Don't Make These Investment Mistakes

I’ve been thinking about writing this article over the past couple of weeks. I’ve made many mistakes investing through the years, and this is not the first (or last) article where I’ll talk about them. The topic of mistakes is a taboo topic in financial markets because everyone wants to portray that they make no mistakes and how good they are, something that (let’s be honest) is not really believable.

The reason I wanted to write this article is threefold:

1. Reflect on past mistakes (an exercise I recommend to any investor)

2. Share them publicly in case they can help you

3. Share how these mistakes have shaped my investment philosophy

I am sure I will make mistakes different than those I am about to share in this article. In all honesty, I might even make the same mistakes I am about to share here in the future, although I hope that the probability of me doing this is significantly lower now that I have some scars. Before starting this article, I planned to write about three mistakes. As I wrote it, I realized I had made many more, so the count ended up being 5 (pretty humbling experience writing about mistakes, I must say). I will follow most mistakes with a real-life example.

Without further ado, let’s start with the first one (they are in no particular order).

Mistake #1: Being too optimistic about inflections/recoveries

As discussed in a relatively recent article, my ideal investment scenario has tilted towards somewhat cyclical companies that comply with a series of characteristics. The short version of that article is that an individual investor might have an edge in acquiring shares of long-term secular growers going through a “rough patch” for reason XYZ. The opportunity tends to present itself in these, in my view, due to the incentives of the investment industry not allowing managers to take on the risk of opportunity cost (individual investors can theoretically take this risk thanks to permanent capital).

One of my mistakes and something I have to work on is closely related to this “new” investment scenario (it’s pretty obvious it needs polishing!). While individual investors can definitely exchange opportunity cost for a lower probability of permanent capital loss without suffering career risk, the magnitude of opportunity cost that they expose themselves to also matters. Opportunity cost can end up becoming a significant drag on long-term returns. Let’s take a look at an example.

Imagine you have $1,000 to invest and two investment opportunities. The first one will appreciate at a 15% CAGR over the next two years, whereas the second one will flatline for those two years (the outcome of these investments is obviously unknown at the time of investment). The first scenario results in an ending investment value of $1,322, whereas the second results in an ending value of $1,000. You have not lost money on paper on the second option, but the hidden cost has been $322 or 32% of your initial investment value. This is only for two years and these numbers compound over more extended periods.

So, what mistake have I made here? My mistake here wasn’t purposely investing in companies where I knew the inflection or the turn of the cycle was two years away; the mistake was being too optimistic regarding when the inflection would take place (i.e., I thought it would happen earlier than it did). For example, many industries have faced post-pandemic stocking dynamics, and I think it’s fair to say many expected these stocking dynamics to last less than they ended up doing (I was one of these people). The lesson here is that multibillion-dollar inflections take time to play out. If one is unsure even remotely of when the inflection will take place, then it might be better to sit things out. Buying something at a tad higher price but with significantly higher visibility might not be a bad idea after all.

One of my most significant mistakes here has been Danaher (DHR). I’ve held Danaher for two years and am around break-even in my position (taking into account the Veralto spinoff). I have not lost money on my investment, but if I had invested this money in Nintendo (which I added to the portfolio at around the same time), I would’ve realized a 24% CAGR (compared to my 0% CAGR in Danaher). If not taken care of, these mistakes can slowly but steadily eat into one’s returns. For the record, I would’ve been perfectly fine if the inflection had taken place one year after my investment, but two years just seems a tad too much. I still hold Danaher today, with the only caveat that the inflection is actually happening as we speak.

Mistake #2: Not understanding WHY a stock should go up

I have sort of explained this mistake in a recent article where I discussed the sale of a position. While I believe the concept of “dead money” is typically overused in financial markets, I think it’s one worth considering. Dead money refers to a stock going sideways because there’s no reason (typically called a “catalyst”) for it to go up. In many cases, a lot of companies will be called dead money just because there’s no evident catalyst on the horizon, but consensus will eventually be wrong. The example I shared above is a dead money situation where fundamentals take longer to catch up, but I want to give it a different twist here. At some point, it’s an investor’s job to answer the following question:

Why will this stock go up?

