Most Investors Fail. Don’t Make The Same Mistake.
Free trading and fractional brokerage apps like Robinhood blew the last “unbroked” parts of the market wide open. Now anyone can invest, even if their account size is not large.
People that could never invest before can now buy part-ownership of their favourite companies for just a few dollars. And, just like everyone who went before them, these new investors are going to run straight into the sausage maker of public markets.
Whether they survive the trip to the other side will depend in large part on whether they’re investing their own money or if they’ve been convinced to trade using leverage or options. Whether they develop a sensible investment process or end up gambling will also prove a major contributor.
So why does this matter?
Most research shows that retail investors on average underperform the market. This finding is consistent across countries and markets — including the UK, USA, Canada, Australia. Depending on how you slice the research (some of which is horrifically outdated), you find that the worst performing investors often have smaller account sizes and fewer years of experience.
These findings make sense. Less experienced investors know less and, all else being equal, should fail more often. Ongoing costs (brokerage, research) are much larger in percentage terms for small accounts and again, all else equal, should make performance worse.
That’s fine and free brokerage and low cost indices solve most of these problems. But once you dive into the craft of investing, there are thousands of specific mistakes that cost people a lot of money. I’ve been investing for thirteen years and working in public markets for eight. I’ve seen all of these mistakes and made most of them myself.
But there is one critical mistake that I see kill investors time after time after time:
To know which way to go, you must have an end goal in mind. Maybe you are young and want to accumulate money for retirement. Maybe you are old and need to generate an income, or preserve what you’ve got. Setting a financial goal that fits your life is far outside the scope of this article, but for the purpose of debate, let us accept that you should have one.
Once you have a financial goal, you need an investment process for how to achieve it. As a simple example, if your goal is to live off dividends from stocks, buying unprofitable lithium explorers probably won’t get you there.
(For more about why investment processes matter, see The 7 Benefits Of An Investment Process)
As part of your process, you must consider how much risk you are willing to tolerate. There are a few ways to think about risk, but for the purpose of this article, let us accept that our definition of risk is “the most amount of money, in dollar terms, that I am willing to lose on a stock”.
Let us imagine that I am an inexperienced investor. I have $100,000 I want to invest. I don’t want to lose any more than $5,000 on any single stock.
This gives us two inputs into our system. I know that I can make things easier by not having more than 5% of my portfolio ($5,000) in any single stock. On occasions when I do that, I must aim to own stocks without risk of 100% loss.
How To Measure Risk
How can you know how much risk you’re taking?? The main problem you will run into here is experience. If you have not been investing for very long (less than 10 years), you have not seen many of the things that are possible. However, your imagination is a powerful tool.
Our hypothetical inexperienced investor imagines what a good investment looks like:
I know that a business must make things that people want, and sell them at a price that lets it make a profit. I know that borrowing too much money can be risky especially if something happens and you can’t pay the debt.
Plus, I have read about Amazon and I heard that it copies competitors and crushes them. My investments should ideally not be at the mercy of a single, powerful company.
If this is all our hypothetical investor knows about investing, she already has a powerful starting checklist:
- The company must have a good product/service that people want and will always pay for. Look for signs of repeat purchases, customer purchase $ amounts growing over time, evangelical customers.
- It must make a profit on the things that it sells. Does the company report a profit or not? Once you learn more about reading financial statements, you can look at things like: Does it have positive gross margins, does it generate cash flow, are the reported earnings due to the sale of the product or some other reason (e.g. gains on the value of investments)?
- It must have little to no debt, and ideally a good amount of cash in the bank. It is extraordinarily difficult to go bankrupt* if you are profitable, have zero debt, and a mountain of cash in the bank. Difficult, but not impossible, so check for consistent positive operating cashflow, and find out if the earnings + cashflow are due to sale of the core product or service or one-off items.
*Australian mining contractors and construction companies have figured out how to do it.
- Earnings and revenues should not fluctuate drastically from year to year. Companies that can sell their product consistently, year after year, are in a good position to create and preserve value for investors. Look for at least five years of consistent revenues and profits. Look further back in time to see how large the biggest downturn was and why it happened. Learn to identify whether the fluctuations are due to changes in the market for the product, or other reasons such as a change in tax codes, a merger that increased earnings, commodity price changes, currency fluctuations, etc. Companies know that investors value consistency, so they will also act in a way to smooth out their earnings. This is something that you will only get good at with time — it is one of the most discerning disciplines of investing.
- The company must not be at the mercy of a large company for its sales or product. In many cases, a company can be seriously empowered by a partner (e.g. accepting Mastercard, or advertising on Google) without being “at the mercy” of that business. These partners typically do not compete with your company, and will not single it out for destruction. What you really want to avoid are situations where a company’s revenue and earnings are dependent on a single customer’s happiness. Being the sole manufacturer of the iPhone could be a good example. If your major customer is unhappy and leaves, your business evaporates. Contract manufacturers and service providers are most likely to run this type of risk.
So. Our hypothetical investor has spent some time in her imagination and knows the risks she wants to avoid. The checklist isn’t perfect. It’s simple in some places. Limited by her experience. But it’s a good starting point and it will keep her out of a lot of obvious traps. If she measures every prospective investment against this checklist, she will substantially improve her odds of avoiding 100% losses.
Over time, she can refine the list and improve her chances further.
The real question is, how does someone implement this type of checklist? Most investors we’ve spoken to do it the old way, with spreadsheets and an investing diary.
We’ve made software that does it better. It’s called Blocks. It’s free to get started, and it comes with a default checklist so you can jump straight in and start looking at companies. (For now, it is Australia-only). It’s a good place for investors to take their first steps into a more systematic world, and improve their investment discipline.
Thanks for sticking with us. Over the coming weeks we’ll have more posts on how to make a good investment process, common traps to avoid, and some deep dives on stocks using our own processes. If you want to stay in touch, you can set up a free account on myblocks.app.