6 Dumbest Things New Stock Investors Do
You Don't Have to Be a Genius to Make Money From Investments
Self-made billionaire and Berkshire Hathaway Vice Chairman Charles Munger is fond of saying that the key to making a lot of money in investing is being "consistently not dumb". It's harder than it sounds, with even the most brilliant of men and women succumbing behaviors that work against their long-term goals.
But by spotting these dumb behaviors, we can best avoid them in the future, protecting ourselves and our families from financial heartache brought on by mismanagement.
1. Dumb Investors Buy Stock on Margin
When you buy stock on margin, you borrow money from your stockbroker to cover the purchase price. The broker charges you interest and has the right to force you to come up with more collateral (or even pay off the entire margin debt balance) at a moment's notice. In fact, the broker can go so far as to liquidate your entire account to pay off the margin debt without giving you any warning at all; not even the opportunity to come up with additional funds. When disaster strikes—and it always strikes, whether it's a flash crash or a terrorist attack—you can find your entire equity wiped out in no time. Even worse, any remaining unpaid balance is a personal debt that you need to repay unless you want to get hauled into bankruptcy court.
2. Dumb Investors Buy Stock Without Reading the 10-K
With very few exceptions, if you haven't bothered to research a company enough to go through the 10-K, analyzing the income statement and balance sheet (among other disclosures), you have no business investing in stocks directly. Throw in the towel, buy a low-cost index fund, and be happy. You're putting yourself at a tremendous disadvantage if you think you can get away with this sort of laziness indefinitely because stocks are worth no more and no less than the underlying intrinsic value of the cash flows themselves. The market value will always come to reflect that eventually. It's the entire premise of modern economics and finance. It's been borne out by the experience of many generations over the past few centuries.
3. Dumb Investors Trade Too Often and Pay For It
Study after study has been done on the returns generated by average investors. The more they trade, the worse they do. The rich, in contrast, hardly ever sell anything. They buy great assets, at good prices, and then proceed to sit on their proverbial behind for 10, 20, 50+ years, passing down shares of incredible enterprises like Coca-Cola or Hershey to their children and grandchildren so they, in turn, can enjoy the stream of dividends. This allows the affluent to avoid frictional expenses; to build up huge deferred tax liabilities, which work to their advantage; to have those deferred taxes forgiven at the time of death by using the stepped-up basis loophole.
4. Dumb Investors Get Caught Up in Fear and Greed
Billionaire investor Warren Buffett has oft remarked that the stock market is a constant battle between excesses of fear and greed. It's crazy to see how irrational panic--or its inverse, unrestrained avarice--can cause otherwise decent people to do nutty things. This is not an intelligent way to live. Above all, remain rational when it comes to your investment portfolio. It's your strongest line of defense.
5. Dumb Investors Trade Derivatives They Don't Understand
It never ceases to amaze me that new investors, who haven't so much as owned shares of stock for five minutes, write my inbox boasting about how they are dabbling in derivatives such as stock options. It's completely inappropriate in most cases and will more often than not end in failure. While there are certain techniques that can lower risk and improve results—writing put options from time to time to get paid to buy a stock you would have otherwise purchased, anyway, is one of my personal favorites—it's much easier to buy ownership in fantastic enterprises, collect an ever-growing stream of dividends each year, and stop trying to be so clever. You can go broke that way.
6. Dumb Investors Buy Things They Don't Understand
If you can't explain how an asset makes money—the actual, underlying operation—to a reasonably intelligent 2nd grader in under 10 seconds, you have no business risking your hard-earned wealth. If you can't understand the strategy outlined in a mutual fund prospectus, you have no business investing. This should be common sense. Never forget that the most valuable word in your vocabulary is, "No". Do not be afraid to use it. It's better to walk away from a future Microsoft, and still end up financially independent than it is to walk into an Enron or Lehman Brothers.