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"The Mistakes Investors Often Make, Part 3"

By Arne Alsin
Special to RealMoney.com
06/26/2003 10:00 AM EDT

"Many people are out of balance in their investing. Some repeatedly make the same mistakes without learning from them, while others are busy trying out new mistakes because they're always switching investment strategies.

Whether or not you make mistakes isn't the issue here -- we all do. In this three-part series, I've simply tried to identify a few of the more common, avoidable investor mistakes. Here's the final installment.


. Investors underestimate the short-term risk of stocks. Most individual investors aren't sufficiently prepared to handle wide price fluctuations after they take a stock position. The average fluctuation in publicly traded stocks exceeds 50% per year. Investors want the high long-term returns of equities (which are, by the way, double the long-term returns of bonds), but they want those returns without the volatility.

Rather than panicking about short-term fluctuations in stock quotes, make volatility your friend. I recently doubled up on three different stocks that had declined from my purchase price in The Turnaround Report Portfolio. In retrospect, I paid a reasonable price for each in my original purchase -- not a great price and certainly not the lowest price -- but a reasonable price. And then I made volatility my friend. My "double-up" positions are up more than 25% on average after only a couple of months.


. Investors overestimate the long-term risk of stocks. While many people panic over short-term stock-price fluctuations, they also overestimate the long-term risk of stocks. Rolling 25-year returns in equities are positive, without exception. Here's all you need to know: Companies are, by definition, profitable, or they won't continue as going concerns. Over a period of years, capital wealth accumulates, increasing business values. So even if you buy high, that doesn't mean that your capital, if invested for the long haul, carries a significant risk of loss.


Unfortunately, while short-term risk should be nearly irrelevant to investors, it commands a disproportionate amount of their attention. Although long-term risk is the most important consideration to capital allocation, investors give it the least amount of attention. As I mentioned in a column many months ago:


"A lot of intellectual capital is being expended parsing the details of the market collapse and attempting to gauge near-term market direction. That energy might be better applied to fundamental analysis of individual companies, looking for undervalued stocks that have a wide margin of safety."

. Investors overestimate their ability to allocate capital. Because the majority of investors are part-timers, they need to realize that, without any help, advice or counsel, the likelihood of long-term outperformance is infinitesimally small. There are too many smart professionals who devote 70 hours a week to the same effort, and many of them are equipped with skill sets that most investors don't have, such as the ability to understand and decipher financial statements.

The competition is keen. Deciding whether to buy shares of Home Depot (HD:NYSE - news - commentary - research - analysis) based on the cleanliness of the store's aisles or the quality of service just doesn't cut it in this ultracompetitive environment. Even the pros actively seek help and advice on a regular basis.


. Investors underestimate the power of thinking outside the box. The natural human tendency -- it's comfortable, after all -- is to go with the flow, to be part of a crowd. Unfortunately, that's a recipe for mediocrity on Wall Street. The consensus will always be average. I track, for example, whether I agree or disagree with analysts on specific stocks that I own. I've found that, generally, the greater the disagreement, the higher the likelihood of my success.

As a kid, I remember going with the crowd to the "nice" neighborhood at Halloween -- the one full of larger homes -- in the hopes that I'd hoist a big take for my effort. I was surprised at how little candy I got compared to the out-of-the-way houses, the ones with the long driveways, at the top of a steep hill or hidden behind a grove of trees. At the time, I didn't understand the reason for the variance in my Halloween bag's rate of return. I'm glad I understand now. "

(in www.realmoney.com)

"The Mistakes Investors Often Make, Part 2"

By Arne Alsin
Special to RealMoney.com
06/24/2003 09:56 AM EDT

"Success in the stock market belongs to the rational, disciplined investor who understands a simple credo: He who makes the fewest mistakes wins.
Here's the second part of my three-part series on common investor mistakes. As I mentioned in Part 1 last week, investors have made mistakes in spades in recent years, much of it due to an unusually robust bull market followed by a historic bear market.

The art of investing requires managing multiple variables. Below, I discuss mistakes in relative terms, such as over- or under-emphasizing certain variables, not in absolute terms, such as do's and don'ts.


. Investors overestimate the accuracy of market prices. The market's pricing mechanism is not wrong all of the time, but it's much less accurate than investors think. For example, the market now gives you the opportunity to buy IBM at $83 per share, but that's not because IBM's underlying business value is $83 per share. The purpose of the market is to provide liquidity, not to render accurate appraisals of businesses.

So it's up to investors, as allocators of capital, to determine the variance between the market price and the underlying business value. For example, back in March, I highlighted A.G. Edwards in my newsletter, and it's up by about 35% since. Has the company changed sufficiently in just three months to justify such a large change in value? Of course not. Either I was right (the business was very undervalued), or I was wrong (and the stock will drop, in time, to reflect the true value).

Most of the companies that I own are multibillion-dollar lumbering giants. Their real value changes very little in the short term -- a tiny fraction when compared with the market-price change. It's an inevitable consequence of having a cash/no contingencies/three-day-settlement marketplace: wide price swings that often bear little relation to the underlying asset value.

. Investors overestimate the correlation between stocks and the economy. Another common mistake is that investors often expect the markets to move in lockstep with the economy. When the market fell precipitously in 1990 and 2000, the moves were not coincident with declines in the economy. In both cases, the economy suffered many months later, not in concert with the market. And when the market began a huge rally in 1990, the economy remained in the doldrums for many months, with the unemployment rate continuing to rise until well into 1991.

