3 Ways You're Going To Lose Money

Published in Investing on 3 August 2012

The risks are very real. But it doesn't have to be that way.

Building wealth through investments in the stock market isn't for the lazy or faint-hearted. Successful stock-picking, in short, calls for research, analysis, judgment and timing -- not to mention an element of occasional luck.

Even investors opting for the very simplest means of doing so -- an index tracker that tracks the FTSE 100 (UKX) or FTSE All-Share, for instance -- have to sift through tracker providers' various offerings in search of low costs and low tracking error.

Presently, of course, that search would point you at trackers from Vanguard or HSBC (LSE: HSBA), either as funds or ETFs such as the Vanguard FTSE 100 ETF (LSE: VUKE) or the HSBC FTSE 250 ETF (LSE: HMCX). But times change, and so too do tracker 'best buy' tables.

Destroying wealth, on the other hand, is a much more straightforward affair. Easily done, it requires no skill, and in contrast to the multi-year timescale required to build up a decent-sized portfolio, it can happen in a matter of days or weeks.

Take, for instance, these three wealth-sapping pitfalls -- each of which claims fresh new victims each year.

1) Lack of strategy

Look at successful investors such as Benjamin Graham, Jim Slater and Peter Lynch, and what you'll see is a consistent strategy. Sure, they deviated from it occasionally, but in the main it is generally possible to describe each of them by their strategy. Graham, for example, was a 'deep value' investor. So in many ways is Warren Buffett, a Graham disciple who studied under Graham at the New York Institute of Finance in the early 1950s.

But while the success of those pursuing a given strategy is in part simply down to that strategy itself, there's another, more subtle reason why following a strategy helps to avoid money-losing wealth-sapping decisions.

And it's this: working within a single strategy, the investor becomes more skilled at weighing-up potential competing investing decisions, and evaluating how well they fit the strategy in question. Try to be a growth investor one day and a value investor the next, and you'll fail to perform well at either role.

2) Making the simple too complex

Warren Buffett famously called derivatives "weapons of mass financial destruction". I'd add a few more to the list.

Spread betting, for instance: I've seen figures claiming that three-quarters of retail 'investors' making such bets lose money. Day trading, too, seems to burn through a lot of investors' cash before dumping them penniless on the pavement.

Stop losses are another example, despite the value that some investors consistently place on them: there are just too many examples of people being "stopped out" by short-term adverse movements in price that were just meaningless noise.

Likewise automated 'buy orders' -- just ask the people who bought into Royal Bank of Scotland (LSE: RBS) and Northern Rock as they crashed spectacularly into the buffers.

3) Failing to diversify

As a number of investment gurus regularly point out -- David Swensen and James Montier among them -- asset allocation plays an important part in determining the overall return that an investor makes over time.

But diversification is a challenge on many levels. There's diversification of asset classes: cash, property, UK shares, foreign shares, gilts, bonds and so on. But also diversification within asset classes -- arriving at a suitably-diversified mix of shares, for instance.

Build such a mix, though, and not only is the risk of a meltdown reduced, but the required 'rate of recovery' is lower. As the most recent edition of Graham's classic Intelligent Investor points out, a 50% fall in the price of a stock will take 16 years to catch up with the rest of the market -- even if you're getting double the market's overall 5% rate of return.

What to do?

Here at the Motley Fool, whether as income investors or investors looking for long-term capital growth, we're enormously influenced by these words of wisdom from Warren Buffett:

"Your goal as an investor should simply be to purchase, at a rational price, a part-interest in an easily understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now... If you aren't willing to own a stock for ten years, don't even think about it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also, will the portfolio's market value."

But how to find such shares? Spend any time on our popular discussion boards, and opportunities abound to exchange views with countless other investors. My own particular favourite, as it happens, is our popular board for income investing, the High Yield Portfolio board.

Low-cost investment trusts are another option. Cheaper than mutual funds, and arguably easier to buy and sell, there are popular trusts to suit most investing styles.

For capital growth, Scottish Mortgage Investment Trust (LSE: SMT) is a good bet, combining low costs with a sector-leading track record. For income investors, City of London Investment Trust (LSE: CTY) has delivered year-on-year dividend increases for 45 years -- as has Bankers Trust (LSE: BNKR), another dividend stalwart.

Follow the experts

Still another option is to follow the strategies -- and stock picks -- identified by other, successful investors. And one investor worth taking a look at is Neil Woodford, who looks after two of the country's largest investment funds, and runs more money for private investors than any other City manager.

A free special report from The Motley Fool -- "8 Shares Held By Britain's Super Investor" -- profiles eight of his largest holdings, and explains the investing logic behind them.

