Most Dreaded? The ‘Mechanical Error’: Pushing the Wrong Button During an Online Trade
October 20, 2022
Most Dreaded? The ‘Mechanical Error’: Pushing the Wrong Button During an Online Trade
There’s no graduation ceremony that acknowledges you’ve evolved from beginner to experienced investor. Hmm. On second thought, it could be losing more than half your money from a bubble popping and then vowing that won’t happen again. But, short of that, there are a few easy to spot signs of experience.
You either know the Stock Study Guide inside out or, if you don’t use it, you recognize most of the ratios and fundamentals on it and understand the logic behind the SSG’s layout and valuation methods. You also won’t be surprised by the market, often because you’ve lived through similar times before. If you are cautious about what you think you know, congratulations, you must be experienced. The market has a way of humbling the arrogant very quickly.
No matter how much experience we pile on, we’ll never be infallible. There are some mistakes even the most tenured investors regularly make. I’ll share some of the potential pitfalls I’ve witnessed over my two decades working in the markets.
Some of the largest losses on Wall Street come from the most basic errors, the sort I think of as mechanical rather than missing something important about the company or a failure to grasp an important investing concept.
For example, a trader at a firm might enter an order to sell a million shares instead of a billion dollars’ worth of shares. Or what should have been a buy order was marked as a sell. Maybe someone entered the wrong stock symbol. Whoops. Caught quickly in a stable market, those errors can be reversed relatively painlessly. It happens all the time.
But if no one checks the trade confirmations carefully and the market gets volatile, they can take down firms and whole markets. With that in mind, read every order twice before hitting enter. Then check the trade confirmation.
Another opportunity for brilliant minds to mess up is through casual math. If a calculation is important to your buy or sell decision, check your math. One of the many benefits of using online tools is how they minimize routine calculations so we can focus on our insights and forecasts. Bonus: It won’t remind us how much harder it became to do math in our heads.
Famed investors Warren Buffett and Charlie Munger view risk differently than modern portfolio theory. Unlike today’s bumper crop of quantitative managers who re-
duce risk through diversification, Buffett and Munger are determined not to lose money. They focus on buying stakes in companies so cheaply that their forecasts don’t need to be more precise than others. They just wait until the rest of the market catches on that the stock is undervalued.
The more undervalued a stock is compared to its intrinsic (“true”) value, the more room you have for something to go wrong and still make money. There’s a world
of difference between buying a stock that is only “cheap” if the company meets production targets and is able to raise prices versus a stock that is still cheap if the company’s business is cut in half.
Those opportunities are rare in any market but even more so after a long bull market makes everything pricey. Warren Buffett doesn’t chase the market. He waits for the market to bring him attractive deals. Then he does a remarkable level of due diligence. If he buys, he buys when other investors are running away. That takes courage.
There’s courage and then there’s foolhardiness. Stock prices are determined by the collective votes of billions of dollars a day. Most of those trades, at least on a volume basis, are made by sophisticated investors with access to extensive data and analytics. Earnings forecasts come from either the businesses themselves or analysts who can pick up the phone and speak to company executives.
Analysts, fund managers and company executives can be and are frequently wrong. But it’s rare they’re wrong enough often enough for a contrarian to make money by taking the opposite position all the time. Your default assumption should be the stock price is reasonable and the market’s assumptions are right. Insist on overwhelm-
ing evidence the Street is missing something and only invest when there’s that high margin of safety we discussed earlier. Investing on hunches simply won’t do.
The best opportunity to make money on your insight is during market extremes. Have you ever noticed that stocks already on their way up attract buy ratings?
That comes from analysts tiring of being on the wrong side of the market and jumping on the bandwagon. They may have been right about everything except timing.
There are many ways to value a stock and it’s easy to choose the wrong one. Drug companies’ profits tend to grow rapidly on the introduction of a blockbuster drug and then fall off a cliff when patent expirations hit, unless they have something new coming out of the pipeline to replace it. Any stock price target that relies too much on past performance is likely missing something important. Analysts use two or three stage discount models to account for their earnings rapid growth, plateaus and declines. Like-wise, if a stock’s dividend history is volatile, it might not make sense to estimate a target based on dividends. Try using cash flow instead.
But the battle isn’t won simply by selecting the right way to pricing a stock. Valuation models are notorious for spitting out very precise stock values based on very fuzzy inputs. That’s why I recommend using scenario analysis to estimate growth rates. The Stock Selection Guide uses lows for dividends, multiples and earnings to develop “worst-case scenarios,” but you can take it a step further by considering what might happen in a black swan event along the lines of Boeing’s 737 Max debacle or, if looking at an investing firm, going back to the depths of the Great Recession. For more information on scenario analysis, see “Making the Stock Selection Guide Your Own” in the December 2020 issue on Page 36.
The market repeats itself, but never exactly. Quant funds usually assume that patterns eventually repeat. That works very well until it doesn’t and the funds get hammered. Patterns can’t repeat because of the almost infinite influences on markets and, if they do prove reliable, investors will get in early in anticipation of them until there’s too much money bidding up the strategy and there’s little to be gained by following it.
BetterInvesting deemphasizes timing the markets. That’s smart, because timing is the most difficult aspect of investing. Market returns are very similar to random motion with a bit of upward drift. You can buy the “right” stock at the theoretically “right” time and still lose money from the market doing something completely unexpected. Rather than timing the market, BetterInvesting stresses buying the best opportunities available at the time.
That discipline has two benefits. It keeps you saving and it offsets overpaying for stock occasionally by buying when the market is cheap. That will remain a solid strategy as long as the market continues its long upward march.
Articles like this one could never give a complete list on what not to do, but the errors here I’ve either seen them repeatedly from clients or, darn it, myself. In some cases, I’ve done them more than once. I will say this, though: The mechanical errors are the most discouraging because they’re the easiest to avoid. The nice thing about stock investing is the system is biased in your favor. Inflation raises revenue and, as long as revenue is greater than expenses, profits will increase. That alone is worth a couple of percentage points in nominal return.
More importantly, America has almost always been good at growth and allocating capital efficiently. And, lastly, we have relatively free markets that are carefully, if always imperfectly, regulated, making our markets attractive to foreign investors.
