Learning from the mistakes of others can help you avoid some pain. That’s why I love reading non-fiction.
I think Isaac Newton’s quote is nice here:
“If I’ve seen further, it’s by standing on the shoulders of giants”.
That sounds egotistical. I’m not referring to myself as a giant. I’m just a dude. Not a perfect Gem. I’ve made multiple mistakes since I started investing in 2015.
Let’s go through my five largest mistakes.
1. Chasing High Dividend Yielding Stocks
I used to love high dividend-yielding stocks. I got excited when the dividend cash payments hit my account. But I did not realize that stellar dividend yields often indicate poor future prospects for the company.
For a few of my stocks, the depressed share price reflects low or risky expected future cash flows from the business. a form of market efficiency. This is why high-yielding stocks are often yield traps.
For some of my high-yielding stocks, the dividend was eventually cut and the stock price declined.
Not only did I take a hit on dividend cash flow, and also suffered capital losses from a declining share price. I fell into the value trap.
Investing based on dividend yield alone is dangerous. You need to look deeper into the business. Shrinking earnings, ballooning debt or an unsustainable payout ratio may be uncovered.
Such factors point towards an unsustainable dividend and an eventual dividend cut.
Check out the Top 5 Dividend Misconceptions for more.
Look at the Payout Ratio
The payout ratio can tell you if a dividend is sustainable. It is the fraction of the companies’ earnings that are paid out as a dividend.
A payout ratio of over 100% over multiple years is bad news. It means that the business is paying out more as a dividend than it earns. The business needs to self-cannibalize by reducing assets or taking on extra debt to pay the dividend. That is unsustainable.
Want to make good money decisions, but never learned how?
Access the resources that I used to learn about personal finance.
2. Not Fully Understanding My Investments
Chasing high dividend yielding stocks was a symptom of a bigger problem. I didn’t understand the businesses that I owned with enough depth.
I would assess balance sheets and income statements, but I did not study trends over time. Nor did I deeply investigate how the company maintained its competitive advantage.
When you buy a stock, you are a business owner. As a business owner, you get to share in the company’s earnings and earnings growth. And you don’t want to over pay for these earnings.
To evaluate the company, you need to understand and constantly track the financial position – the income statement and balance sheet. Plus, you need to understand how the business works, including:
- Strategy and competitive advantage;
- Organizational values; and
- Industry and business risks.
3. Not Investing in Indexed Funds Sooner
For my first three years of investing I only invested in individual stocks in the U.S. and Canada, inspired by the book “The Intelligent Investor”.
Some of these investments turned out great. Others did not. Over a five-year period, I did not beat the market after fees and transaction costs. Furthermore, I spent lots of time researching and monitoring specific companies.
Today over 97% of my portfolio is in globally diversified indexed funds. I’ll share why. Some great books that cover these topics include:
- A Random Walk Down Wall Street
- A Little Book of Common-Sense Investing
Available information is priced in to each stock by millions of investors. Markets are fairly efficient. To beat the market, you need to:
- Have information and forecasting abilities that exceed the combined efforts of millions of others;
- Have insider info that no one else has; or
- Be lucky.
Skill. A stock’s price is based on millions of buy and sell transactions. Each transaction embeds information into the stock price about expected future cash flows, including the risk of these future cash flows. With the internet, new information becomes available rapidly. Other humans and algorithms quickly exploit security mispricing and embed the information into the stock price. Markets are not perfectly efficient. But they are efficient enough to make it extremely difficult to beat returns through selection of individual stocks.
Luck goes both ways. Good luck results in market-beating returns, and bad luck results in underperformance. The role of luck will naturally reduce to zero over the long-term, say 30+ years. I wrote this post to show how luck can cause a disparity between Decisions and Outcomes – a core investing concept.
Insider Info. Trading on insider info is illegal and unethical. Don’t do it.
4. Lottery-Like Investments In Tax Sheltered Accounts
One of my largest mistakes was to invest in Options Contracts in my Tax-Free Savings Account (TFSA). For American’s reading, the TFSA is similar to the Roth IRA.
An overconfident Jake thought he could predict the market; this is the overconfidence bias. At the time, I invested roughly 2% of my portfolio. The potential upside was huge. But the options expired worthless. I lost out on the future tax-free compounded returns that money could have provided.
I treat TFSA contribution room like gold. Money invested within the TFSA not only grows tax-free, but it can be withdrawn from the account tax-free. You can learn more about How the TFSA Works.
Opportunity Cost of Lost Contribution Room
I did not only lose $2,000. I also lost $2,000 worth of valuable tax-sheltered contribution room. I missed the opportunity to grow $2,000 tax free – an opportunity cost.
Over 30 years, at an 8% return, that $2,000 could have grown to $20,100. I could have sold for a tax-free gain of $18,100. Or, I could have used the $20,100 to pull $600 tax-free annually, forever, assuming a 3% sustainable withdrawal rate.
Making huge returns is great. And keeping your money is even better.
The Richest Man in Babylon outlines seven personal finance rules from 4000 years ago. One such rule is to preserve your nest egg.
If you need to gamble in lottery like stocks or options, do so in your taxable account. This will preserve valuable contribution room. Plus, you can write off losses.
5. Trying to “Time” The Market
Waiting for Valuations to Fall
I avoided exposure to technology stocks in the U.S. market over the years as I feared sky-high valuations. I was always concerned about the Shiller P/E ratio. But valuations kept rising as earnings routinely beat expectations. I missed out on some great gains.
Holding Excess Cash
In addition, I held roughly 15% cash in my investment accounts. This was cash in excess of my emergency fund. I didn’t “need” this cash anytime in the next 10 years. I just wanted to be ready to take advantage of market dips.
By the time a crash actually came (COVID), I had lost more money by waiting than I would have lost during the crash. By holding excess cash, I missed out on the gains and dividends of the market. I invested all this extra cash at the bottom of the COVID crash, but I would have been better off if it was invested earlier.
Time in the market is more important than timing the market.
You likely have a steady income and many routine expenses. If this is the case, you can save and invest consistently.
Under this system, you will naturally catch the highs and lows of the market over the decades. Most importantly, investing will become habitual.
Dollar Cost Averaging Vs. Lump Sum Investing
If you have a large sum of cash and are concerned about a market crash, you can use Dollar Cost Averaging instead of a lump sum. Studies show that sum investing outperforms DCA 60% to 70% of the time. If DCA gets you invested, it is a win, relative to holding cash.
I lost money due to these mistakes. But it was worth every penny. I consider the money lost as tuition. I’m glad the mistakes occurred in my early 20’s when my portfolio value was relatively small.
It’s a hard balance to learn from your mistakes and move forward. This is a difficult balance, and it is hard. Accepting and learning from our mistakes requires self-discipline, the key to building wealth.