The One Question You Need To Ask When Investing

“What should I buy now?” is a tongue-in-cheek question I get asked often by people who know of my job as a writer with The Motley Fool Singapore. I have no qualms telling them what’s in my portfolio at the moment, but I do think they’ve got the question all wrong.

The one question they should have been asking – and that goes for me as well – should be, “What should I not buy now?”

Importance of Avoiding Mistakes

In Simon Ramo’s book Extraordinary Tennis For the Ordinary Player, he wrote about the dichotomy that exists between expert and amateur tennis players.

For the experts, 80% of points are won by making great shots. For the amateurs, 80% of points are lost. To be a good amateur player, you need only reduce the number of mistakes.

Economist Erik Falkenstein applied that train of thought to investing by writing, “The same is true for wresting, chess and investing: beginners should focus on avoiding mistakes, experts on making great moves.”

As much as most of us would like to think of ourselves as the second-coming of the Warren Buffetts and George Soros-es of the world, it just isn’t true. We’re likely to be amateurs, or at best, good amateurs (even if you think highly of yourself, it won’t hurt to apply a tiny dose of the ‘humility’ balm!).

That doesn’t mean we can’t do well at investing. It just points out how we should focus on not making mistakes, rather than chasing that perfect ‘tennis serve’ so-to-speak.

The Real Odds of Making Poor Investments

Falkenstein’s forceful admonition is also enhanced by a truly enlightening study done by Longboard Asset Management regarding the returns of thousands of stocks in the USA from 1983 to 2006.

What Longboard found was that:

  • 39% of stocks were unprofitable investments
  • 18.5% of stocks lost at least three-quarters of their initial value
  • Almost two-thirds of stocks – 64% to be exact – lost to a benchmark index
  • 25% of stocks were responsible for all of the market’s gains

Those are remarkable statistics. According to Yahoo Finance, the Russell 3000 index (the benchmark index used in the study) had grown by almost 360% from Sep 1987 to Dec 2006, suggesting that its total returns from 1983 to the end of 2006 are likely even greater given the bull market that was prevalent in the 1980s.

But in a period where the index logged strong gains, a significant portion of stocks actually lost money. A majority of shares even lost to the index.

Looking at Longboard’s study, it shows me that perhaps, what’s important in picking stocks -at least among the general public – is not so much about picking good investments, but in avoiding bad ones.

What To Avoid

Of course, this would trigger the question of what exactly should we not buy? While there are no exact answers, history has a knack of pointing us in the generally-right direction.

I’ve shown how shares like Keppel Telecommunications & Transportation (SGX: K11) have lost tremendous amounts of money for investors in addition to losing to the market, represented by the Straits Times Index (SGX: ^STI), by a wide margin over a period of more than five years from 11 Oct 2007 to 27 June 2013.

The reason was likely due to Keppel T&T’s shares being priced for perfection at the start, resulting in its subsequent corporate performance being unable to keep up with the market’s sky-high expectations.

So, shares that are being priced absurdly high in relation to their underlying value would be one area to avoid.

There’s another category: the chronic loss makers. For the five years ending 3 June 2013, the returns on shares like Stratech Systems (SGX: S73) and China Kunda Technology Holdings (SGX: GU5) had lost to the STI significantly due to them chalking up year after year of losses.

These chronic loss makers weren’t hard to spot either as they are required to serve up notices to the investing public if they’ve made losses for three consecutive years.

Buffett once said, “If a business does well, the stock eventually follows.” What might not be that obvious was that the reverse likely holds water as well. If a business doesn’t do well, the stock eventually follows.

Foolish Bottom Line

Charlie Munger, the billionaire sidekick of Buffett and an investing-maestro himself, once offered an invaluable investing aphorism: “Tell me where I’m going to die, that is, so I don’t go there.”

It reveals even Munger’s desire to avoid making investing-mistakes.

History has given us good clues on spotting investments where the odds of an eventual unfavourable outcome are high. It’s up to us to ask that one important question to enable us to avoid them.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.