There are almost limitless ways to lose money in the financial markets and if you know some of the biggest offenders then if can prevent you from making those wrong moves.
Here are four final thoughts on how to go really wrong when what you thought what you were doing was right.
1. Be a constant contrarian
“What!” you say. “I thought being a contrarian was the smart thing to do.”
In truth, blind contrarianism is a fine way to lose money. You make money by riding the broad trend, not fighting it. It’s only when markets are at extremes (when euphoria is combined with high valuations or abject pessimism with extremely low valuations) in both valuations in sentiment that you make money going against the primary trend. Those are the times — with stocks, bonds, metals or real estate — that you can and should fight the consensus and move the opposite of the crowd.
Ordinarily, you will lose money fighting the consensus. That’s why it is rightly said that “the trend is your friend.”
2. Invest in great stories instead of great numbers
How many investors have fallen for the next cancer drug, the next technology breakthrough, the next gold strike? A story, in short, instead of great numbers. What are the numbers you should look for? Increases in sales, earnings, profit margins, market share and returns on equity. These are what matter to growth investors. Value investors, on the other hand, will look for reasonable P/Es, low price-to-book values and high dividend yields.
I don’t care how great “the story” is, if the numbers don’t add up you’re likely to lose money.
3. Use mental stop orders instead of actual ones
You may have heard that it’s foolish to use actual stop orders and duplicitous specialists and market makers will pick you off. Occasionally — especially with small-cap stocks — that may happen. But let’s be real. Do you really have time to watch all your stocks bounce around for six and a half hours a day? My guess is you have better things to do. And a “mental stop” is really no stop at all. It gives you a chance to rationalize and avoid the discipline of protecting your profits and your principal.
So when investors ask me if they should use mental stops or actual stops, I have a standard reply: If you’re investing real money, you should use real stops. Otherwise, you’re likely to lose a lot of money.
4. Fail to know your total investment costs
This is a biggie. As someone who spent a lot of years in the money management industry, I know that not one investor in a hundred knows his or her complete investment costs. I’m not just talking about commissions. How about management fees, wrap fees, mortality expenses, surrender penalties, front- and back-end loads, 12(b)-1 fees, administrative costs and so on?
Most of these charges are hidden inside a prospectus or account-opening documents. But the old saying is true: small leaks sink great ships. You should do everything in your power to minimize your financial expenses. They are one of the few parts of the investment process where you have complete control.
If you’re not paying close attention or if you are delegating key tasks to a “full-service” broker, then you might be shocked to know how much you’re really paying. And, as the years click by, you will forfeit an awful lot of money that is rightfully yours.
What to do
This series of columns underscores a key point. There are almost limitless ways to lose money — serious money — in the financial markets. And only a few proven ways of doing things right.
That’s why every investor needs to stick to those tried and true principles, for instance:
• Hedge your portfolio by dividing your assets among large and small stocks, foreign and domestic securities, high-yield and high-grade bonds, real estate investment trusts, gold shares and inflation-protected securities.
• Stick to quality.
• Diversify broadly.
• Use a proven sell discipline (like trailing stops).
• And keep a sharp eye on taxes and expenses.
Do these things and even if you make a lot of mistakes — such as blunder into a number of poor-performing investments — you can still reach your goals and, ultimately, financial independence itself.
Deviate from these principles and you may find yourself in a very deep hole. And the older you get, the more devastating this development can be.
Knowing how to lose more money than you could have imagined has one big advantage: It keeps you from doing exactly that.