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Friday, 15 January 2010

How to Fail at Investing in 5 Easy Steps

By Morgan Housel

I'm a fan of checklists. Especially the ones listing things you shouldn't be doing. It's easier to overlook what you shouldn't be doing than to focus on what you think you're doing right. If you're not humble enough to admit this, you've just proven the point accurate.

One such list I came across resides in Philip Fisher's groundbreaking 1958 book, Common Stocks and Uncommon Profits. Who is Philip Fisher? You could ask Warren Buffett, who admits, "I'm 15 percent Fisher and 85 percent Benjamin Graham." Ben Graham is Buffett's well-known, highly praised, mentor. Philip Fisher, a sort of godfather of growth investing, doesn't get enough credit.

Common Stocks and Uncommon Profits is one of the best guides for evaluating businesses ever written. Buried in the back of the book, right after "Five Don'ts for Investors," is "Five More Don't for Investors." It's quite simple. To fail at investing …

1. Overstress diversification
Diversification is usually a good thing, but Fisher cautions against blind diversification. In his own words, "Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others about which they know nothing at all."

Far too many investors approach diversification with the mindset of, "I need financials. I need tech. I need telecom. I need healthcare," etc., etc. Wrong. What you need is diversification among good, high-quality companies, not a blind selection among diverse sectors. Let me give you an example of a "diverse" portfolio gone astray:

* Financials: Lehman Brothers
* Telecom: WorldCom
* Energy: Enron
* Industrials: General Motors
* Technology: GlobalCrossing

These are obviously cherry-picked. But you can see how, in an attempt to blindly diversify among sectors, you can just as easily concentrate in failure. Even slight diversification among good companies that you understand can be superior to blind, yet broad, diversification.

2. Be afraid of buying on a war scare
Fisher writes, "The fears of mass destruction of property, almost confiscatory higher taxes, and government interference with business dominate what thinking we try to do on financial matters. People operating in such a mental climate are inclined to overlook some even more fundamental economic influences."

In short, don't be scared of investing in wartime. Some might even say: Buy on the cannons, sell on the trumpets.

Fisher's more direct point regards war's ability to spread inflation through increased government spending. Again, that's quite analogous to today. "Modern war always causes governments to spend far more than they can possibly collect from their taxpayers while the war is being waged. This causes a vast increase in the amount of money … the classic form of inflation."

But rather than sell in panic, "This is the time when having surplus cash for investment becomes least, not most, desirable."

Bingo. If you're scared witless over today's policies, and many are, cash isn't your answer. There are several very high-quality companies that derive enormous revenue from abroad, enabling success in the face of ravaging domestic inflation. Philip Morris International (NYSE: PM), Coca-Cola (NYSE: KO), and Johnson & Johnson (NYSE: JNJ) are three such examples.

3. Forget your Gilbert and Sullivan

"The flowers that bloom in the spring, tra-la, have nothing to do with the case." This Gilbert and Sullivan tune confused me, too. Fisher's analogous takeaway from the example is that "there are certain superficial financial statistics which are frequently given an underserved degree of attention by many investors."

His examples include focusing on past share performance and previous years' earnings. "One reason [investors are] fed such a diet of back statistics is that if this type of material is put in a report it is not hard to be sure it is correct" he writes.

Another set of data investors give undue focus to is quarterly earnings. Lehman Brothers was announcing record quarterly earnings not much over a year before it went kablooey. Ford (NYSE: F), Citigroup (NYSE: C), and Bank of America (NYSE: BAC) announced abysmal earnings in the process of becoming multibaggers last year. The underlying value of company's shares can be far disconnected from their short-term reported earnings.

4. Fail to consider time as well as price
"When the indications are strong that [rapid growth] is coming, deciding the time you will buy rather than the price at which you will buy may bring you a stock about to have extreme further growth at or near the lowest price at which that stock will sell from that time on."

This is a hard point to understand, but Fisher apparently studied companies' prices and found they were normally lower at certain points in their business cycle -- say, about a month before a venture reaches the pilot-plant stage. I finally equated it to Buffett's rule that, "if you wait for the robins, spring will be over." Waiting for Apple (Nasdaq: AAPL) to actually release a new product like the iPhone, for example, means undoubtedly foregoing the gains that anticipation has priced in.

5. Follow the crowd
Around 2000, top-selling books included Dow 36,000 and The Roaring 2000s. Whoops. In 2006, Why the Real Estate Boom Will Not Bust was a big hit. As of late, top-sellers have included The Great Depression Ahead and The Ultimate Depression Survival Guide.

Pandering to fear and exuberance at or near the peak is nothing new. That's when it's most prevalent. That's when it sells the most. But if the history of the outcome of these extreme views is any indication, you might find optimism in visiting the business section of your local bookstore. More often than not, popular yet awe-inspiring views are dead wrong.

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