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Greatest Investment Mistakes: Following a Single Source

Everybody gets it wrong sometimes—and most hang onto those errors, too.

John Rekenthaler, 03/29/2017

Lone Voices
This week’s installment of Greatest Investment Mistakes is about making decisions based on but one perspective. Indeed, that has been the most common error among the emails that I have received. (Keep those stories coming. Send your personal faux pas to john.rekenthaler@morningstar.com.)

Writes Mr. S. (not the Mr. S. of last week's column—a different victim), “I’m sure I’m not the first person to say that listening too much to a single source must be my biggest mistake.” No, sir, you are not.

That single source, inevitably, gave a stock recommendation. Not that fund researchers are superior to equity analysts, but rather because stocks go to zero, and funds do not, it is depressingly easy to turn a small fortune into no fortune at all with a stock, and refreshingly difficult to do so with a registered mutual fund. (Hedge funds and highly leveraged exchange-traded funds are sometimes the unhappy exceptions.)

Mr. S’s experience follows a familiar pattern. He bought a stock because an expert recommended it. The price declined. The expert said, “Great! That makes it an even better deal!” Mr. S. increased his bet, purchasing more shares at a lower price. He writes, “I kept averaging down into these ‘great’ long-term bargains, losing almost $50,000 alone in that security, which eventually went bankrupt.”

Conviction, or Convicted?
This happens often—an equity analyst follows a stock down a long, dark road. The researcher believes that he has an insight, that he perceives something about a security that the investment community has missed. The stock trades at $70, but should be $85. If its price then falls to $60, it presumably has become that much more of a steal. The researcher should not change his mind because of a short-term reversal. If he did that, he would be weak. He would lack conviction.

Sound familiar? Every active portfolio manager is prodded to see if he or she possesses sufficient conviction. The foundation of good portfolio management, we are told, is knowing not to “panic” when the market is unwelcoming. Ben Graham: “The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a disadvantage.”

You heard it straight from the master himself. The analyst who counsels you to buy more at $60, and then at $50, and then at $40, all the way down to zero, is following best industry practices. 

Which leads to the problem. The Morningstar stock researcher—yes, this was a morningstar.com recommendation, not surprising since Mr. S. is after all a morningstar.com reader—behaved as analysts are taught. He could well have been rewarded. Consider Terex TEX, a midsized construction company (brought up because I twice owned the stock). Investors who doubled down during Terex’s declines, and who unloaded during its rises, would have profited nicely. So, how to tell the difference between those two situations?

is vice president of research for Morningstar.

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