Now that I have been investing in stocks for more than a decade (started in 2012), I thought it would be a good idea to write down some of the most important lessons I have learned during my adventures in the capital markets. The topic of my first blog post was a description of my investing philosophy. That was 5 years ago. Looking back I realize that not a lot has changed during that time.
The most important thing about investing is to understand the importance of it and to get started in the first place. Because compounding interest works best over very long timeframes, the sooner you get started, the better. And you do not become a good investor by reading books and blog posts, you have to actually do it and put your own hard-earned money at risk. There is no substitute for hands-on experience. But books and blog posts like mine can provide valuable tips and guidelines to at least steer you in the right direction on this journey. Also check out my previous post about personal finance for more reasons to become an investor.
While I like to invest in stocks of individual companies, I realize that index funds and ETFs are a better choice for most investors. While learning about individual companies can be a fun hobby, doing it properly takes a lot of time. Instead of doing that, it would be much more cost-effective for most people to spend the extra time working on their main job and then just dump that extra income into index funds. Consistently dumping your money into an index fund like the S&P 500 over a long period of time has been proven to be a winning strategy and very difficult to beat by active investing.
That being said, the rest of this post will cover lessons learned from investing in common stocks.
Make Mistakes Early
Losing money is never a pleasant feeling but unfortunately that is part of investing. Generally speaking, if there is no risk there is also not much opportunity for return on investment. The capital markets are very efficient that way. Incidentally, if someone tells you about an investment opportunity that has above-average returns with below-average risks, be very careful and suspicious. There is no "free lunch" in investing and if something appears too good to be true, it often is.
Since making mistakes and losing money is an inevitable part of investing, the key is to make most of your mistakes early in your investing career when the amounts are small. Lets say for example that you have $2000 when you start investing and you put them into two stocks, $1000 each. Then something bad happens and one of them goes to zero. You just lost half of the value of your portfolio. If you only had $2000 to begin with, losing $1000 feels horrible. But it's still only $1000 that you can replace and try again. On the other hand, if you are nearing retirement with a $1 million portfolio, losing half of it would be a catastrophe.
Don't be too hard on yourself when you make mistakes during the first steps of your investing journey. Treat your mistakes as learning opportunities and study what you can do differently to prevent the same from happening again. Human beings only learn from mistakes and losses, not from wins. When we win, we often just tend to think (or imagine) that we are just that good so that's why we won, and there is not a lesson there to be learned. But make mistakes when they are cheap, during the early years of your investing career.
Get Rid of Losers Quickly
Perhaps the most important lesson I have learned is that in some situations it is best to just sell a stock quickly if something fundamentally changes in the operating environment of the company. I tend to be a buy-and-hold type investor, so generally selling stocks is not common or natural for me.
For example, what sometimes happens is that there is some big shock that sends a stock down 20% or more in one day. At that point it is easy to think that the chance to sell was already missed, and it doesn't make sense to sell now, after the bad news is already priced in. But actually in these situations the stock will often just keep going down even more during the following weeks and months.
The problem is that even if the company can restore their operating performance, and the share price will recover equally, it will usually take a very long time. Depending on what happened, it can often take 2 or 3 years. During this time your capital is "trapped" in the stock while you wait for it to recover. This is also known as being a bagholder in the hobbyist investing community. But if you had just taken the 20% loss quickly, and invested the capital in some other company, it would have likely generated much better returns over that same 2 or 3 years.
A good example of this is what happened to Boeing. When they had a problem with the 737 MAX plane, it was grounded (not allowed to fly) in March of 2019. At that time it was not clear how long it would take to fix the issue and gain certification from authorities to use the plane again. Finally in November of 2020 the FAA ended the grounding and many other countries followed much later in 2021. Combined with ramping up production again, the issue took more than 3 years to fix. The Covid-19 pandemic disproportionately affected Boeing during this time as well.
Another example of this is European companies that had operations in Russia. After the war between Russia and Ukraine started in February of 2022, it became very difficult for many European companies to continue operations in Russia due to sanctions. Nokian Tyres was particularly badly affected because their main production facility was located in Russia. In the end they had to decide to sell that factory for a very cheap price and start to build a new factory in another country. Again, it will take 2 to 3 years before the new factory is fully operational.
Having "losers" in your portfolio is normal and expected when investing in individual companies. It's part of the game and cannot be avoided. But the key lesson here is that if the situation fundamentally changes for a company, it's also time to re-evaluate whether it deserves a place in your portfolio, or whether you should instead take that capital and put it to work in some better opportunity.
Hold On to Winners
Just as it is important to let go of losers, it is equally important to hold on to winners. Often the best companies will continue to perform well year after year. Just because a stock is up 50% or 100% in your portfolio is no reason to sell it. In fact, if a company is performing well, an increasing share price may often be an indication that you should buy more of it. But only if the actual underlying earnings are also growing to justify the higher share price. On the other hand, you have to be careful of ballooning share prices which do not result from growing earnings. Buying overvalued stocks is a sure way to be a losing strategy over any longer timeframe.
The key takeaway here is that once you get some good companies in your portfolio, stick with them. Do not try to trade in and out of positions and time the market. Instead, use temporary dips in the share prices of your best holdings as opportunities to buy more of them. If you sell a good company, now you are faced with the dilemma of trying to find another (even better) company to buy with that money.
Optimizing your portfolio over time by adding to winners and trimming losers is a good practice. But for the most part it should be done slowly and gradually, not with over-trading or changing a big portion of your holdings at once.
Over time I have realized how important it is to have shareholder-friendly management in place in the companies that you invest in. Before I used to think that managers were almost always acting in the best interest of their shareholders and emphasis on who was running the company was not so important. But now I have understood that just because we are talking about large publicly traded companies, that by itself is no guarantee that they have good management in place.