. Investors overestimate their rationality. Most investors think that they're rational, but the opposite is true, particularly in the heat of the battle. When the market is moving fast and furiously in either direction, most investors are irrational. Fast-moving markets breed emotion, not rationality. Here's what I wrote in a prior column:

"When an investor is emotional, he or she tends to trust instincts (e.g., self-preservation, survival) and intuition (e.g., 'I have a feeling this will get worse') rather than engaging cold, calculating logic (e.g., 'This bear market is part of a cycle, and it will end') and rationality (e.g., 'This is a poor time to sell discounted assets')."

Also, investors don't always rationally recognize that when prices go down, their emotive reaction -- fear -- amplifies their perception of risk. That's misguided. In fact, when prices decline, risk declines, because assets are cheaper. When prices rise, the emotive reaction -- enthusiasm -- is also misplaced. When prices go up, risk goes up, because assets are more expensive.


. Investors underestimate the yield curve. Forget about finding a magical, infallible stock market indicator; it doesn't exist. But a simple look at the yield curve -- the spread between long- and short-term rates -- can aid your allocation of capital. Too many investors ignore it, so you'll be better served by sliding the yield-curve variable toward the emphasizing end of your investing continuum.

I stumbled on an old Federal Reserve chart covering the '50s through the '70s. A flatter curve presaged every economic downturn -- in 1953, 1957, 1960, 1969 and 1973 -- and a steeper curve preceded the expansion that followed in each case. As I mentioned, an infallible indicator doesn't exist, but this is one weapon that should be in every investor's arsenal.

Look for Part 3 of this series on Thursday. "

(in www.realmoney.com)

Deixo aqui uma série de três artigos de Arne Alsin sobre os erros mais comuns dos investidores. Vou colocar as três partes em posts separados, dos quais destaco a segunda parte, sendo a primeira um bocadinho maçadora.

Ulisses

"The Mistakes Investors Often Make, Part 1"

By Arne Alsin
Special to RealMoney.com
06/19/2003 11:00 AM EDT

"If you want to be a great investor, you have to avoid the big mistakes. ... Capital is too dear and too difficult to acquire in the first place to needlessly squander it because of avoidable mistakes."
I wrote that in a RealMoney column about a year-and-a-half ago. Maybe it's because we've had a once-in-a-generation bull market followed by a once-in-a-generation bear market, but it seems to me that investors have made mistakes in spades in recent years.

Don't underestimate the impact of mistakes. The stakes are high. Slice 5% from your rate of return each year because of mistakes, and if you do the math, you'll be staggered by the long-term implications to the growth of your capital. You can't eliminate mistakes, but by being aware of some of the more common errors, perhaps you can limit your exposure.

In this three-part series, I'll review my list of common investor mistakes. It's not a comprehensive list -- it's not even close to the definitive list. It's just my list, from my perch as a money manager, a writer and an observer of investors.

One of the mental constructs I use in my approach to the markets is to think in terms of continuums. Axioms that are absolute and fixed, like "do"s and "don't"s, are much less useful to me than learning which variables to emphasize or de-emphasize. So, below, each of my investor mistakes uses the continuum construct.


. Investors overemphasize linearity. Most people are comfortable thinking in straight lines, taking today's good news, for example, of 15% earnings growth for a company, and extrapolating it into the distant future. Business doesn't work that way. As much as investors want to paint a linear future for a company, it almost never happens.

For instance, Cardinal Health has a long history of double-digit earnings gains. But to look at this company in linear terms is a big mistake. The story for this medical-products distributor may not be obvious: Among other things, there's market saturation, fewer acquisition opportunities, the emergence of competitive margin pressures, a change in accounting (from pooling to purchase accounting) and a thin-margin business model (a two-edged sword, margin compression translates into disaster).

Avoiding the mistake of overemphasizing linearity -- investing on the assumption of continued good fortune -- serves to protect the investor. The likelihood of Cardinal replicating the past 10 years is virtually nil.

Companies have tried to placate investors' desire for linearity by artificially "managing" earnings. It's gotten so bad in recent years that I'm not disappointed when the companies in which I own shares miss guidance by a wide margin because at least I know they're real. For example, one of my holdings, H&R Block, recently missed expectations by a few cents. The opposite is also true -- I get nervous about just how "real" earnings are when one of my companies hits expectations on the button.


. Investors underemphasize cyclicality. The very stuff of business is cyclical. Would you like your company to meet your earnings expectations every quarter? Get ready for disappointment.

The natural life cycle of a business is a never-ending series of bad news and good news. The prudent investor, though, regards a spate of bad news as an opportunity. I wrote a positive column on Home Depot last October when it was in the throes of a bad news cycle -- making the case that it was a better value than Lowe's. The news cycle has begun to turn, with the return of Home Depot stock threefold the return of Lowe's since then.

. Investors underestimate their time horizon. I'm continually amazed by how much the average investor underestimates his or her investment time horizon -- usually by a wide margin. I've talked to 30-somethings in a panic over short-term market fluctuations when they're investing for retirement!

I've heard from many retirees in recent months who have sold all of their equities in favor of fixed income, annuities and CDs. I talked to one person two years away from retirement who has a 5% equity allocation. This person has a 33% allocation to a money market account.

The long-term data for equities are clear: Rolling 25-year returns are always positive. That's because companies, in the aggregate, are profitable -- or they won't last as businesses. The capital base gradually builds over a period of years, notwithstanding market price fluctuations, meaning the long-term trend for business values will always be on the upswing.

McDonald's makes a profit every day. I have no idea what the price quote will be for McDonald's next month, next quarter or next year. I do know that it will be much more valuable, though, 10 years from now, if it continues to be profitable every day.

Even if you're 65 years old, your time horizon should perhaps be 25 years or more. The allocation out of stocks should be a gradual process for retirees, a gradual scaling-back -- it shouldn't be a wholesale, irrational "all or nothing" market-timed decision.

More on these matters in Part 2 next week. "

(in www.realmoney.com)