We recently ran an article on The 3 Most Important Words in Investing. If you haven't had a chance to read that article, do yourself a favour and check it out.
I couldn't agree more with its premise, but today I want to go one better – one less, if you will.
While perhaps not the 2 most important words in investing, there are two words that will underpin your investing success if you take the time to understand their meaning – and their potential impact on your wealth!
The 3 most important words in investing – margin of safety – will ensure you don't overpay for an investment, and will give yourself the best chance of not losing money. If you've done your analysis, you'll make sure you understand what an investment is truly worth, and will refrain from paying more than that amount.
The Cost of Opportunity…
The next challenge facing many investors is a simple two-word concept that can have a very significant impact on their financial futures – opportunity cost. Those who can remember back to high school economics will recall opportunity cost as the 'cost' of bypassing the next best option.
Opportunity cost plagues the investor in many ways – but I believe the most significant opportunity costs facing investors are the age old struggle between investing and spending, and the investments not made in one asset because the money is invested elsewhere.
A dollar invested in Spacely Space Sprockets is a dollar that can't be invested in Cogswell Cogs, just as that money you just spent on the iPad 2 can't be used to invest in shares of Apple or JB Hi-Fi (ASX: JBH), or any other quoted company.
…and the Benefits
Neither of these opportunity costs are necessarily bad – all investing and no spending would make life very dull indeed, and I'm sure Fortescue (ASX:FMG) CEO and $6 billion man Andrew Forrest isn't sorry he held onto his shares over the past few years, rather than diversifying his holdings.
The key point is that in both of these areas – and in life in general – each dollar only leaves your wallet once. What you do with that dollar counts – both in terms of what you do with it, and also with regard to what you don't do with it, by making a different choice.
Using the Fortescue example above, if you had invested your money in April 2006 in a speculative miner that went bust, the cost isn't just the money you lose, but the gains you have forgone by not investing in Fortescue – which has increased 11-fold over that time.
Hindsight is always 20/20, and I don't know where Fortescue will go from here, but the example above neatly illustrates the concept of opportunity cost.
Buying Well is the Best Defence
The Motley Fool believes in investing for the long term, so we're not suggesting you chop and change wildly each time you have a better idea. And if you've chosen well, you shouldn't need to move that money in a hurry, anyway. The key is to always remember that there can be a cost to inaction – the opportunity cost of gains foregone in a different investment.
In Mr Market's world, prices can be erratic – sometimes very much so. Just because prices rise in the short or medium term, we shouldn't assume we've bought well. Similarly, if prices drop after we've bought, we shouldn't blindly rush for the exit.
Face Your Mistakes
But sometimes, prices do drop for the right reasons. I've made mistakes in my investment decisions in the past. I've invested without doing the proper research, and really knowing why I'd bought. I've also bought on the basis of a particular thesis, which hasn't panned out.
As a result, I've been down maybe 20 or 30%… okay, maybe even more. It hurts – a lot.
No-one likes selling for a loss. When the chips are down, we can be paralysed by wanting to avoid 'realising' that loss – figuring that it's only a loss on paper until we sell. We want to wait until we've recouped our losses, often hoping against hope, just so we don't have to admit we've lost money.
Imagine for a minute that you'd bought shares in Waiting & Hoping Ltd (Ticker: HOPE) at $1.00 that are now trading for only 80 cents. You only have to wait until they get back to $1.00 and then you'll sell, right?
And if it takes a year or two, at least you didn't lose money. Surely that can't be a bad strategy, and you'll feel a whole lot better knowing you didn't suffer a loss.
Cut the Anchor Loose
Always comparing your investments to some previous price – be it the purchase price, or some previous high or low – is called 'anchoring', and you'll do well to avoid it where you can.
What if you'd taken the decision to hang on to Waiting & Hoping Ltd in April 2006, forgoing buying shares in Fortescue to hold on to the investment that was underwater, 'just until I make my money back'? By April 2008, while you waited to recover that 'lost' 20 cents, Fortescue had hit $8.20 – a gain of almost 1300%!
Not every situation provides so stark a choice, and the future is always uncertain. You can at least prepare yourself as well as possible if you keep an eye out for situations in which you are 'anchored' to some previous price.
Instead, ask yourself: 'if I didn't own the shares, would I buy them at today's price'. If you're honest with yourself, your answer will both save and make you money.