Maybe I’m lucky.
Or maybe it’s just common sense.
I’ve been involved in the investment advisory business for thirty years. And except for a few early mistakes buying real estate, the big financial hoaxes and bubbles that devastated so many investors never burned me.
That made a huge difference over time. It allowed me to grow my net worth year after year without a single year of loss. In this essay, I want to identify several lessons I learned, and how to avoid the biggest mistakes average investors make.
The financial life of the typical investor is marked by a plethora of hopeful speculations. Only a few dozen, at best, achieve their promise. My investment history is less exciting but more profitable. I get into trends only after they are proven, I get out as soon as they don’t make sense, and I turn my back on nine out of ten opportunities that come my way.
In the 1980s, I worked for a publishing company that produced, among dozens of other financial publications, two publications that promoted penny stocks. Penny stocks were the rage back then. The financial press was full of stories about investors who got rich by buying little-known companies at fifty cents a share. My boss invested in one and tried to convince me to do the same. I was tempted. But something inside of me told me to let this bus pass me by.
I’m glad I did. My boss, a very savvy investor, lost 100% of his money on that deal. It turned out to be a scam. I remember thinking that if a sophisticated investor can be fooled by one of these cheap stock deals, I’d stand no chance.
Five or six years later, technology companies were hot. Again, the press was filled with exciting stories about all these great little companies going public. The technology sector was bigger and more legitimate than the penny stock market. And that turned out to be a problem. The success of early investors led to millions of ordinary people climbing on board. And many of them were making big profits. I remember my brother-in-law coming over on weekends and telling me, over a beer, how much money he was making.
Again, I was tempted. When you see people–people who know next-to-nothing about business–making profits month after month, you think, “Hell, if they can do that then so can I!”
I remember one deal that my brother-in-law recommended. It was a company that had a “patented” method of expanding some gizmo related to computer memory. He showed me the newsletter story about it. It explained how every major computer manufacturer in the world would soon use this new technology. It hinted that a “major deal” was pending with one of them.
I asked my personal assistant to get me the prospectus. And although I was a novice at reading them, I could tell right away that it was hardly a sure thing. Other than the president, whom they appeared to have recruited as a figurehead (and who had only a small stake in the business), the rest of company’s honchos were brokers and dealmakers, not proven entrepreneurs. The “use of proceeds” was actually scary. There was too much money allocated for offices, employee salaries, and “consulting fees.” What I wanted to find was a believable marketing plan–something to make me believe they knew how to sell their product at a profit. If you have had any experience in buying businesses, then you know one thing: a start-up business must devote 80% of its resources to creating the first profitable sale. That means it must be frugal with office expenses, salaries, and other non-essential start-up costs.
This company clearly had another plan. It was to make and spend a lot of the funding on everything but investing. I didn’t need to know more than that. I decided not to invest and warned my brother-in-law to sell his shares. I don’t think he did, because when the company went bust six months later, he never said anything to me. Investors love to brag about their winners, but they keep their losers hidden in the closets of their minds.
Flash forward another five or six years. My brother-in-law was back again with exciting new stories about making money from the internet boom. Again, he told me amazing stories. And again, I looked into a few of them, hoping to find something I could believe in. But the prospectuses for these dot-com companies were just as fishy as the high-tech offerings I had seen earlier. No, they were worse. The valuations were based on a method of selling that had never existed before: advertising fees based on “eye balls.”
Do you remember that?
Forgive my skepticism, but I can’t get myself to put my money down on business ideas with selling strategies that have never worked for anyone. The idea that you could invest billions of dollars attracting people to websites and then profit by selling ads in those websites seemed positively bizarre to me.
As it turned out, most of the investors in the internet boom fared no better than investors in the high-tech frenzy. There were some exceptions, but they were few and far between. My skepticism may have blinded me from a few good opportunities, but it prevented me from losing big money on hundreds of deals that went bust.
And then finally, five or six years later, we were in a real-estate bubble. By that time, I had been investing in real estate for more than ten years. I knew the game. I had made a lot of money.
But by 2006, the houses I had been buying were selling for twenty times their yearly rentals. (A single-family house that could fetch $15,000 in a yearly rental was selling for $300,000-plus.) I knew it was time to get out. I stopped buying and advised my friends to do the same. They thought I was crazy. I’m sure they wish they had listened to me now.
