“Never invest in a business you cannot understand.” Warren Buffet
“Behind every stock is a company. Find out what it’s doing.” Peter Lynch
There are two key decisions in investment decision-making: the buy decision and the sell decision. By being aware of the common pitfalls of buy decisions, we can potentially save ourselves from a painful sell decision.
Social proof is an extremely powerful force. It’s often noticeable at intersections when a group of pedestrians are waiting to cross. Often, if one breaks rank, others quickly follow.
Social proof equally applies to investment decision-making. Humans are inherently social characters and there is a perceived sense of safety investing in a share if we know others are also invested. This sense of safety is increased when that person is a ‘guru’ or successful in their own right. As Dr. Idel Dreimer stated, “Men think in herds, not because herds are right, but because they offer security.”
This principle was painfully learned when I bought my first share. Without any exposure to or education in investing, I bought into a company called Pryme Oil and Gas (ASX: PYM), for no other reason than my wealthy uncle was a significant investor. I reasoned that if he was rich and successful, surely he knew what he was doing. I bought at 34c and sold at 2c, a loss of 95%. Lesson learned: don’t just buy a share because someone else has.
Forecasts and Ratios
Investors often put too much emphasis on “key” numbers like forecasts and ratios. Favourable looking numbers alone are not a sound basis for deciding to buy a share.
John Kenneth Galbraith said “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.” Brokerage reports typically contain forecasts for the next years’ earnings and financial statements. It’s easy for investors to be sucked into these numbers, taking them more seriously than they should be. The further out the forecasts go, the more untenable they become.
Related to basing the buy decision on attractive forecasts is buying because of favourable looking ratios. ‘The company is trading on a PE of 7, it’s a bargain.’ ‘Its Price to Book is much lower than the other banks, it must be better value.’ There’s probably a very good reason why a company is trading on a low PE. While ratios can help analyse information quickly, attractive ratios alone are no basis for buying a share.
Fear of missing out, or FOMO, is often attributed to the younger generations feeling left of social circles. Whilst FOMO undoubtedly has a social application, it can equally apply to investing, prompting the buy decision at the wrong time. Often people make the buy decision for fear of missing out on a company’s success. Perhaps their friends have invested and are riding the wave of paper profits, or perhaps they’ve followed the company for some time but are yet to make the decision. As they see the share price continue to rise, driven by the fear of missing out while others gain, they relent and finally make the decision to buy, often at precisely the wrong time.
History has consistently seen waves of hype in various degrees. From Tulip Mania in the Netherlands in the 17th century, to the dot com boom at the turn of the millennium, investors have consistently been swept up in bubbles and crashes. Excessive hype can also apply to specific industries and companies. Currently there is a great deal of buildup around medicinal cannabis. While laws have been passed to legalise cannabis for patients with chronic pain, the industry is still in its infancy. Supply and demand forces remain to be determined, especially as they relate to overseas imports. Now it is not suggested medicinal cannabis companies are bad investments, just don’t let the hype alone drive the investment decision.
Humans suffer from a range of inherent biases, a number of which apply to investment decision making. Overconfidence bias occurs where a person’s subjective confidence in his or her judgment is greater than the objective accuracy of those judgments. Applied to investing, overconfidence bias is often suffered by smart, intellectual people who have been successful in other fields. Their success elsewhere leads them to assume equal success in investing. However, investing for successful people can be similar to golf for good sportsmen – just because you’ve been good at one, doesn’t mean you’re necessarily good at the other. Just as a professional footballer might shoot over 100 in a round of golf, investing can be a humbling experience.
Now that we have examined the common pitfalls of bad buying decisions, a logical follow on question might be what are the smart buying decisions. Whilst that requires a separate and long discussion, in reference to Mr Buffett and Mr Lynch at the start of the article, it is clear that the first step to analysing a company is to understand what it does. ShareStart.com.au helps investors answer this question by concisely summarising a company’s activities in a clear and unbiased manner. ShareStart is a free resource and has currently covered 170 ASX listed companies.
About the author:
Tim has worked for some of the leading fund managers and superannuation companies in Australia. While working in superannuation, he helped managed a $16bn share portfolio, meeting and learning from the best stock pickers in the country. Tim is a CFA Charterholder (probably the toughest finance qualification in the world) and launched ShareStart to help investors understand what they’re investing in.