There’s an old adage that says there are only two ways to learn any lesson – either upfront, or from experience. Sadly in the investing world, the latter method is often the more commonly used one.
Below are a few of the expensive lessons learnt through experience.
Lesson: one cannot eat assets — cash flow is king
This refers to companies that have a large asset backing, often higher than its market value. In theory, investors can often buy $1 in cash for 80c by liquidating the company’s assets and paying back its liabilities.
Unfortunately, many asset-rich and cash-flow-poor companies are unable to control their own destiny because they are unable to sell off assets quickly enough to pay current liabilities during stressful market conditions.
Lesson: assumptions must be stress tested — how robust is the company’s business model?
One of the weakness most people share is extrapolating the future based on the past, and assuming that recent conditions will remain so for the foreseeable future.
Nokia, Kodak, and Blockbuster, are but a few former ‘blue chip’ giants that couldn’t adapt to the disruptive change in their respective markets.
Lesson: set firm limits on exit prices and loss limits.
“The market can remain wrong longer than one can remain solvent”
Lesson: The market does not know one’s entry price — it values a stock based upon future expectations and market emotions (Anchoring bias)
Anchoring refers to the investing tendency to rely on the first piece of information offered when making decisions. These pieces of information can range from an entry price to an investment thesis, such as growing Chinese demand for iron ore.
In this case, an investor may say, “I bought X share for $20 and it has declined. I know the business faces more challenges, but it is a blue-chip stock and I will wait till it gets back to $20 before I sell it.” Here, the investor anchors their decision based on a past number, rather than a valuation based on the prospects for the business going forward.
Lesson: do not love a stock, as it is not worthy of one’s affection.
In the mid-2000s, Incitec Pivot went from a sleepy fertiliser manufacturer (at the time, 70% owned by now arch-rival Orica) who’s share price was consistently around $12–$17 to a $100 and then to almost $200 per share company. This occurred due to the combination of a fortuitous purchase of an unwanted phosphate plant from BHP and a dramatic increase in the fertiliser price due to an artificial step change in the demand for corn.
The GFC and a few other factors
As a stock rises, the emotional attachment to it grows. When the time came to critically evaluate whether to sell the position; being objective is very difficult.
Every investor makes mistakes, but these mistakes offer more lessons than stocks that went up several hundred percent. Investing is a game of endurance, where out-performance ultimately comes to those who make the fewest mistakes over time. The famous quote “Those who don’t learn from history are doomed to repeat it” applies equally to investing.
There are many strategies available to avoid errors, such as the above, and it’s our role at Doctors Wealth to employ these to your benefit. While the risks can never be eliminated, they can be minimised.
If investment is on your radar, contact us at 32528810 or email@example.com to arrange a confidential discussion on ways to maximise returns while minimising risk.