Lesson #22: Five Deadly Sins of Investing
You’ve probably heard of the seven deadly sins. In traditional moral teachings, these transgressions – wrath, greed, sloth, pride, lust, envy and gluttony – are human tendencies that, if not overcome, can lead to other sins and a path straight to hell.
The investing world has its own version of deadly sins. These attitudes, approaches, actions and omissions can hurt results, and they compound the damage by leading to other transgressions.
To become a better investor, one needs to be aware of these missteps and learn how to overcome them or at least minimize their negative impact.
So here are the five deadly sins of investing and why you must avoid them, at all costs, to ensure a successful investing career.
Sin #1: Compounding Your Costs
We have learnt how compound interest can do wonders for you. But only when you’re on the right side of the compounding equation.
Albert Einstein said, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
Now the question is – In investing, how do you “pay” compound interest? In other words, what can cause you to land up on the wrong side of the compounding?
You do this by paying a lot in fees and commissions to your broker who provides you his stock trading services.
While paying a commission on each trade is mandated by law and you cannot do anything about it, what is worrisome is how these commissions/costs add up when you trade in and out of stocks too often.
You see, unless you invest in FDs, PPFs and the like, you have no control over how an investment will perform in the future. The one thing you can control, however, is costs. The lower, the better.
Small differences in fees can have a big impact. Say you start with Rs 10,000 and invest Rs 5000 a month for 30 years. If you invest in a fund that charges just 1% each year and the fund returns 15% a year before fees, your account will grow to Rs 2.8 crore. If you buy a fund that charges 2.5% annually, however, you’ll net Rs 1.9 crore – almost Rs 80 lac less.
Even if you are a direct stock investor, the fee you pay to your stock broker compounds over the long run. Pay a lot (by trading a lot), and you will be left far behind an investor who trades seldom.
Stop looking at trading costs as one-time events, and recognize the long-term impact they can have on your portfolio. Trade sparingly and compare costs before you invest.
Sin #2: Following the Herd
The statue outside the Bombay Stock Exchange in Mumbai of a hard-charging bull could well symbolize the herd mentality that affects many investors. When a stock – or an asset class, such as gold or real estate – soars, investors pile in. The longer the asset rises, the more eager people become to join the stampede.
In fact, the herd tends to gather the most strength right before the popular investment is about to go off the cliff. Ill-timed moves and dancing in and out of stocks explain why the performance of fund investors is decidedly poorer than the reported results of their funds.
Charlie Munger says…
Remember that just because other people agree or disagree with you doesn’t make you right or wrong – the only thing that matters is the correctness of your analysis and judgment.
He adds, “Mimicking the herd invites regression to the mean (merely average performance).”
So follow rules, not herds. Resisting the urge to follow the crowd can prevent you from committing the sin of buying high and selling low.
Sin #3: Giving in to Fear
Avoiding losses is Warren Buffett’s first rule of investing. Since the 2008 stock market crisis, however, many investors have taken his advice to an extreme and abandoned stocks for the seeming safety of such things as bonds, bank accounts and debt funds.
But what the typical investor sees as risk is merely volatility, normal day-to-day swings in the market. Although volatility can be frightening, the real danger lies in being too afraid of risk: You lose buying power – permanently.
For example, suppose you invest in a FD that pays 8% annually. With inflation at 10% today, you’ll actually lose 2% per year in buying power. The loss will be greater if inflation increases beyond 10%.
It’s important to put the stock market’s day-to-day volatility out of your mind and focus on the long term. This is where real long term wealth is created.
Sin #4: Envy
Here’s an old joke.
After twenty years, a man decided to track down his three best friends from school. He was shocked at what they had become.
The first was an alcoholic who never got a job. The second had been in prison for robbery. However it was when he saw the third that he felt sick to his stomach.
The third one got a fantastic job and a really attractive wife.
Charlie Munger says…
Envy is a really stupid sin because it’s the only one you could never possibly have any fun at. There’s a lot of pain and no fun.
Now, the root cause of our envy is comparisons we make in life, investing…everywhere. So, instead of spending your time studying businesses that you may buy for the next 20 years, you spend time comparing the past performance of your stocks with others.
The grass is always greener in someone else’s portfolio. We all have stories of a friend-of-a-friend who’s got lucky and made the right move, at the right time, on the right stock. With envious eyes we covet their investments, curse our indecision and vow to better their success.
Maintaining discipline, staying the course, and aligning your decisions with your long-term financial goals becomes very difficult when you cease to be an objective investor and instead become a competitor.
Remember to focus on your own portfolio not your neighbour’s. The decisions you make should be unique to your financial goals and shouldn’t be influenced by the actions of those around you.
Sin #5: Focusing on Outcome, Not on Process
Consider any field of activity where probabilities play a big role – the outcome is largely unknown – and research has identified a common trait amongst successful performers – they all emphasize process over outcome.
Look at investing, and look around you. Most investment experts selling their services always highlight the outcome – so much return in so many months or years – and never the process they used to get this outcome.
This is simply because, while the outcome is there for everyone to see (availability bias), investors rarely ask the question whether that outcome was due to the skill of the expert (a proper investment process) or merely luck.
This is not to say that result doesn’t matter; obviously it is important in measuring success. But if the result has been largely thanks to luck, it may not come in as expected in the future.
What is more, if you focus only on the outcome, you are less likely to achieve it. Instead, if you focus on the process, the outcome will take care of itself.
Charlie Munger says – “The only way to win is to work, work, work, work, and hope to have a few insights.”
If you are not willing to work on creating the right investing process that suits you – and just rely on the readymade stuff available out there – you face a great probability of ending up with a bad outcome.
Focusing on your investment process, and not the outcome, should be your goal.
Here is the payoff: Over the long term, a good process delivers highly desirable results, and generates better and more reliable outcomes.
This isn’t any secret. At least not any more!