In 1998, Long-Term Capital Management (LTCM) lost $4.6 billion
in less than four months. Although the hedge fund was led by Nobel
Prize winners, noted professors, a Federal Reserve Vice Chairman
and well-known Wall Street arbitrage experts, it made two basic,
but costly, investment mistakes.
Investing always carries an element of risk. But even the smartest
investors can greatly reduce their exposure to unnecessary losses
by avoiding common, but often overlooked errors.
Over the Labor Day weekend, I was invited to speak at the annual
Lone Star Mensa Conference. Mensa is the largest and oldest high-IQ
society in the world. My talk was entitled "The Top 12 Mistakes
Made by Brilliant Investors."
Of the 12 mistakes I covered in my talk, three are especially
prevalent -- and potentially costly -- in today's market. They are
not difficult to understand nor are they hard to fix. But it is
crucial that investors step up to the plate and tackle these issues
right now.
1. Raise cash when you need it the least
One mistake LTCM made was probably the most common mistake smart
investors make. It ran out of cash at the wrong time. The
hedge
fund got caught in one bad investment. To get themselves right
again, it had to sell off sound investments. In the end, it turned
one loss into many.
As investors, we've been made to believe that to maximize our
returns we need to have every penny of our portfolio actively
working for us. If we're not fully invested, we equate that with
being inefficient or overly cautious. LTCM fell into that same
trap. In its heyday, it had the chance to take on more cash and
more investors and turned it down. When the "you-know-what" hit the
fan, the hedge fund couldn't find the cash.
You can find an investment professional who will sell you on
anything -- stocks, bonds, real estate , gold, structured products
and annuities. But you won't find many who talk about the
advantages of cash. It's probably because they don't make a
commission
on cash.
Gold performed well during the last market crash. Guess what? So
did cash. I made money on my cash. I increased my cash position
near the top of the market in 2007. Was I a genius? No. I've just
been riding in this rodeo a long time.
The better things get, the more you want to be thinking about cash.
Cash allowed me to sleep through the night. It also allowed me to
pick up bargains at the bottom of the market, without having to
sell off my other positions at a loss.
2. Stop protecting your downside risk by limiting your
upside potential
Mark Twain once said, "The cat, having sat upon a hot stove lid,
will not sit upon a hot stove lid again. But he won't sit upon a
cold stove lid, either."
Almost everyone who was in the market in the last five years got
burned. The silver lining is that if we didn't know what our
tolerance for risk was -- we do now.
But this revelation jarred some investors. They withdrew from the
market. In Godfather parlance, they "took to the mattresses." And
unfortunately, they missed out on much of the recovery.
If you got burned, it doesn't mean you have to stay away from the
stove. You just have to develop ways to measure your tolerance for
heat and the temperature of the stove. I didn't make big changes in
my investments. I did, however, change in how I manage those
investments.
Just because I was more sensitive to risk than I thought I was, I
didn't plow all my money into bonds or
CDs
-- although I do own both. I did, however, start using more tools
to protect my gains and limit my losses on riskier assets.
For instance, I bought shares of
Olin Corporation (
OLN
)
for $12.92 a share for my
Stock of the Month
portfolio. At the time, about two-thirds of Olin's revenue came
from chemicals, making it a very volatile holding. But the
remaining third of Olin's revenue was coming from ammunition sales.
At the time, ammunition was in tight supply -- most stores resorted
to rationing just to keep a small inventory on the shelves.
I was down -11.4% on OLN in July of 2009 and set a stop loss to
protect against a potential -17% loss. The stock rebounded and I
reset my stop loss to protect a +20% gain. As the stock continued
to climb, I continued to bump up my stop.
I was finally stopped-out of my Olin position at $19.62 per share
in May 2010. Including dividends, I had a total return of +58.0%.
3. Don't invest in what you know best
Peter Lynch became a superstar managing Fidelity Investment's
Magellan Fund. From 1977 to 1990, the fund returned an average of
+29.2% annually under his watch. One of his famous investment
principles was to "invest in what you know." But this can lead to
another common, but costly, error.
Research has concluded that investing in what you know best isn't
such a great idea. A recent study looked at 10 years of stock
transaction data, comparing it with investors' jobs. The
expectation was that individuals' investments in the industries
they worked in should outperform the market. After all, they had
better access to information and could better understand the
significance of that information. But that's not what the data
showed.
Instead, all of the study's estimates showed that in cases where
investors put money into stocks within their own industries, they
underperformed the market.
It's hard to be objective about our own area of expertise. A
software developer may get really pumped up about a new application
he or she is working on. But maybe a competitor has a better
product waiting in the wings. Or even if the new application is
successful, the rest of the company's product line might be under
pressure.
Sometimes even knowing your company is trumping the competition
isn't enough. Industries are cyclical and even the top dog can
languish on a down cycle. For instance,
Ford (
F
)
has had the upper hand on most of its rivals, but all automobile
stocks were hit hard going into the recession.
The last thing you want to do is invest solely in what you know or
where you work. Many Enron employees had all their investment eggs
in the energy company's basket when the company went bankrupt in
2001.
A side note about Peter Lynch and me:
I worked summers at Brae Burn Country Club in my home town to earn
money for college. Although I got my high school letter in golf, I
decided not to work as a caddy. Caddying was hard work and I wasn't
exactly big and strong. Instead I worked on the kitchen staff.
Peter Lynch, however, was a caddy at Brae Burn. He ended up working
for Fidelity after caddying for Fidelity's president. I ended up
putting on four pounds. This was a case where I probably should
have invested -- at least my time -- in what I knew best.
Action to Take -->
Remember: Cash is not the enemy. It is your friend. And the time to
think about cash is when things are going well -- not after the
bottom falls out. And even though you might be more sensitive to
risk than you once thought, you don't have to sacrifice upside
potential. Learn to manage the risk of riskier assets with simple
tools offered by almost every brokerage service. And finally,
be sure to know everything you can about any investment before you
make it.
In my
Stock of the Month
newsletter, I spend all month researching a single opportunity that
I believe will outperform the market. But that's not all I do. I
make sure I have an appropriate cash balance in my portfolio. I use
trading tools to manage my riskiest assets. And I try to be
especially skeptical of the industries I know well.
After all, there is enough risk in the market. As investors, the
last thing we need to do is introduce more by making avoidable
mistakes.
-- Amy Calistri
A graduate of both Columbia University and The University of
Texas, Amy's experience includes managing $5 million in trust
funds, economic consulting and financial risk management. Read
more...
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Disclosure: Neither Amy Calistri nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.
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