Seven deadly sins for investors

This article is a summary of post on masterinvest.com. While most investors focus on making money, picking good stocks and finding winners, few focus on avoiding the traps that end in permanent capital loss which is the real risk of investing. As Charlie Munger advises, “invert” the problem. So instead of asking “How can I make money?”, first ask “How can I avoid investments that lose money?” Outlined below are the seven deadly sins of portfolio management. Ordinarily it’s a combination of these factors that gets investors into trouble.

Sin 1 – Excessive Leverage – Leverage gives someone else the right to say when the game is over. Too much leverage at the portfolio level and/or in the companies that you own can lead to permanent loss of capital. Limit your leverage.

Sin 2 – Excessive Concentration – Mistakes in investing are inevitable given the magnitude of variables involved and imperfect information. Having too much exposure to one stock or sector can be a costly mistake. Large positions can become illiquid and if publicly known may attract predatory activity. Limit the position sizes to minimize this risk.

Sin 3 – Excessive Correlation – At times certain stocks may become correlated and all move in the same direction offsetting the benefits of diversification. Correlations can “go to 1” in difficult market conditions. Things you expect to be uncorrelated may become correlated due to crowding, index implications, money flows, economic factors or geographic events. There is little protection in a bear market outside of short positions and cash. Seek diversification, limit sector exposure, hold cash and constantly think of where the correlation risks lie in the portfolio. 

Sin 4 – Illiquidity – Illiquidity hurts when an investment thesis changes or the investor needs cash and wishes to exit a position. There may be no market to sell into. 

Sin 5 – Capital Flight – Capital flight occurs when investors want their money back at the same time, usually when markets or stock prices are weak. Selling a stock at a low point can lead to permanent loss of capital. It’s even more risky when positions are illiquid

Sin 6 – High Flyers – When expensive stocks get into trouble or a bubble is burst they can be de-rated leading to the permanent loss of capital. Having all your portfolio in tech stocks at the height of the Nasdaq boom in 2000 or the Nifty-Fifty boom in the late 1960’s is a good example of the risks to capital when stock PE’s are significantly de-rated.

Sin 7 – Fraud – When a company acts fraudulently this can lead to a permanent loss of capital. Think of Enron or Satyam as an example. Ensuring you really understand how the business operates and analyzing the long term track record of management can go a long way to avoid these problems. 

Remember successful investing starts by not losing. Portfolio management is a skill that requires a lot more thinking than just picking a bunch of stocks you like. Each stock and its respective size, liquidity, correlations etc. must be considered in the context of the whole portfolio.