While I will not share specifically the mistake I made here, it relates to a discount-to-NAV situation. In some cases, a company will be trading below the value of its assets, and many investors will pile in waiting for the discount to close (it’s the classic “buy a dollar for 50 cents” situation). I have been one of such investors and unfortunately fared poorly because I failed to ask myself:

If the discount to NAV has been there for several years, why will it close now?

If I would’ve asked this question, I would’ve most likely not invested in the company and avoided two years of flat returns. I think the word “catalyst” is somewhat prostituted in financial markets, but it’s undeniable that the job of an investor is not to invest in a phenomenal company but to invest in an phenomenal company whose stock appreciates. It’s worth keeping sight of our objective here: to make money. I don’t think an investor needs to obsess over a catalyst, but if a stock has not moved for a long time despite fundamentals going the right way or if a gap to NAV has always remained constant, one should ask oneself why that’s the case.

Mistake #3: Underappreciating the role revenue growth plays in long-term returns

I have sometimes disregarded revenue growth on the condition that earnings or free cash flow growth could be achieved through different means (like margin expansion or better cash conversion). While the theory that stock prices follow cash earnings (not revenue) is correct, I have found out the harsh way that this is (most of the time) conditional on free cash flow growth being driven to an extent by revenue growth. In other words, I have yet to find a long-term winner that has grown free cash flow without enjoying acceptable revenue growth (I am obviously ignoring divestments).

All three drivers (revenue, margins, cash conversion) can increase cash earnings, but if revenue is a significant driver, this sends some positive signals to investors that will probably result in a higher earnings multiple (which is also an important variable when looking at returns). A company going ex-growth can have several implications, but the most important one (imho) is that it might signal market saturation, ultimately resulting in higher competitive intensity. If an industry is large and growing, it’s far easier to enjoy a benevolent competitive environment than if it has gone ex-growth or is shrinking (exceptions apply).

An evident mistake I have made here (although this was most likely not the only factor involved) was Diageo (DEO). I bought Diageo on the belief that, even though sales growth was expected to be moderate at best, the transformation to premium spirits would yield acceptable earnings growth through expanding margins. The environment became more competitive than anticipated due to a lack of growth and destocking. This not only translated into low revenue growth but also into margin compression. I now think about revenue growth as a safety net. You can get a thesis wrong, but investing in a company that is not expected to grow its sales at a good clip in the future is just stacking the odds against you.

Mistake #4: Letting losers run

Even though the market can be wrong, it’s not wrong often (especially when the drop is severe). This means that if a stock has gone down significantly over a prolonged period (important caveat), one needs to be pretty sure they are on the right side of the trade. Even though the “buy the dip” strategy has worked exceptionally well at the index level over the past few decades, there’s a ton of survivorship bias in this mentality regarding individual companies. While some companies have indeed bounced back violently after dropping significantly from highs (Meta probably the best example over the past couple of years), the reality is that the majority don’t ever touch ATHs again.

In some instances, I have become complacent in selling purely due to emotional attachment. Generating investment ideas is a lengthy process, and no human being likes being wrong. This means it’s normal to sometimes suffer emotional attachment to our positions, but this can cloud our judgment (it has clouded mine in the past!). I adhere to the term #neversell, with the only caveat that this is conditional on the thesis not having changed. Thesis, moats…all of these things tend to be quite dynamic in a capitalist world, and therefore, the reality is that these can (and will) change over long periods.

A subscriber and friend recommended a book to me not long ago that has shaped my philosophy on this topic (I have not had to put it in practice yet, but I will). The book is called ‘The Art of Execution’ by Lee Freeman Shor:

The book does not share dissimilar advice to Peter Lynch's: cut the losers and let your winners run. It offers a good POV on executing decisively to obtain the desired results. Finding good investments is tough, but long-term outcomes are determined by how investors execute on their investment ideas (not only by the investment ideas themselves). In short, you can be a great analyst but a terrible investor just due to poor execution.

