Ten classic mistakes share investors make and how to avoid them

With the share market so easily spooked into panic selling amid fears over China’s economy, record low commodity prices, over-exposure of banks to commodity-based debt, and talk of the US economy going back into recession, even the best investors have succumbed to irrational decision making when it comes to buying or selling shares.

By simply understanding how fear and emotions impact you as an investor, you’ll be more likely to make rational investment decisions. To ensure you avoid the most common gaffes investors experience when buying and selling shares, you need to devise an investment plan suitable to your own situation and stick to it.

To avoid expensive investment traps you firstly need to second-guess the investor herd-mentality, which is so often fuelled by fear, greed and doubt.

It may seem counterintuitive to defy ‘conventional’ investor wisdom, and buy when others are selling, and exit those stocks when the same investors are crawling over themselves to buy more, but it’s proven to be a sensible approach.

Sadly, when markets get sold off, too many investors are quick to turn a paper loss into an actual loss by selling well below their entry price, only to watch the price correct and often within short order.

The mispricing thrown up by panic selling since the start of the year also presented some golden buying opportunities for those investors who knew exactly what they’re doing.

To help you side-step costly investment errors in future, here’s a window into the ten most commonly made investment mistakes even the most experienced and financially literate investors can fall into.

1) Buying tomorrow’s absolute dogs

As an astute investor you need to determine whether the company you’re considering buying represents value for the price you’re prepared to pay for its shares.

The world’s most successful investor, Warren Buffet proved convincingly that share prices eventually converge with a company’s intrinsic value (the sum total of the company’s worth based on earnings, dividends, equity and debt). Ideally, you want to buy good companies trading at an attractive discount to their underlying value.

Paying too much for a top quality company can destroy wealth as fast as investing in those with excessive debt.

It’s equally important to avoid value-traps. Admittedly, they appear cheap (based on P/E), but these companies typically have rising debt levels, fading competitiveness and declining cash flows.

Remember, if you’re drawn to a company because its shares are trading under the psychological $1 barrier, you could be confusing affordability with value.

 

2) Treating the share market like a casino

How you approach the share market will determine whether you’re a punter/speculator or an investor.

Punters are happy to trade-off higher levels of risk on the off chance it might deliver higher-than-average returns. By comparison, investors reduce the risks associated with holding a listed company while maximising returns.

Part of being a good investor is recognising that you’re buying into a business that employs staff, borrows money, generates earnings from one or more core business activities, and where appropriate pays dividends.

So unless you’re a day trader, buy companies based on quality fundamentals not share price momentum, and avoid low quality businesses displaying little opportunity for growth.

Remember, while there are over 2,000 stocks listed on the share market, less than 10% would be regarded as investment grade companies.

Above all, avoid low quality businesses and stop treating the share market like a lucky dip.

 

3) Seduced by an unsustainable yield

While there are over 850 Australian publicly listed companies paying regular dividends, many of them are unsustainable. For example, plummeting earnings within the resources sector is likely to take its toll on dividend pay-outs.

As a case in point, BHP Billiton (ASX: BHP) could well cut its dividend pay-out ratio to position itself for acquisitions at the bottom of the mining cycle.

What determines the ongoing affordability of a dividend is the quality of the underlying business, and its ability to consistently grow earnings. For example, Woodside Petroleum (ASX: WPL) recently slashed its dividend payments by almost 60% as a result of collapsed oil and gas prices.

It’s important to avoid companies offering dividends that cannot be supported through cash generated by the business, or where the company has to borrow to fund to execute a dividend to shareholders.

Similarly, avoid stocks where the high dividend yield is only attributable to a falling share price due to declining fundamentals like high debt, falling profits or negative cash flow.

Any signals that the current dividend level is no longer affordable could be an opportunity to exit the stock, especially if you bought it as an income-play.

4) Riding a stock down

The closer a company’s share price gets to its intrinsic value, the greater the risk of holding the stock. And the more the share price exceeds a company’s intrinsic value, the greater the argument for locking in your gain.

But don’t be too greedy and don’t rely on unwarranted optimism.

On the flipside, it’s irrational to hold onto a value-trap where the falling share price reflects lost earnings due to number of reasons, like lost monopoly status and/or loss of competitive advantage.

It’s better to improve the performance of your overall portfolio by selling the deadwood stocks you own, deploying what funds are left to the market’s next best opportunity, and booking the loss against future gains for tax purposes.

Equally important, remember this: stocks with low P/E ratios or high dividend yields have typically become that way for good reason. Take these smouldering time-bombs out of your portfolio before they do greater damage.

