I've been studying a lot of Charlie Munger lately and I've been diving more and more into his mental models. One of his models that I love is his inversion method, a great example he's quoted as saying: “All I want to know is where I'm going to die, so I'll never go there.”
Inversion is simply inverting a problem to figure out the solution. If you want to be wealthy, do not do the things that poor people do and you'll be one step closer to your goal. In the case of this post, I want to use inversion to look at the qualities of a poor investor. The fact is, the majority of investors, both retail and institutional are poor investors. They regularly lag the market and make poor-decisions which ends up losing themselves and their investors a tonne of money.
The main characteristics I'd see for being an investor who constantly loses money would be the following:
- Tries to time the market
- Regularly moves in and out of stocks, i.e. high turnover rate
- Utilizes margin
- Doesn't understand what it is that they own when they purchase a stock
- Does not take into account the price of what they pay for something
- Buys heavily leveraged companies
Let's take a look at each of these characteristics in a little more detail and discuss what other options you could take to avoid the fate of losing money in markets.
Market Timing
Many traders and investors who like the action of trading will buy and sell stocks (or a multitude of different things like commodities, futures, crypto, currency, etc.) thinking they have better insights into where the general market is heading than "the heard." The sad fact is, if anyone could time the market, they'd automatically become the richest person on earth in a very short time, and if you look at the richest people on earth, no one there has gotten there by "timing the market."
Yes, you may be able to time the market every now and then. The problem is the number of times you are wrong will more than makeup for any gains you make when being right. Let's say XYZ thinks the market is going to turn due to some sort of technical analysis or fundamental reason. XYZ puts his net worth on a long bet because the market is "going to the moon baby!!!!" He thinks the bear market is ended because of (insert multitude of reasons that media likes to tell you is controlling the market on that particular day)
He ends up waiting 2 years for his long hypothesis to come to life and in the meantime sees 90% drawdowns on his long. He ends up suffering enough pain and sells his long at a 90% loss, then his hypothesis actually comes true and he sees a decade-long bull run.
The best way to combat this is to forget about timing the market. Forget about the day-to-day, week-to-week, or even month-to-month fluctuations. Warren Buffett didn't even discuss the market in his last annual report. Why? It has no bearing on the value of what he owns. If you can look past the fluctuations of the market you'll do a lot better, but it's not easy.
"I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years." - Warren Buffett.
High Turnover Rate
Many investors are looking for small gains or maybe even a double then they can exit and put their profits into their "next big idea." It's like a drug addict looking for the next fix. If you are regularly buying companies that have very short-term value (maybe you buy a retail stock in October before the Christmas run-up shows good earnings for Q4) then you will have a high turnover rate.
There are numerous problems with this:
- You pay more taxes on realized gains. You don't pay taxes on unrealized gains, so you are somewhat incentivized to hold onto your investments
- Good ideas don't grow on trees. If you think you'll make good money generating a new idea every day, then good luck! Mohnish Pabrai says he needs 1, maybe 2 ideas a year to be successful.
- You end up cutting your losers, which may just be really good companies going through a rough quarter or two. This reminds me of a great quote: “Selling your winners and holding your losers is like cutting the flowers and watering the weeds.” - Peter Lynch
Using Margin
This is something that many investors and traders do. If you want to amplify the amount of money you can make, you can use margin to "make more money." The problem is that your downside is absolutely massive. The people lending you the money aren't going to let you burn it all. They'll ask for it back before you have the chance to do that to them and you'll be left with zero, zilch, nada.
Trading with margin hammered me when I was gambling on Crypto. If I hadn't pissed it away doing that, I'd be a slightly wealthier investor. It ties in with the turnover rate, when you make a trade, you get a dopamine rush just watching your ticker move up and down. But believe me, it probably isn't worth it. If you think you have a great idea, put your money into it, and let it do its thing without using margin.
