Sunday, September 20, 2009

Investing is personal; investments are scientific: 5 mistakes and how to avoid them

Investing is personal—and don’t ever forget it. However scientific your approach to evaluating risk and return, the ultimate decision is a personal one and the results of your investment will have a great deal to do with how well you know yourself. Here are five common personal mistakes to avoid in investing:

Popularity: If an investment idea is popular, it is only natural to want to be a part of it. If it is truly popular, you can be pretty sure it’s overpriced. Market tops are always defined by what is the most popular investment. Think Real Estate in 2007, think internet stocks in 1999. One of my favorite indicators for measuring the most popular industry (and thus a place not to invest) is the most popular job for newly minted MBAs. In 2006 it was Private Equity, in 1999 it was Venture Capital, and so on. It is part of human nature to align with what is popular, and so many of our investment mistakes stem from that

Horizon and Liability Mismatch: John Maynard Keynes said it best: “In the long run, we are all dead.” So many people will say they are in for the long run but they really are not. They are in for the long run as long as the values don’t go down too much, or until they have something else they would rather spend their money on. It is essential to match your horizon to the predictability of the environment you face. Fund your liabilities within that horizon. You may outlive your assets if you expect too much from them. It works both ways—it is easy to be too liquid or too illiquid, and managing the balance is a PERSONAL choice.

Momentum (Greater Fool Theory): People always expect that someone else will always be there to buy what they are holding, thus the crash of 2008 could never happen. Or worse, they expect there will always be debt capacity to carry the investment. 2008 happened, and it happened for all of the reasons mentioned in this post.

Rich means Smart: The New Yorker had a great editorial years ago: “If you’re so smart, why aren’t you rich?” Rich does not mean smart nor does smart mean rich. Some of the greatest success stories of all time die broke—and how many wealthy college professors do you know? Many people like to invest in deals where Mr. Big is leading the charge: ”If he has his money in the deal, it must be good.” Nothing could be further from the truth. Often Mr. Big does have good investments, but his risk profile and appetite may be entirely different than yours and if so, it may cost you dearly.

Strategy Stew:
Averaging Down - how to take a failed fundamental strategy and turn it into a technical “bounce” strategy.
Missing the Boat - diving into a deal without enough due diligence to justify the investment because you are afraid you will miss out on “the deal of a lifetime.” Also calls out a potential horizon/liability mismatch.
High Risk = High Reward - not really, if an investment is very well thought out, the reward comes from recognizing there is much lower risk than the popular uninformed view, which should mean ultra smart low risk = high reward.

I hope you find this helpful!

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