In early 2007 Fairfax Media’s (ASX: FJX) share price was almost three times higher than what its business was worth. Locking in a profit would have been a very smart move. Fairfax is now trading around $0.82 and its intrinsic valuations vary between 55c and 67c.

5) Placing price over value

Contrary to popular opinion, P/E ratio – (current) share price / (historical) earnings per share – reveals precious little about the value of a company. All it really does tell you is what the market is prepared to pay for the current earnings per share.

More meaningful measures when it comes to stock selection are the following performance ratios:

  • Intrinsic Value
  • Return on equity (ROE), which should be greater than 15%;
  • Management’s track-record;
  • Net-debt to equity, which should be under 40%;
  • Earnings per share (EPS) growth, which offers a snapshot into future prospects and profitability.

 

6) Overlooking leading market indicators

Whether it’s listed on the ASX or not, every company is impacted by a plethora of macroeconomic influences. These leading (domestic) indicators provide useful insights into what sectors and stocks stand to benefit (or lose) from the economic activity directly beyond their control.

Key economic indicators you need to keep an eye on include:

Interest rates, currency, job vacancies, unemployment rate, building approvals, trade balance, GDP, housing credit, commodity prices, and inflation as measured through CPI.

By keeping abreast of the global and local economy, you’ll be better positioned to actively review your investment portfolio in light of those sectors that will either benefit or suffer going forward.

 

7) Sitting on your hands

Within an environment where the market can move over 2% in a day, a ‘set & forget’ approach – whereby you park shares in the bottom drawer forever – must give way to a more flexible strategy for actively managing the stocks you own.

Given that value is a constantly moving beast, you need to regularly pressure-test your stocks against key fundamentals.

Remember, past performance is no guarantee of future returns.

So you can’t simply buy blue-chips with strong brand names, high profiles – and a long history of good performance – and expect them to continually deliver strong results.

As a case in point, there was seismic fall in the Suncorp Group’s (ASX: SUN) insurance trading ratio (ITR) — a key measure of profitability — to 10% for the half year to 31 December 2015, and some analysts fear the company will struggle to again reach the ITR of 14.7% it achieved for the full year ended 30 June 2015.

 

8) No investment plan

By undergoing a comprehensive review of your current financial position, you’re more likely to develop an investment strategy that’s custom made for your specific requirements.

But before devising an investment plan, you need to get an accurate picture of your cash flow, including income, regular outgoings – especially any discretionary spending – and your capacity to save/invest surplus money.

The right investment plan depends on so many factors unique to you – none the least being your age, earnings and existing assets – which have a direct bearing on both your investment time-horizon, and risk/reward profile.

Like everybody else, more cautious investors would like above average returns, but their need for wealth preservation is higher than more aggressive investors who can afford to take greater risks in pursuit of higher gains.

One common aim that all good investment plans share is wealth accumulation over time.

Learning how to invest and understanding why will not only crystallise your short and longer-term financial goals, but help to diversify your portfolio’s exposure to key asset classes according to your risk appetite.

Exactly how much of your portfolio is allocated to each asset class should directly reflect economic conditions and investment prospects, plus your requirement for investment generated (or passive) income.

Given that markets are constantly moving beasts, your plan needs revisiting regularly.

 

9) Backing value destroying capital raisings

While a capital raising may reduce company debt, and bigger question for you the investor is will it increase value on a per share basis over the long term?

Generally speaking, a capital raising will dilute earnings per share (EPS) in the short term, in the hope that the future earnings impact will be positive. But remember, this outcome is never guaranteed.

So if a capital raising results in a material decline in intrinsic value, then sustainable price increases are unlikely. In the long run a company’s share price and its intrinsic value are destined to converge at some future point.

In 2012 White haven Coal (ASX: WHC) raised more than $2,500 million and added more than $300 million debt to its balance sheet. Over the same period profits fell $20 million and return on equity (ROE) more than halved, to 3%.

 

10) Quick-buck syndrome

Given that longevity is the ‘new norm’, don’t be surprised if you end up spending as much time in retirement as you did working.

That’s why it’s important to look well beyond the short-term wins (and losses) thrown up by a volatile share market, and search for wealth creation – through both share price appreciation and dividends – over a much longer haul investment horizon.

We may have entered a new era of single-digit returns, but don’t forget that even based on long-term annualised return of 7%, you’ll still double your money every 10 years.

But remember, while it’s important to stay ‘in the market’, that doesn’t mean buying stocks and parking them in the bottom drawer indefinitely.