There’s one thing an investor knows for sure when they look at their portfolio: there are a couple of mistakes in there. How they react to these mistakes is likely to impact their returns significantly, and the idea is to find them as soon as possible and weed them out. It’ll sometimes be the case that the market will be telling us that we have made a mistake. I have never had a “stop loss” criterion when investing, but to contain the impact of my potential mistakes, I do now: if any of my positions goes down 25% from my cost basis, I’ll sell it and reconsider the position. While this doesn’t seem very long-term oriented, I believe it’s the most rational decision (I must note that it’s not automatic and obviously excludes broad market selloffs). First, we lose nothing for selling a position because we can always rebuy it later. Secondly, by selling, we are taking emotions off the table, and we can decide later if we believe the drop is justified or not.

The book explains that if a position is down significantly from our cost basis, we basically have to choose between the following:

1. Double our position because it became a much better opportunity

2. Sell it

Standing still is not an option because it leads to complacency and poor risk management. If you had asked me a couple of years ago, I would not have agreed with this, but I do now. Note that the 25% I discussed above is a personal number I set based on the types of companies I invest in. If you are a hyper-growth investor, then your number is arguably higher.

My biggest mistake in this regard was Five Below (FIVE), which I sold at a 44% loss. If I had had this “check” in place, I would’ve probably sold it at a 25% loss and would not have included it in the portfolio again.

Mistake #5: Underinvesting in my highest conviction ideas and diluting the quality of the portfolio

This is a double mistake, but it has to do with the same topic: position sizing. I have historically given too much importance to finding the companies I would like to include in my portfolio, but not to the topic of position sizing (which is extremely important). To some extent, this mistake is related to mistake #4 because it’s a matter of execution.

Over the past couple of years, I feel that I’ve given up the chance to invest significantly in my highest conviction ideas. While this is something easy to realize in hindsight (because we already know the performance of the different companies), I feel that in some cases it was abundantly clear that I should’ve sized some positions higher. A clear example here would be Nintendo. When I added Nintendo to the portfolio, it was pretty clear that it was significantly undervalued. The stock has performed spectacularly well since, and it’s now close to being the largest position in the portfolio, but the company has earned this position through performance (not by me adding). While Nintendo continued to earn its right to be among the top positions of the portfolio, I kept adding to companies like Danaher that had not earned their right to be there. As discussed above, I now feel much more positive about Danaher, but adding to my Danaher position while it was not moving, while not averaging up on Nintendo, was definitely a mistake.

It takes a lot of work to find skewed risk/reward opportunities in financial markets, but they do appear from time to time. My only objective from now on is to invest aggressively behind my conviction when I think to have found one of these. Some theses will not play out as I expect them to, but that’s also why we have the safety net discussed in mistake #4. The irony is that the mistake of underinvesting in the real winners is much more costly than holding losers for prolonged periods. This stems from the asymmetric nature of stock returns: losers can only drop 100% (and you will arguably find out it’s a loser before it gets so severe), whereas winners can go up multiples more.

The amount of these high-quality and heavily skewed ideas is quite limited. If we add to this the fact that it’s tough to hold conviction in a lot of companies at the same time, I have concluded that I would much rather hold a more concentrated portfolio (ideally one where positions are ranked by conviction). This doesn’t mean I will transition to a 5-stock portfolio, but to a portfolio with around 15 names. I think this will have several (hopefully) positive implications…

1. My standard of quality will go up as positions in the portfolio will be pretty limited, and therefore, I will have to think long and hard about tradeoffs

2. It will be easier for me to follow all positions

I expect this to be a transition that takes some time (both reducing the number of positions and concentrating on my highest conviction holdings), but I think it’s the step I must make to generate better returns going forward. Position sizing is a critical topic.

I hope the mistakes I discussed in this article are useful to you, maybe not in implementing changes to your investment philosophy but in thinking about some topics that you might have not thought about before.

In the meantime, keep growing!