A few weeks ago, I sat down on a Saturday afternoon to write a post about the top investing mistakes people make on their journeys.
We’ve covered all that before.
Instead, I wanted to peel the proverbial onion back a little bit more and cover the “second layer” of investing mistakes.
The kind that wouldn’t necessarily torpedo your journey to financial independence – but could definitely add more than a few years to it.
Alas, the very first topic on that list turned out long enough to merit a separate post on investments and investment vehicles.
Today, let’s come back to the broader topic and cover off a few others.
Buying What You Don’t Know
Let’s start with the cardinal sin of investing:
You should never invest in a financial instrument unless you have a solid understanding of how it works.
If that means you are only sticking to stocks and bonds, then so be it.
You don’t need options, futures, warrants, or any other fancy derivatives to have a well-performing portfolio.
On the contrary, you are probably well-advised to avoid them.
Just ask anyone who loaded up on oil futures in April 2020.
Buying What You “Know”
Popularized by the wildly successful Peter Lynch, “buying what you know” became a mantra for millions of fundamental, value investors.
The idea, of course, being that you focus on shares of companies whose products you use – and like.
Other than the fact that this is as active of an investing strategy as it gets, here are some other reasons why buying what you know is NOT a good idea:
#1: Concentration Risk
Even actively managed portfolios should hold at least 30 different stocks in order to eliminate idiosyncratic risk.
In reality, very few retail investors will be that diversified.
Loading up on shares of just a few companies you “know” can push your portfolio severely out of kilter.
Bad news, because taking a hit on just one investment can decimate your entire portfolio.
#2: Home Equity Bias
There is strong empirical evidence that investors tend to tilt their portfolios towards domestic equities:
Clearly, this is not the direction you want to go.
However, buying what you know has a real danger of giving you even more exposure to domestic companies as opposed to a nicely diversified, global set of equities.
#3: Your Own Biased Perspective
Sure, you may love the product. But would others agree?
Are there formidable competitors on the horizon, about to blow the proverbial Blackberry out of the water?
Or does the company in question face some deep-rooted internal issues that even a fantastic product lineup won’t fix?
#4: No View On Value
And even if the above doesn’t apply, you simply cannot invest without forming a view on value.
Do you know what the right metric is to value the companies in the sector?
Is it a multiple of revenue, EBITDA, or earnings? Is it some kind of a cash flow measure?
What’s the right baseline to apply the metric to? Is it trailing earnings, next twelve months, or a few years out (for hypergrowth companies)?
Where are the company’s peers trading? And are you cross-checking your valuation with a DCF?
The above is just a subset of very basic analysis you will see in any research report worth the paper it’s printed on.
If you don’t have an answer to these questions, single name investing probably isn’t the best option.
Don’t get me wrong – I totally get the appeal of receiving dividends.
Over the past 12 months, I’ve accumulated a meaningful shareholding in my employer which I plan to liquidate once the share prices rebound:
Those shares happen to pay a dividend, which amounts to a few thousand dollars a quarter.
And yes, it feels good to get that check in the mail (though it still beats me why I get a check instead of a direct deposit into my brokerage account).
So far so good. What I do have a problem with, however, is making dividends the ultimate end goal of investing.
The only goal of investing should be maximizing risk-adjusted returns.
Sure, dividends can help you reach that objective. However, dividends can also be:
- A sign that the company has no better way of deploying cash – so it chooses to return the capital to shareholders instead. This often indicates limited growth prospects for the business.
- A tax-inefficient way to return capital to shareholders. Stock buybacks accomplish the same goal as dividends – all while providing incremental flexibility and (often) much more favorable tax treatment.
- A function of the company’s shareholder register. If many of the shareholders are income-oriented (for example, income funds or retirees), maintaining a dividend is a good way to prevent shareholder churn and share price volatility.
At the extreme end, very high dividend yields (defined as annual dividends divided by share prices) can be a sign that the dividends are about to get cut, which is exactly what happened in the Covid pandemic.
Here are some other hidden dangers of dividend investing you may want to educate yourself about.
Investing In Non-Productive Assets
Bitcoin? Gold? Oil?
I could tell you why this is a bad idea. But why don’t I let Mr. Buffett do the job for me on this one.
It’s taken from his 2011 shareholder letter, hence the examples are a bit dated – but the concept hasn’t lost its punch:
“Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.)
At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A.
Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with an output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually).
After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?
Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion.
Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.
A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be.
Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons).
The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.
Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold.
I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.”
Going “Risk-Off” As You Approach Retirement
In the past, conventional wisdom ran as follows.
About ten years before packing it all in, your financial adviser would slowly start rebalancing your portfolio from equities to bonds.
At age 50, you may have been 20% bonds, 80% equities. By the time you clocked 60, that split would be reversed, perhaps even taken to the extreme case of a 100% bond portfolio.
Safe from the vicissitudes of the stock markets, you retired with a “safe” portfolio yielding a predictable stream of interest payments.
Sadly, with interest rates near zero – and retirement horizons extending both due to growing life expectancies and early retirement plans, that approach no longer works.
The good news is that it has now been proven that an equity portfolio can be just as helpful in supporting you in retirement.
Now, you can debate whether the 4% is the right number to use. Monevator has done a stellar job illustrating why the 4% rule doesn’t work.
What you shouldn’t forget, however, is the following: even at a 4% SWR, while the “failure” rate stands somewhere in the single digits, there’s also a very meaningful chance you (or rather your heirs) will end up with even more money than you started with.
And wouldn’t that be a nice problem to have?
About Banker On Fire
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Banker On FIRE is an M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.
Find out more about me and this blog here.
If you are new to investing, here is a good place to start.
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