For example, if the CEO of your company is talking about social and political issues instead of business performance, that is a huge red flag and sadly much too common in this day and age. Sure, social and political issues are important, but think carefully do you really want to give your hard-earned money to a company with a CEO who is pursuing some personal agenda? There are plenty of charitable organizations with a stated purpose of improving social and political issues that would use your money much more efficiently for those purposes. The purpose of a business is to earn money for its shareholders and then let each shareholder decide individually what social causes and political issues they want to support.
The important lesson here is to get to know the upper management of your company. Take a while to read at least some basic information about the CEO and board members. Do not blindly trust that they are working for your benefit. And do not confuse investing with charity. Both are important and have their place, but they are not the same thing.
There are important differences in culture, laws and politics of different countries which have a huge impact for companies that operate in those countries. Some countries do not have strong protections of private property and the extreme example is when a hostile government chooses to nationalize the factories and facilities of a private business for little to no compensation. The government controls the military and holds the monopoly on the use of force, so there is not much that the business can do in that unfortunate situation. In practice nationalization is rare but certainly possible in some undeveloped countries. More often governments use softer tools like taxes and regulations to pester companies.
As mentioned before, this country risk also materialized in a horrible way for foreign companies who operated in Russia in 2022.
Before investing in a company, take a good look at the country (or countries) where it primarily operates. Does that country have a rule of law with strong protections of private property? Does it generally have a business-friendly culture among the general populace?
With these questions in mind, my experience is that America is the best country to invest in. While the media portrays the country as heavily divided about many social and political issues, there still seems to be wide consensus among both political parties that they want to maintain a pro-business environment which encourages and supports the growth of companies and private property more generally. This is really important from the viewpoint of an investor. And while I warned about the dangers of CEOs embarking on personal social agendas, generally businesses in USA are very focused on delivering value for their shareholders. These are the reasons why the majority of my portfolio is composed of American stocks and that geographical overweighting is not likely to change anytime soon unless there are major changes in the political landscape.
I have always loved dividends because keeping track of a steadily increasing stream of dividend income can be a better measure of progress than the overall value of portfolio which can fluctuate more during ups and downs of the economy. Many investors discount this focus on dividends saying it does not matter if the return on investment comes from dividends or capital appreciation. In fact they say dividends are not preferred because you have to pay taxes on them. They have a point as well.
But I have understood that dividends have another function as well which is somewhat hidden initially. This function is that dividends can serve as a proxy indicator of company health, and being able to pay dividends is a sign of a healthy company. When a company has a track record of steady dividend payments over many decades, and especially if the dividend has not been reduced during recessions or economic turbulence, it really instills confidence in the underlying business. On the other hand, if the dividend needs to be reduced or even eliminated completely, that is usually a really strong indicator that the company is experiencing serious problems.
Megatrends are trends that affect the economy on a global scale. They are important for investors because they can provide significant advantages or disadvantages for companies and whole industries. For example, one global megatrend is urbanization which means large numbers of people are moving from rural areas into cities. This will benefit companies that offer solutions for problems that big cities face such as transportation.
Another megatrend is that ever increasing share of GDP is spent on healthcare, especially in developed countries with aging populations. The benefactors of this megatrend are not just traditional pharmaceutical companies, but also healthcare-related real estate such as hospitals, research laboratories and medical office buildings. I have tried to overweight the healthcare sector in my portfolio and it has been the right decision at least so far.
Generally speaking, you should try to choose investments that have powerful megatrends as tailwinds to provide boost to your companies and industries. Yes, there is certainly money to be made by being a contrarian investor as well. But that is often more difficult and requires more expertise from the investor. Just choose the easy way if you are not an expert in the given field.
Role of Central Banks
For the most part, you do not have to pay too close attention to what the central banks are doing, but you should at least have some generic idea of what is happening. Because central banks provide the economic backdrop with interest rates, changes in those interest rates will affect all assets that are denominated in the same currency. This includes stocks and bonds. When the central bank lowers interest rates, they loosen financial conditions and give a boost to the economy. Usually stocks will do very well during this period. When the central bank raises interest rates, they tighten financial conditions and slow down the economy. Usually stocks will struggle during this period.
As an investor, you should ask whether the central bank is currently trying to loosen or tighten financial conditions for the economy? Particularly important: are they shifting from loose policy to restrictive or vice versa? Note that I strongly believe you should be buying stocks of excellent companies in any almost any environment, because the share prices of individual companies have their own cycles and ups and downs, regardless of the overall economy. But that does not mean you should be blind to the economic backdrop where your companies are operating. It is much better to have the central bank "on your side" as an investor. There is a famous saying in the investment community: Don't fight the Fed.
Learn from the Best
When learning any new discipline, it makes sense to learn from the most successful practitioners of that discipline. Even if Warren Buffett is the most well known investor in the world, and it is difficult to avoid running into him when studying investing, I still cannot recommend him enough. His annual letters to shareholders are full of investing wisdom that every investor should read. They are particularly helpful in promoting longer time horizons in investing. In short: own shares of high quality companies over many decades and you will have a pretty good outcome.
Another one of my favorite investors is Howard Marks. It is always entertaining to watch his interviews where somebody asks him "What is going to happen next (in the financial markets)?" and he answers with humility "I don't know". Then he clarifies that some outcomes might be slightly more likely than others, but again, he doesn't know what will happen. That is an important lesson to keep in mind for all investors. If you convince yourself that you know what will happen next, that is a recipe for disaster. Mr. Marks regularly publishes memos about investing which are available here. Definitely great reading for anyone who is seriously interested in becoming a better investor.
I think that's it for this post. At least I did get quite a few important points written down. I really should try to have more time for writing this blog.