Greatest Investment Mistakes: Following a Single Source

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

source: Morningstar Analysts

In answering that question, investment professionals have two paths to failure:

Fundamental Error The analyst might be wrong about the company.

For example, everybody realized by the start of the new millennium that Eastman Kodak's KODK film-paper business was eroding, and that the firm would need to re-invent itself. There was no doubt that Kodak was struggling. Where Kodak would eventually land, however, was very much open for debate. Would the company’s newer business lines fully replace—or even supplant—its film-paper revenue? Would they only partially compensate for that loss? If the latter, did Kodak’s stock have a future?

It took 10 years to answer those queries, with the final verdict being “even worse than we thought.” Kodak’s stock tumbled from $80 in 1999, to $40 by 2001, bounced in the $20s and $30s for the next seven years, headed straight south along with the rest of the market in 2008 … and then failed to rebound. Kodak declared bankruptcy in January 2012, with the stock at $0.36 per share.

The lesson: Forecasting corporate fortunes is hard! The investment collective that determines stock-market prices agonized over Kodak for more than a decade. And it was never truly correct. Even at the start of 2011, Kodak traded at $5. Yes, it was down more than 90% from its late 1990s peak—but in percentage terms, that was only half the pain. The stock would plunge another 90%-plus during its final two months.

There is no easy answer to avoiding fundamental errors for either investment professionals or their customers. Obviously, though, the latter would do well to consider dissenting views. It is unlikely that the professionals will make mistakes so obvious that they jump to the attention of everyday investors. However, all have leanings. Those preferences—and the risks they entail—may become apparent when reading other analysts’ reports.

Loss Aversion Last week's Greatest Investment Mistake, "The Bear Trap," involved loss aversion. Those who time the stock market by exiting before an anticipated downturn, usually cannot get re-invested until after that downturn occurs. To return to stocks beforehand, when prices are higher than when the investor left, is to admit error. The investor has realized an opportunity loss. He blundered.

Few people are willing to face up to such errors. The admission is psychologically bruising. For investment professionals the penalty is greater yet, because returning to the market means permanently abandoning the chance to catch the competition. Staying on the sidelines retains the possibility of regaining ground on rival portfolio managers (or rival research analysts), should stocks plummet. Rejoining the market scotches that hope.

Thus, the bear trap. Those who have made a decision that has so far worked against them, feel compelled to stick with their plan. (Ironically, while “conviction” is regarded as a rare virtue for investment professionals, it often is the easy road. The hard choice is to sell and concede defeat.)

The application to investment analysts is clear. Once they have recommended a stock, they will be loath to cease, until that stock validates their prediction. In such an instance, even more than with fundamental error, the client will wish for a second opinion. Or third. It is completely understandable why investment professionals become entangled in bear traps—but that should not be the investor’s problem. Listen to somebody else!

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.