Price and any and every decision taken with respect to that asset generally starts with the buy price. 

Owing to Corona, there has been a surplus in houses available for rent. The same anchor bias prevents a lot of landlords from giving the houses at the new prices which may be lower than what the previous tenant had paid. There are landlords who have kept their houses empty for a year rather than give it out for a slightly lower amount. 

Averaging higher is also problematic when one focuses on the entry price. Should I buy the stock that has gone up 50% stops additional investment which if the original thesis is still true should not really matter. 

This is also a question I face with investors who wish to enter the portfolio at the current juncture. Since the portfolio is up X%, is it advisable to buy now or wait for a correction. What about the stock which has gone up 300% since it was introduced, should I buy or not? Most of these questions to be honest have no right answer but have their roots in our fascination for the entry price.

When it comes to prices, sometimes Ignorance is Bliss. 

Mistake #7: Believing High Price Stocks are always Expensive

A disclosure: Portfolio yoga has a portfolio that is composed of High Priced Stocks. 

Higher the price, more forsaken the stock tends to be when it comes to an investors portfolio. A high price NAV of a Mutual Fund is a tougher sell vs a new fund offer even though NAV has nothing to do with future returns.

Most investors when given a choice between a high nominal price stock vs a low nominal price stock will invariably choose a low priced stock. Of course a higher price doesn’t have to mean a lower risk either. In the financial crisis crash, MRF which then as its today commands the highest nominal share price fell by an astonishing 84% from the peak. 

But does a high share price mean anything? Warren Buffett has this to say on why he won’t split the stock (Berkshire Hathaway) 

“Were we to split the stock [writes Buffett] or take other actions focusing on stock price rather than business value, we would attract an entering class of buyers inferior to the existing class of sellers. Would a potential one-share purchaser be better off if we split 100 for 1 so he could buy 100 shares? Those who think so and who would buy the stock because of the split or in anticipation of one would definitely downgrade the quality of our present shareholder group.” 

While Splits and Bonus are good as a form of publicity, they add nothing to the bottom line of the company. Infosys would have been as good as it is today even if they had not given out a single share in Bonus or split the shares. Underlying business and valuations are what matters more than the nominal price.  

If one is building a portfolio for “Rip Van Winkle”, I would have much greater confidence buying a set of stocks with very high nominal stock price vs any other portfolio chosen by any other method. A management that doesn’t go for gimmicks in my books has a lot more integrity than one that does.

Mistake #8: Worrying too much and being Impatient

The cardinal sin most of us end up making. We worry too much and this ain’t even limited to the stock market. I was impatient once and I have learnt (or have I, I do wonder some days) the lessons that are worth a lifetime. 

When I talk to prospective clients, I always mention that the first year will be the toughest. This is because when one is starting off fresh, he has no cushion of profits to take the blow if the market starts to trend down and the portfolio ends up losing money. From year two, this risk reduces though one could still end up being negative at the end of the 2nd year though the risk is low. Only by year 5 can you be pretty sure that there will be a very low percentage of risk that one is underwater after that count of time. 

Five years is a very long time and not easy to digest if things don’t work out. Patience can be really tested and crack even the best of investors. 

Patience in investing is sometimes confused with being patient with a bad investment in the hope that one will finally see a return to the golden age. Patience in bad stocks rarely gets rewarded. 

We all learn from mistakes. But this is only true if we take the right lessons. For me, learning is what has fascinated me for long and continues to help me build a framework with respect to not just investing but other aspects of life as well.