Wednesday, October 15, 2008

Stock Market Education For Beginners - Learning From Your Mistakes

Have you lost money in the stock market? Okay, that might seem like a stupid question with most major share indices down by almost 50% from their highs. But just humor me. Have you made some poor stock market investment decisions which have resulted in a permanent loss of capital (beyond the paper losses you're probably sitting on just now)? If you're like most average investors, including myself, you probably have.

It's never fun losing money, but if you look at it in a positive light, it's a great opportunity to learn a thing or two about investing and maybe even something about yourself. In fact you could even look at the funds you've lost as an investment in your stock market education.

In my recent post Analyzing Your Stock Market Investment Performance, I discussed the need to measure your investment performance and to benchmark that performance against financial returns generally. I don't want to labor the point, but I think it's a very important step in the investment process and one which some investors seem to ignore (the professionals as well as stock market beginners.

The next logical step in this process is to drill down and take a close look at the results of some of your individual investments. We have a tendency to congratulate ourselves when an investment goes well and we make money out of it. But many of us also have a habit of downplaying our investment losses, treating them as an aberration. "Let's just sweep that one under the carpet... move on - there's nothing to see here!"

But to become better investors we each need to be able to stand back and objectively analyze the losses we've made in order to work out what went wrong. In order to do this you really need to get inside the investment.

Objectively analyze the position the company was in when you bought into it. Now compare that to how it looked when you sold. Did the state of affairs deteriorate in the period over which you held the stock? If so, was that foreseeable? Did you pay a premium for what looked like a rapidly growing business, only to see the price plummet when that growth didn't eventuate or wasn't is high as the market wanted?

Revisit your thinking. Why did you buy the stock in the first place? Review any notes you may have taken at the time. See if you can recall the reasoning which led to the original acquisition. It's important to be honest with yourself and not just rationalize your actions after the event.

The goal of this exercise is not to shame and humiliate yourself, but rather to identify any shortcomings in your investment process or in your stock market strategy as a whole. Only then can you take steps to address these shortcomings, refine the way you make investment decisions and reap the benefits of out-performance of future gains.

The end result might be a fundamental shift in your investment philosophy. Or it may just be a minor adjustment to the process you follow - an extra filter, or another point to add to your analysis checklist- learning to get back to stock market basics. I'm a big believer in being patient - invest less frequently and only when you're convinced of the value being offered.

Investment Lessons I've Learned...

While there are way too many lessons for me to list in this post, here are a couple of the more expensive lessons I've learned in the past.

First Mistake - Too Much Debt!

As a stock market beginner, one of my first forays into the market resulted in me buying stock in a company which looked extremely cheap based on fundamentals. Things like price to earnings and dividend yield. In my efforts to learn stock market investing concepts I'd read that value investors like Benjamin Graham and Warren Buffett had made money by investing in extremely cheap bargain stocks - and being a contrarian, I figured this business fit the bill perfectly. What I didn't take into account was the amount of debt the company carried and that the cost to the company of servicing that debt meant that a decent breeze blowing through the economy might be enough to bring the whole thing down. Investors had marked down the price accordingly but I was too naive to recognize the very real risk of insolvency. I know - every half-decent stock market guide & tutorial you read will warn you about this but I had to find out for myself.

While the company did survive, it had to re-capitalize and in the process destroyed a significant amount of shareholder value. This investment resulted in a permanent loss of capital on my part. While I was diversified enough for it not be cause undue hardship, it still stung to lose money. That was a big leap forward for me in understanding the stock market.

Anyway, since then I've been much more careful when investing in companies whose debt may turn out to be a problem. Using tools like the quick ratio and debt to equity ratio I've been able to navigate my way through the latest financial crises relatively unscathed. I should explain that last statement. While I, like most other investors, am sitting on paper losses for a few of my investments, none of the companies I own have encountered any fundamental problems due to the credit crunch. Rather their prices have suffered along with the general market. But each of the businesses is strong and still growing in value and I believe in more stable market will sell for prices significantly in excess of what I've paid for them.

Second Mistake - Believing What Management Say.

This is another lesson I learned from the situation I described above. Management constantly downplayed the risks associated with the financial position of the company. They continually attributed low probabilities to certain financial events which may or may not have occurred. Without going into specifics, lets just say I think I had the wool pulled over my eyes.

When I looked back on the matter (hindsight's a wonderful thing) a couple of things became clear. The financial reports were at odds with the soothing noises which emanated from the upper echelons of management. And I noticed the guys running the show had no skin in the game - they had none of their own personal wealth invested in the company. No wonder they weren't worried!

As usual, I've gone on much longer than I intended, but the upshot of all of this is that I now have a couple of extra boxes to tick before I'm willing to part with my hard-earned cash.

So take some time to learn from your investment mistakes. After all, you've already parted with the funds so you may as well get value for your dollar and advance your stock market education.