Is he worth listening to? Well, on a dividend re‑invested basis over the 15 years to 31 December 2011, Mr Woodford has delivered a spanking 347% return, versus the FTSE All‑Share's distinctly more modest 42% performance. Which to my mind, speaks for itself. Download the report, and see for yourself the shares that are powering his portfolio right now.

Another investor worth taking a look at is Warren Buffett himself, of course. As it happens, he's been loading-up on one UK share recently, buying on dips, and now holds over 5% of it.

Does it fit his criteria of investing 'in an easily understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.. '? Once again, why not download another of our free reports, "The One UK Share Warren Buffett Loves", and judge for yourself? It's free, so what have you got to lose?

Want to learn more about shares, but not sure where to start? Download our latest guide -- "What Every New Investor Needs To Know" -- it's free. The Motley Fool is helping Britain invest. Better.

More investing ideas from Malcolm Wheatley:

> Malcolm holds index trackers from Vanguard and HSBC, and holds shares in Scottish Mortgage.

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

goodlifer 03 Aug 2012 , 11:44pm

I've had a bit of a look at your "8 Shares Held By Britain's Super Investor"

It may be an illusion, but Mr Woodford's practice doesn'i.altogether seem to square with the gospel you Foolish writers preach, particularly over asset allocation.

For example Mr Woodford holds no less than three tobaccos (none which I'd touch with a bargepole, but that's neither here nor there.)

In a recent interview Mr Kuo was at great pains to point out that holding both Sainsburys and Tescos didn't amount to realistic diversion/asset allocation because they're both in the same sector.

It also seems to be true that Mr Woodford holds no shares in the banking sector.

Is Mr Woodford unaffected by the investment principles that apply to ordinary mortals?

Or does your article misrepresent his strategy?

Or - perhaps most likely - does the Foolish teaching on asset allocation need to be updated?

As you probably realise, I think a lot of what's said about asset allocation is superstitious rubbish.
Do you agree?

thebuffoon 03 Aug 2012 , 11:50pm

Malcolm,

People speadbetting/gambling on indices, with or without leverage, do tend to lose money. Those of us who use no leverage to invest in shares do no worse than anyone else who invests in shares.

I use spreadbets with moderate leverage, and have done very well over a long period, as have others. Not having to pat CGT is a HUGE plus.

Please stop perpetuating the myth about spreadbetting by misusing statistics.

Buffy

ScottishPound 04 Aug 2012 , 9:08am

"Your goal as an investor should simply be to purchase, at a rational price, a part-interest in an easily understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now... If you aren't willing to own a stock for ten years, don't even think about it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also, will the portfolio's market value."

Words of wisdom indeed, and an excellent basis for an investment strategy.

lotontech 04 Aug 2012 , 12:37pm

Hi Malcolm,

I'm a little puzzled about spread betting falling under the heading "Making the simple too complex".

Spread bets are much simpler than traditional share trades because there are no commissions to account for, no tax implications, and no "management charges" that there would be in an ISA or SIPP account. Index spread bets are much more transparent than (for example) index ETFs in a brokerage account, because there is no tracking error with the index spread bets.

Having studied, practised, and written articles (here) and books about spread betting over a number of years, I think -- with respect -- that in this case you may be wrong. Same with Stop Orders.

I agree on lack of strategy and failing to diversify, though.

Tony Loton

goodlifer 04 Aug 2012 , 8:55pm

Hi Dr Wheatley,

"As you probably realise, I think a lot of what's said about asset allocation is superstitious rubbish.
Do you agree?"

Whether you agree or not, it would be very helpful to a lot of us if you - or one of your Foolish colleagues - were to write something about the superstitions, the heresies and the whys and wherefores of diversification, asset allocation, dynamic hedging and all that jazz.

Just a thought.

MDW1954 05 Aug 2012 , 6:13pm

Hello goodlifer,

I'll make sure the folks at Fool HQ see your request.

Malcolm (author)

goodlifer 05 Aug 2012 , 8:28pm

Many thanks

rober00 06 Aug 2012 , 4:37pm

"As you probably realise, I think a lot of what's said about asset allocation is superstitious rubbish.
Do you agree?"

Not So!! Have a look at ITs that publish their profit breakdown and you will see that in nearly all cases Asset Allocation accounts for the bulk of their returns.

If you want further evidence have a look at Tim Hales Smarter Investing.

goodlifer 06 Aug 2012 , 8:16pm

rober00

You're probably quite right.

But it could still be true a lot of what's said about asset allocation is superstitious rubbish.
Or not, as the case might be.

goodlifer 06 Aug 2012 , 8:40pm

Hi again rober00,

If I remember correctly, you and I once had a bit of a difference of opinion about whether investment is necessarily always a zerosum game.

What i found particularly interesting was your assertion that anyone who didn't realise this is heading for disaster.
What's the thinking behind this warning?

If I've got the wrong guy, please accept my humble apologies.

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