The Biggest Mistake Investors Make

Q : The Biggest Mistake Investors Make

A:

The reason most retail investors (+90% according to some estimates) lose money is they don’t understand the fundamentals of what their are investing in. 

People spend more time researching a the purchase of a new car than they do putting the same amount of money (or more) into buying stocks. 

They buy shares in firms whose names they recognize, brands they like, or dubious stock tips they saw on TV or read about online. 

They chase investing trends and “hot stocks” because they have a fear of missing out. In a real sense, they are gambling: placing their bets and hoping the stock goes up with no real sense of why it would or wouldn’t.

Even when they perform a cursory analysis, they approach it “bottom up”: Overwhelmed by the choice of thousands of firms, they pick a stock first, then look at semi-meaningless single points of data like price/earnings ratios and historical prices to justify their choice. “It used to trade at $50 a share, now it’s at $35 - it will go back up!” Or worse, they do the inverse: “The stock price has doubled in the last 3 months, I better buy now before it goes up more and I miss out!”

Instead of “picking a stock” and trying to figure out if it is a good investment, investors need to think “top down”, starting with the economy, industry sector, companies with in the sector, and then the company’s outlook. Stocks don’t exist in their own little bubble: They are part of a dynamic ecosystem, and influenced by many different inputs.

A top down approach would look like the following:

• What is the forecast for the overall economy? Is the economy growing or shrinking? Is money flowing in or out of the market? It’s easier to make money when the overall economy is growing, but there are market opportunities when it shrinks as well.
• What business sectors are rising or in decline? What is the outlook for the sector? Is the sector at its peak, or at the bottom? If housing demand is in decline, buying stock in a home builder is a really bad idea no matter what their financial ratios look like.
• What forces influence the sector? What are the leading indicators for the sector? For example, rising demand for copper is usually a sign that construction is picking up. Which sectors or companies win or lose when specific commodities like oil, aluminum, or gold rise or fall in price?
• What are the leading firms in the sector? Which are the strongest financially? Who has a sustainable competitive advantage over the others? Which firms would survive a market shakeout? Are their new innovative firms that threaten the old ways of doing business?
• Now evaluate the handful of leading firms. (Nasdaq offers a 12-step process for evaluating stocks.) What is the outlook for the firm? Do you believe in the strategy outlined in the annual report? What will drive growth and future earnings? Is it realistic that they can open twice as many stores in a year, or double sales? Is the recent growth a fad and based on short term demand? If the firm’s market cap is $36 billion, current sales are $4 billion, and the firm lost $900 million last year, what revenue is required to justify the stock price?

Most investors don’t have a strategy or methodology for finding quality stocks. Its 8th grade level math at most, but most people would rather stare at stock charts and try to read the tea leaves than figure out a firm’s tangible book value. 

Looking at all the data available for a company, they feel overwhelmed, throw up their hands, and just pick something. Then they watch the stock ticker all day as if it were a horse race, fretting over the daily ups and downs, with no idea when to sell.

uccessful investors have a strategy and a checklist for evaluating stocks. They know the fair value of the stock, buy when the price drops below that value, and sell when it rises too far above it. 

They avoid the hype and buy when others panic. Modern stock screening tools make it even easier, giving the average investor access to much of the same data that is used by the professionals. 

You don’t need a PhD to be a successful investor, just the willingness to do a little homework.

Source : Quora, yahoo