Warren Buffet didn't use margin and I hear he's been pretty successful. There are many great investors who do use margin, but I don't think it's necessary to be successful. The risk-reward ratio just gets skewed into the red for me, and I'd prefer to stay away.
Little To No Understanding of What Is Owned
I have no idea what the data would say on how well people actually understand the stocks they own. I'd be very surprised if 20% of retail investors had any clue what it was they were buying. I've talked to people who bought some pot stock and their reasoning was "it does well in the city it's in that I visited once." When I ask for the financials they look at me like I have shit on my face.
Don't think of stock as some letters and digits on your computer or phone. It is literally fractional ownership in the equity of a company. You literally own a small percentage of that company. You should understand what assets you own, how the company makes money, what its future prospects look like, who its competitors are, what are their main risks.
If you want to take it a step farther, Charlie Munger says he likes to know the short side of a company he's interested in better than individuals who are actively short the company. If you can understand a company inside out, to that level, and still can't come up with a compelling reason that it won't succeed, then you have a winner.
Buying something because some anonymous person on Twitter says it will go from 3 bucks to 30 dollars in a year is not good intel. Don't be lazy.
Evaluations Problems
A poor investor does not particularly care about what they are paying. A poor investor thought process might be something like this: AMD is a great company, I think they'll do well this year, I'm just going to hit the buy button and forget what the price is. After all, someone will pay more for it after they keep "doing well."
Poor investors will also look at stocks that have had huge run-ups and pile money in. Their first level thinking will be something like "Tesla went from 72 to 600 in the past year, this thing just keeps going up. I better get in now before it's at 6000."
This is like going to the car lot to pick up a car, the car salesman rolls out a 95 civic with no hood, and a rusted engine and tells you it's yours for 50 grand. No one in their right mind is taking that deal because you know that a POS like that is near worthless. The same person is then going to put 50000 in Tesla without understanding that the value isn't 600. I'm not going to pretend to know the value of Tesla, but I can say without a doubt, it's well below the current evaluation.
You can buy a great company underpriced, and you can buy a shit company overpriced. For instance Company A sells for 100 dollars and Company B sells for 100 dollars. Which one would you buy? The one that is worth 200 dollars or the one that is worth 50 dollars? If you can't get a grasp of why you are paying 100 dollars per share for a company, then you should pass. My general rule is to find a company that is trading for 50% of its current value. That way you are essentially paying 5 dollars for a 10 dollar bill.
Another big issue people have is buying company XYZ then complaining that the price isn't going up. If you had the chance to buy 10 dollar bill for 5 dollars, would you rather do it once, or over a long period of time? Having your stock going for cheap for a long time means you can have larger ownership of that company. If you truly know that something is undervalued, it's fine if it stays that way for a while. If it keeps succeeding, it won't be able to hide this success from the market forever.
Purchasing Leveraged Companies
Most people intuitively understand that being in debt is less desirable than being debt-free. Yet they'll go out and buy stock in companies with high levels of debt that would take a decade to pay off. If you're buying companies that are running up debt you aren't guaranteed to lose. After all, many companies need debt to grow or even function. What you are doing, however, is increasing your chances of losing as many debt-laden companies' destiny is to go bankrupt.
Companies with no debt aren't guaranteed to succeed, but they have fewer avenues to fail as bankruptcy is not an option. This is a subject that whole books have been written about, so I won't go into detail past asking you to make your choices carefully and try and choose equities with little to no debt to help reduce your risk.
There are definitely angles to be played in companies with larger amounts of debt. If you don't clearly understand the risks in playing these angles you will probably get bitten in the ass at some point in your investing career. What's an appropriate amount of debt? Phil Town's rule of 3x TTM Free Cash flow is a great start, but you need to figure that out on your own.
Everyone has their own trading style and some investors do execute in the inverted mechanism discussed above. But I think an investor who is truly disciplined to staying away from the characteristics of a poor investor will prevent themselves from losing money. And as Warren Buffett says "Rule Number One: Never Lose Money. Rule Number Two: Never Forget Rule Number One"