Here are the key takeaways from the article:
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The goal of every investor should be to be both smart and wise to avoid big mistakes
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It is essential for investors to have a quality-focused long-term investment strategy if they want to achieve success in the investment world. It is very challenging to follow such a strategy, as it involves resisting the temptations to respond to short-term attractive opportunities
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Three things that indicate the true quality of a business: strong and predictable cash generation, sustainably high returns on capital and attractive growth opportunities
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The best thing to do after making or observing a mistake is to acknowledge it and absorb the relevant lessons to avoid repeating it
Common mistakes:
- Cunningham says investors can make mistakes if they give more importance to and follow a top-down approach over bottom-up analysis. This is often the case when large macroeconomic factors start affecting stock prices, leading to investors questioning their exposure to factors such as trade, inflation or currency values.
“Although these macroeconomic trends warrant close attention, as they bear on given companies and industries. However, when top-down factors trump bottom-up analysis, it often leads to choosing companies and industries for the wrong reasons," he says.
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Being over-optimistic: He says investors often fall in the trap of believing companies, which assure investors that good times are around the corner. Investors must be able to identify when a structurally challenged moment arrives in the industry/individual business
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Overconfidence: Investors should stay alert to the risks of venturing into unfamiliar zones, which can help recognize and respond to surprise events or disruptions rationally
"Straying beyond the boundaries of one’s knowledge and experience increases the risk of making an error. For instance, any investment in a stock that depends on the outcome of external factors beyond a company’s control is on shaky ground,”
- Debt: debt-oriented mistakes are most likely during periods of economic expansion as amid prosperity, even mediocre companies appear to perform exceptionally well
“Debt can be seductive because even those wary of excessive leverage can be deceived into stressing its upside more than its downside”
- Retaining a stock: Investors often make mistakes as they get complacent and fail to recognise when a ‘once-great company’ is falling out of favour. No firm is invincible, investors should devote considerable effort to monitor and notice signs of deterioration to prevent further damage to a portfolio.
“investors must detect the gradual decay of a company and resist complacency and denial even if it had given great returns in the past. The overall deterioration of a business generally begins with small things not going according to the plan, like growth not materialising, unexplained pressure on margins, more discussion of competitive pressures or gradual increases in capital expenditure”.
- Failing to spot accounting irregularities: Cunningham says investors should study the financial reports of a company carefully to spot whether all the financial parameters will remain healthy in the future.
“As accounting is the language of business, every investor must be conversant in it. Beyond assessing the fundamentals of asset turnover and margins to evaluate business quality, financial reports often contain innumerable subtle clues about the sustainability and predictability of earnings growth, cash flows and return on capital.”
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Falling for the 'Endowment Effect: over-appreciation of things already owned compared with other opportunities. Quality investing is particularly susceptible to the endowment effect because the considerable upfront and extensive research increases the effect as the investor’s sense of ownership confines not just the stock, but also their analysis and judgment. Longer a stock is owned, the more the emotional connect with it
How to reduce making mistakes:
- Have complete knowledge about a company
- Prepare checklists
- Perform inertia analysis: Investors should compare the hypothetical performance of an unchanged portfolio with actual performance to check how much value trading decisions add.
“The exercise is an acute reminder that doing nothing can be a positive action and weighs every decision against this,"
- Analyse past mistakes
- Mitigate behavioural biases (can be part of the checklist)