Back again covering off from last week’s ‘Do You Invest and Trade to Lose? Part 1’ where I covered four ways to easily drain your bank account. Those included trading quickly and frequently, letting mainstream media be your guide, subscribing to the latest fads and dwelling on lost opportunities.
Here are some more effective ways to lose your money:
1. Buy cyclical stocks when they reach their peak
It is human nature to focus on the most recent events we have observed and use our perception of these events to make generalizations. Thus, when we look at a cyclical stock that has struggled for the past few years, we are most likely to assume that it will continue to struggle for the foreseeable future.
Sometimes, this can create good opportunities for us as investors. Conversely, when we see a stock that has had a good run for a number of years, we might assume that this good fortune will continue on indefinitely.
Both scenarios are mistakes; they are just at opposite ends of the cycle.
When a stock is at its peak, investors can mistake a cyclical stock for a growth stock. As a result, the investor can bid the shares up, possibly to a very high PER. The problem is that when profits are at a peak with cyclicals, we should be selling, not buying. When the earnings pass their peak and start declining with the cyclical downturn, the shares also come tumbling down.
- Follow excessively acquisitive management
Trevor Sykes, author of the book, Two Centuries of Panic, asserts that ‘more companies are ruined by bad management than by bad economies’. I wholeheartedly agree with this statement. Excessively acquisitive managers, those that will stop at nothing to achieve growth, are particularly vulnerable when it comes to getting into trouble. Why is that?
Acquisitions are risky in that they often involve significant amounts of debt. As an example, when interest rates climb, it becomes necessary to divert a growing portion of cashflow to service debt rather than investing it in the business or paying it out as dividends.
In addition, managements with overly inflated egos tend to spread themselves too thin as well as clouding the business’ financial accounting. This might pull the wool of the eyes of shareholders and bankers for a little while, but once the extent of the trouble is exposed, it may be too late.
- Invest in fast growing financial institutions
Depending upon how risky the borrower is, a financial institution may make a ‘spread’ or ‘margin’ on loans of anything from 1% to 5% per year. While this is enticing, when the loan goes bad, it can wind up costing them 100%. This risk requires very careful management. Warren Buffet summed it up best by saying that a bad bank manager can flush all our equity down the toilet in your lunch hour.
If we think that vigilance and watching accounting ratios is going to save us, think again. In the banking world, bad loans can actually be temporarily covered up by growth.
Banks that are experiencing high loan delinquency rates can temporarily cut those rates in half by writing new loans and doubling the size of its loan book. This buys the bank time because new loans have a bit of time before it goes bad. However, new loans that are made in a hurry are most likely going to be poorer quality.
Just throw our money into a rapidly growing financial institution and we maybe on your way towards financial ruin.
- Employ the ‘greater fool’ theory
One strategy that some investors use is to buy expensive stocks, very much aware that they are overvalued, and count on that fool who will come along and pay an even higher price than they did.
The dot com boom, oil and nickel boom is an example of how this works. Getting caught up in these kinds of booms is a sure fire way to the financial as well as emotional poor house.
By simply avoiding these losing strategies, we will already be far ahead of those who get caught in these common traps.