Tuesday, April 29, 2008

Where Many Investors Trip Up

Whether you realize it or not, many investors often commit mistakes that regularly go unnoticed. Or worse, the mistake is made under the false assumption that the activity is actually correct. Such common traps include:

1. Investing for capital appreciation when instead you should be investing for capital preservation. Investing in this manner is like crossing the street after only looking straight ahead. The destination might be clear, but without looking left and right, the consequences can be perilous.

2. Interpreting market volatility as a destroyer of opportunity when it is instead a creator of opportunity. If your approach is sound then volatility allows you to buy that which was cheap yesterday cheaper today.

And most important of all: spending time thinking about when to sell a security when all your time should be spent learning when to buy a security. This is a mistake that many investors commit without ever realizing it.

Many people believe that knowing when to buy is much simpler and easier to do than when to sell. However, the real reward in investing comes from making smart buying decisions. Selling is simply the activity that rewards your disciplined buying approach. Far too many investors exaggerate the selling process. In doing this, they subconsciously approach the investment process backwards. In my most recent letter to partners, I discussed the fallacy in "learning" when to sell an asset:

"...you only need to do a few things right to be a successful investor. Knowing when to sell a security is not one of them. Money is made when the asset is bought not when it's sold. Learning when to sell is a task that far too many investors spend far too much time attempting to perfect. In his 50+ years as an investor, Warren Buffett has realized losses on an absurdly low percentage of his investments (less than 5%). Buffett spends little time worrying about when he should sell his investments and instead on focuses on buying assets cheaply. This buying process should be at the center of an investor's focus. You can never go broke by taking profits. If you maintain a disciplined approach to the price you pay for an asset, the selling process will take care of itself. Echoing Shelby Davis, 'you just don't know it at the time.'"

Your profits (or losses) are made the minute you buy an asset. You just won't "see" it until you sell. If you concentrate your efforts on buying businesses selling at a discount to intrinsic value, the odds are favorable that when you need your money, you will sell at a higher price. Understand of course that intrinsic value can be impaired if the fundamentals of the business deteriorate. This is possible with any investment, but much less likely with superior businesses with successful long-term operating performance.

The common mistake is made when investors confuse buying a business and buying a stock. When buying something cheap, investors often take that to mean buying the stock at the bottom. This is flawed thinking. You can still make money even if you buy at top--as long as the intrinsic value is substantially higher.

Also, investors assume that if they sell at a profit only to see the share price advance further, then they made a mistake by selling too soon. But that too reflects the wrong perspective. First of all, anytime you sell an investment at a gain, you have succeeded. I learned at an early age that you will not lose money by selling something for more than you paid for it. So, if that's the name of the game, then mastering the buy side is how you win the game. Warren Buffett once remarked that "investing is simple, but not easy." It's simple in that all you need to do is find a handful of great businesses selling at reasonable prices and let time do its thing.

Yet investing is not easy because most investors have a hard time being patient. Mohnish Pabrai once told me that two things occur to him after he makes an investment: When he buys, the stock usually dives, and after he sells, the stock rockets. Yet in the almost nine years that he's been running the Pabrai Investment Funds, he's boasting an annualized return above 20% -- after fees.

All investors make mistakes. But if you do your work, chances are you won't make many big mistakes. A couple of huge mistakes can wipe you out for good. Concentrate your efforts on a few very simple lessons and you tilt the odds of outperforming most.


Jeff said...

Excellent Post Sham. I guess there are a two different types of value-based investors. Buy at 50/60 sell at 90/100 (Mohnish), and Buy and hold for very long periods(Modern Berkshire Buffett, Sequoia). If you can find your style, I think that's about all you need. Will you sell when the stock hits intrinsic value, or will you hold until the business loses its competitive advantage? A simplified distinction, I suppose, but the sell process should be simple, as you stated.


Sham Gad said...

Thanks Jeff. You're assestment is exactly correct.

Anonymous said...

nice post.

Jagadeesh B Reddy said...

Hey Sham, I've been reading your articles and every one are quite impressive in a different ways. You wouldnt have known me. But some how I made an habit of opening your blog daily to check any news posts.Well Iam much more impressed by George soros than Mr.Warren buffet coz I started my profession as a F&O trader and Still trading in derivatives. But nothing can beat the art of Investment. Keep the good work on Sham....

Sham Gad said...

Thanks for the nice note Jagadeesh.