Tuesday, July 26, 2011

Mistakes of omission are a bitch!

Warren Buffett once explained how some of his biggest mistakes were mistakes of omission which cost billions of dollars. This kind of mistakes doesn’t show up in the financial statements, but they can still be a real pain. In this article I will talk about some of my mistakes of omission and some of the things I learned to better avoid such mistakes in future. I hope that you would find this article useful.

A few days ago, I met up with an old friend and we started talking about my favorite topic, business. During the conversation, Prada’s IPO in Hong Kong came up and that reminded me of 2 fashion stocks (Coach and Tiffany’s) that I thought was pretty good before but didn’t do any further research and therefore didn’t invest in the stocks. Anyway, I checked the price of these 2 stocks when I reached home and they were up I think about 200% since when I first thought that those stocks could potentially make good investments at the prices they were trading then. I lost the opportunity to get invested in 2 good companies at attractive prices because I decided to sit on my ass instead of dive into the companies’ annual reports.

Now, it is only a mistake of omission if you can understand an investment opportunity and are in a position to capitalize on it.  So, it doesn’t count for me if I missed out on the next leader in cloud computing or a future biotechnology superstar as I don’t understand the businesses of those companies. I could understand the business of Coach and Tiffany’s and I was in a position to buy those stocks if my research confirmed that they were good businesses and good buys at the prices that they then traded at, but I did absolutely nothing, didn’t even bother to have a quick glance at the annual reports.

Here are some of the things I learned with regard to better avoiding mistakes of omission:

If you can understand something and it’s something you like to do and have time to do it, then don’t let potentially great opportunities pass you by. Do your research and if the facts tell you that the company is good and it is trading at an attractive price, then buy.

Don’t try and time the market and wait for a good company that’s already significantly undervalued to drop a few more percentage points. What difference does it make if you buy a stock at $15 instead of $16 when you believe that the stock’s intrinsic value is $60?      

Bet big. If the facts tell you that a stock is very attractive, don’t throw pocket change at it; bet an amount that’s significant enough for the investment to have a meaningful impact on your portfolio if your judgment to buy the stock turns out to be right.

Invest for the long-term; don’t sell a stock just because it went up by 30% or 100% or whatever, so long as the company isn’t terribly overvalued and the company is generating good profits, has honest and capable management, maintaining its competitive advantage and has a good balance sheet, then you’re ok and you don’t have to sell the stock. If you have invested in Berkshire Hathaway in its early years or Apple when it was trading at $10-$20 and sold those stocks when they doubled or even tripled, you would have missed out on their meteoric rise and the opportunity to become incredibly wealthy.

Similar to the point above, if you’ve missed out on investing in a great company and the stock when up by a lot but you believe it is still very attractive, don’t dismiss the company as it could still create a lot of value for its shareholders.  

Another mistake of omission is holding on to shares of a company that is producing lousy returns. I remember Warren Buffett once saying that Berkshire Hathaway could be worth twice what it’s worth today had he not invested in Berkshire Hathaway (originally it was a textile manufacturing company) and instead channel the funds elsewhere.

If you’re disciplined in your search for companies with good fundamentals and don’t overpay for stocks, then mistakes of commission should be few and far between. It’s the mistakes of omission that gets the prudent investor and those mistakes can be on a very large scale. True mistakes of omission aren’t as dangerous as mistakes of commission (these mistakes destroy your capital and can set you back for a very long time), but they can result in you missing out on a pile of money. Missing out on that one stock could be the difference between financial independence and great wealth; so be vigilant, and try not to make costly mistakes of omission.   

If you have any questions or have anything that you would like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.