Avoiding Pitfalls

“An investor needs to do very few things right as long as he avoids big mistakes” -Warren Buffett

To avoid losses, we need to understand the pitfalls that create them.

Sources of error are primarily analytical/intellectual or psychological/emotional.

Psychological forces are some of the most interesting sources of investment error.

How are investors harmed by these forces?

• By succumbing to them
• By participating unknowingly in markets that have been distorted by others’ succumbing
• By failing to take advantage when those distortions are present

If you buy when the price exceeds the intrinsic value, you’ll have to be extremely lucky. The asset will have to go from overvalued to even more overvalued in order to experience gain rather than loss.

Average investors are fortunate if they can avoid pitfalls, superior investors look to take advantage of them.

An example of not taking advantage of a pitfall is failing to short an overvalued stock. This is an error of omission.

The first step in avoiding pitfalls is to look out for them.

What do we learn from a crisis?

1. Too much capital availability makes money flow to the wrong places.
2. When capital goes where it shouldn’t, bad things happen.
3. When capital is in oversupply, investors compete for deals by accepting low returns and a slender margin for error.
4. Widespread disregard for risk creates great risk.
5. Inadequate due diligence leads to investment losses.
6. In heady times, capital is devoted to innovative investments, many of which fail the test of time.
7. Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem.
8. Psychological and technical factors can swamp the fundamentals.
9. Markets change, invalidating models.
10. Leverage magnifies outcomes but doesn’t add value.
11. Excesses are correct.
12. Investment survival has to be achieved in the short run, not on average in the long run.

What could investors have done leading up to the 2008 investment crisis?

1. Take note of the carefree incautious behavior of others
2. Prepare psychologically for a downturn
3. Sell assets or at least the more risk-prone ones
4. Reduce leverage
5. Raise cash
6. Tilt portfolios towards increased defensiveness

The usual ingredients of investment error:

• Data or calculation error in the analytical process leads to an incorrect appraisal of value.
• The full range of possibilities or their consequences is underestimated.
• Greed, fear, envy, ego, suspension of disbelief, or some combination of these moves to an extreme.
• Prices diverge significantly from value, and investors fail to notice this divergence.

Other possible investment mistakes to try to avoid:

• Not buying
• Not buying enough
• Not making one more bid in an auction
• Holding too much cash
• Not using enough leverage
• Not taking enough risk

You must be aware of the times for aggression and the times for caution.