I don’t want you to think that I kept my money in the mattress during these bubbles. In fact, I made millions by investing in private companies that I could understand and control. I got in when the economics were good. And I got out the moment they were bad.
I’m telling you these stories not to brag, but to illustrate an important point: you don’t have to be a sophisticated investor to avoid making big investment mistakes. You can do so by applying a little bit of common sense.
Looking back on these experiences, I can see now that the biggest mistakes most investors make are simple ones–ones that any person with a modest amount of business experience should be able to avoid.
What follows is a list of the five biggest mistakes most ordinary investors make:
Mistake #1: Being swept away by exciting stories.
The business my boss got suckered into had an amazing story. A company in Central America was turning beach sand into gold. The company had “proof” of their success in the form of audited financial statements, geologist reports, and endorsements from investment experts. My partner even went down and saw the operation. He saw the sand going in and the gold dust coming out.
I didn’t invest because the story sounded so fantastic. I remember telling him, “This sounds like alchemy.” I didn’t know anything about geology or gold, but I didn’t need to. The story itself was just too crazy. When I hear stories like that nowadays, I am totally turned off. One part of my brain might get excited, but the smarter part tells me, “Stay clear!”
Mistake #2: Investing in businesses you don’t understand.
My boss was a sophisticated investor. He had his own seat on the stock exchange when he was in his twenties and had been successfully investing since that time. But he knew nothing about gold mining. Nothing at all. His ignorance allowed him to be duped by the reports and by the fraudulent factory tour. The scam was exposed by a few people who were in the mining business. They understood the industry and they knew how to read reports with the sophistication of experience.
If you don’t understand the business you are investing in, then you are investing blind. That’s why we place such a big emphasis on education at The Palm Beach Letter. We don’t want you investing in anything–even companies we recommend–unless you really understand how they work.
Mistake #3: Allowing yourself to be bullied by good salespeople.
I mentioned that early in my real estate career, I made some bad investments. Those were due to a combination of the two mistakes I just enumerated, plus I buckled under pressure from a real estate broker who also happened to be my landlord and, I thought, a friend.
I agreed to make the investments even though I had a hunch they wouldn’t work out. I ignored my instincts because she was so good at manipulating me emotionally. Nowadays, whenever someone tries hard to sell me something, I take that hard selling to be a signal: stay away!
Mistake #4: Investing in trends too late–when the only chance of making money is to find “the bigger fool.”
I got into real estate investing at a good time, when prices were already going up but also when the values were still very good. I made a lot of money as the market rose, but when I could no longer buy properties at eight or ten times yearly rental… I realized the only way to profit was to ride the bubble to the top.
But riding a bubble when the economics are bad is a fool’s game. Your only chance of winning is to find someone else willing to buy you out, who knows less about the market than you do. Insiders call this “the bigger fool theory.” You would think anybody with common sense would not fall victim to this impulse, but millions of Americans (including bankers and brokers) did.
There is a time to get into a trend and a time to get out. Neither is that difficult, so long as you pay attention to the fundamental economics of the deal and ignore the excitement caused by the bubble.
Mistake #5: Investing without a way to limit your losses.
Sometimes, even if you use your common sense and avoid the four mistakes I’ve already explained, you can lose money because something entirely unpredictable happens. To avoid this, I have a rule that I never get into an investment unless I have a way out.
When you are investing in a business deal, that way out might be a buy/sell agreement. When you are investing in real estate, it is the income you can get from renting it if you can’t sell it for any reason. When you are investing in stocks for yearly gains or income, it is the trailing stop loss (that we use at The Palm Beach Letter in our main portfolio). There is always a way to limit your downside–so long as you identify what that is before you make the investment and stick to it, even if you feel like you shouldn’t.
So those are the five biggest mistakes ordinary investors make. As you can see, they are all pretty obvious–the kind of mistakes that you can avoid by applying common sense.
In future issues, I’ll get into more detail about each of them, and I might even come up with another one or two. Your assignment for today is to think about your own investment experiences and the investments you are making right now… and ask yourself honestly: “Am I making any of these five common mistakes?”[Ed. Note: Mark Morgan Ford was the creator of Early To Rise. In 2011, Mark retired from ETR and now writes the Palm Beach Letter. His advice, in our opinion, continues to get better and better with every essay, particularly in the controversial ones we have shared today. We encourage you to read everything you can that has been written by Mark.]