This article provides an overview of Preston’s interview where West Point instructor, Brian Rutherford, gives you the cheapest education you can think off: Learning from other people’s mistakes in investing.
This article and podcast answers the following questions:
- Who is Brian Rutherford?
- What are the 7 biggest mistakes investors make?
- Ask the Investors: How can a company like Tesla continue to operate with negative earnings?
Who is Brian Rutherford?
Brian is a graduate of West Point and MIT and is now an instructor at West Point teaching investing and accounting. Based on numerous questions and experience, he has created a list of the 7 biggest mistakes his students typically make. Brian’s students are particularly interesting not just because they have very little experience with money, but also because they get access to loans (up to $36,000) with very favorable terms as West Point cadets. The question they all ask is: “What to do with my money?” Brian’s answer is first to avoid the following mistakes…
So, what are the top 7 biggest stock investing mistakes?
In a non-prioritized order, Brian’s list includes the following mistakes:
#1: Stock Investing based on price charts.
Students look at price charts and think that they can base their investing strategy based on a pattern. This is not surprising, as you can’t look up any stock online without seeing a price chart, and how the price has changed over a period of time. Brian, who knows that you can predict future price movement based on the past, compares this to going to the casino. Some people would similarly conclude that if you went to the roulette board and saw that it has been black 5 times, you can then bet on red.
#2: What is cheap versus expensive for a stock?
Brian likes to tell the story of Apple. Apple’s stock was trading at $700 and went down t $100 a year later. What happened? Should we buy stock in the company now that it’s a lot cheaper? To understand what is cheap or expensive, Brian emphasizes to look behind the stock market price. If a stock has dropped that much in price, there is often a good explanation. In Apple’s example, it was because the company decided to split the stock and thereby also the split the stock price. A shrewd stock investor should always compare price and value – never price alone.
#3: To earn money in the short and not in the long run
Brian’s students sometimes come to him with an impressive track record. The problem of that track is that it’s short – very short. A student might have made 20% return in one year. Well, that might sound great, but this should be compared to the overall market. If the market did the same, the student has actually lost because he has taken a risk by only investing in very few or even a single stock and not diversifying. In the long run what will typically happen is that the student will place too big bets and lose a significant amount on a single stock.
#4: I’m always a genius – except when I’m unlucky
As humans, it can be dangerous to make money when you first start out in investing. Yes, that is actually what Brian Rutherford is saying. The reason is that you risk getting overconfident and start attributing profitable stock picks to your own superior abilities, and blame less unprofitable stock picks to pure lack of luck. This form of mental accounting does compound as you’ll feel that you don’t evaluate your own mistakes, and you keep feeling like you are beating the stock market because you only include winners in the evaluation of your performance.
#5: What are opportunity costs?
Most students – and the same goes for a lot of people – don’t think about the concept of opportunity costs. The concept is actually very simple. Once you have invested in one thing, you can’t take that money and invest in something else at the same time. Some students are happy with 1% return on a money account because they don’t lose any money. Brian doesn’t look at it like that. He’s rather saying that you are losing every year, because you are only getting 1% return, whereas you could invest in something else and get a higher expected return. Over time, this creates a vast compounding difference. Time is the most precious asset for the good investor.
#6: Protect your downside
In today’s market, the expected earnings yields from the stock market are around 4% and only 2% for fixed maturities. While these returns are clearly better than 0%, you also need to factor in what the risk of loss in your principal is at the current level. A classical mistake is to focus on where the return looks to be highest, but not having the full picture of the downside. There is a reason why the most successful people always say that you should protect your downside, before even thinking about where you can make the best return.
#7: Ignoring relevant variables
A variety of factors play a role for how the value of a stock changes over time. A common mistake is to only include your own 2-3 top variables of why you want to invest in that particular stock, and then ignore the remaining, or at least to attribute a lot more weigh to your reasons of why to buy the stock. This is actually a very natural thing to do for us as people, especially if you’re young and are used to perform well. This is called “confirmation bias”, which means that we search for information that will back us up on the previous conclusion that we already arrived at about the individual stock pick.
Ask the Investors: How can a company like Tesla continue to operate with negative net income?
Personal finances and corporate are not that different. You can never have negative earnings in the long run. In the short run, however, as a company you have two different options. The first one is debt. If you can find creditors that believe that the company eventually will be able to turn the business around the debt, it might be a temporary solution. Clearly, you should not only worry about the principal of the debt that has to be repaid; you’ll also need to be aware of the increasing interest expenses.
Another option is to issue stock. By doing so, it attracts capital in exchange for diluting the ownership of the existing shareholders. Which path to take for a company that is currently unprofitable is difficult to answer and Tesla been doing both like many other companies. One thing is for sure though. In the long run, the same rules apply to Tesla as to all other companies: To keep operating, it must eventually show a positive bottom line.
BOOKS AND RESOURCES
Preston and Stig’s executive summary of Robert Cialdini’s Book