In my first three years of investing, I made each of these mistakes.
There are benefits to learning from the mistakes of others. That’s why I love reading non-fiction. By learning from others, you can avoid the pain of making these mistakes yourself. You can start with a foundation built by others. This concept is demonstrated through Isaac Newton’s quote:
“If I’ve seen further, it’s by standing on the shoulders of giants”.
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 low P/E ratios and high yields were justified by a poorly performing business. After all, 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 can be like a trap. This is called the value trap.
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.
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.
Understand Share Buy Backs
I also learned that dividends aren’t the only way for a company to return cash to shareholders. They can also use share buybacks. When a company purchases its own shares, it reduces the total number of shares available. Your “share” of the business expands to represent a larger portion of the business. With share buybacks, you see the cash in the form of increased stock price – a capital gain.
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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 acquired and 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.
Market Efficiency and Indexed Funds
Further, it will be very difficult to find information that is not already baked into the stock price by millions of others. This is called market efficiency. It is for this reason that I now invest in Indexed Funds.
Indexed funds allow one to invest without digging into the unique details of specific companies. However, it’s still important to understand the underlying mechanics of indexed ETFs or indexed mutual funds. I like to read about market efficiency, to know the stocks that make up the index.
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.
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.
Indexed Funds Have Low Fees
Index funds simply buy the stocks that make up an underlying index. This is easy to manage, and can be done at massive scale. Both scale and ease of management result in low fees. You can see this through the tiny Management Expense Ratios (MER) of 0.03% to 0.2%.
Indexed Funds Limit Behavioral Errors
You are your greatest enemy when it comes to investing. Your behavioral biases can get in the way. Overconfidence, loss aversion, and herding are common and costly human biases. The less involved you are with your portfolio, the fewer errors you will make. This is why I love portfolio simplicity. I discuss common biases more closely in this post.
Indexed Funds Preserve Your Time
Indexed funds preserve your time – the most valuable thing you have. You’ll spend less time managing your portfolio and more time living life.
You must keep up with the financials, industry developments and unique business risks for each stock (business) that you own. That’s a lot of work. Multiply that work across 10+ companies, and stock selection quickly equates to having a second job or intense hobby.
Researching individual businesses and keeping up to date takes time. A ton of time. Most people, roughly 99% of us, don’t have the time or passion to manage our own portfolios of individual stocks.
4. Failing to Preserve Contribution Room 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.
I thought I could predict the market, a key form of 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 want to gamble in high-risk items, do so in your taxable account to preserve contribution room.
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.
Consistent Savings and Investing
Most of us earn a steady income and have consistent expenses. When expenses are consistently lower than income, you can save and invest on a routine basis. Under this system you will naturally catch the highs and lows of the market over the course of 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 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.
Learn from your mistakes and move forward. Don’t dwell on them, and don’t repeat them. This is a difficult balance, and it is hard. Accepting and learning from our mistakes requires self-discipline, the key to building wealth.