Throughout this journey, you may encounter good as well as bad experiences. You will make mistakes and you may end up with bad investments. But don’t get disheartened by them.

Even the legendary Warren Buffett has made mistakes which he discusses quite openly in public.

In 1993, Buffet purchased Dexter Shoe Company for US$443 m. However, later he admitted buying the company was the worst deal he ever made. This mistake cost his investors more than US$9 bn.

So what’s important is to realise the mistakes and act upon it as early as possible.

Investors must monitor their portfolios periodically to weed out any bad investments.

In this article, we share some scenarios which could help you spot a bad investment.

When you don’t understand the business

You can’t be a doctor if you don’t understand the human body. You can’t be an engineer if you aren’t well versed with machines. Similarly, you can’t be a better investor if you don’t understand businesses.

Investing is not similar to betting your chips on a random number. Investing entails ownership. To invest is to own a part of a company.

And be honest here, would you invest in a company without understanding what it does? I’m sure you won’t. Therefore, it is imperative to understand a business before investing in it.

To have a clear understanding of how a business works, you need to read about it. You can find all this information in its annual reports. An annual report contains all the information you may need to understand a business.

However, the sad truth is many people don’t read this crucial report. Many have invested in companies about which they don’t know anything.

If you have ever invested in a company without understanding its business, then forget about right or wrong. It may be the worst investment you could have ever made.

Start reading annual reports if you don’t already. It’s certainly better than betting your savings blindly.

When balance sheets and cash flows don’t paint a similar story as the P&L

Three financial statements depict the financial profile of a company. These three statements are the profit and loss (P&L) statement, the balance sheet, and the cash flow statement.

These statements are to be analysed holistically. However, many investors don’t abide by this. They put a lot of emphasis on the P&L statement ignoring the other two completely.

Mind you, there are companies whose P&L statement looks all rosy. However, the balance sheet and the cash flow statement indicate caution.

Let me give you one such example.

Summaya Industries, a company unheard of, came into the limelight a year ago. In financial year ended March 2021, the company reported mind-boggling numbers. Revenue and profit shot up by 1,062% and 4,375%, respectively.

However, the cash flow statement painted a different story altogether. The company reported negative cash flow from operations. From a business perspective, this didn’t make any sense at all.

Post the announcement of its financial numbers, the company’s share price rallied 269% to its all-time high levels. However, since then it has lost 75%.

Therefore, focusing only on the P&L statement could give you a skewed image. And investing based on such a skewed interpretation could prove harmful for your capital.

So, if you ever find yourself invested in a company whose P&L statement looks all hunky-dory while other statements look scary, then that’s a strong sign of you being dead wrong about your investment.

When your investments aren’t in sync with your goals

What do you intend to achieve with your investments? What are your investment goals? These are perhaps the most important questions you should have answers to before you start to invest.

Having investment goals gives you a lot of clarity regarding your investment decisions. They help you decide which asset to invest in, how much to invest, how long to remain invested, how much risk to take, etc.

For example, suppose one of your goals is to save up for your child’s education. That requires you to stay invested for a period of above 10 years. As far as risk is concerned, I’m sure you would not want to take a high risk in this case.

So, that gives you investment options such as FDs, government bonds, bluechip stocks, gold, etc.

As you can see, your investments and your goals go hand in hand. They complement each other. Ideally, your investments should help you realise your goals.

Falling for a well-crafted narrative or a popular opinion

If you have been investing for a while, you might have heard “bubble” a few times.

In the finance world, a company is in a bubble when its market value exceeds its intrinsic value by a large margin.

What creates a bubble?

A bubble emerges when investors fall for a well-crafted narrative or a popular opinion and invest based on it. The story is so convenient that investors tend to ignore the facts.

This behavior puts the prices of securities on steroids resulting in a bubble. When the bubble bursts, these naive investors are found on the losing side.

Do you remember what happened in 2008?

Many investors believed that the housing market wouldn’t collapse ever. This belief led investors to invest in housing.

However, when the subprime crisis came to light, the housing market collapsed like a deck of cards sending shockwaves across the global financial markets. Investors experienced huge losses as many listed companies filed for bankruptcy.

Investors experienced the same when the dotcom bubble burst. In the 1990s, internet companies were the darlings of Wall Street. Everybody wanted to invest in these companies. These companies traded at unsustainable valuations even though they had poor financials.

Subsequently, the markets tanked, thereby hurting amateur investors.

Something similar is unfolding currently in the Indian markets. New-age tech companies are being touted as the next wealth creators.

However, their financials don’t support the growth thesis. So be very careful while investing in these companies. The growth narrative is too good to be true.

So if you have invested in a company based on a popular opinion instead of hard facts, you know you have a bad investment that needs to be dealt with immediately.

What to do when you’re dead wrong about your investment?

To err is human. If you made a mistake, that’s okay. Don’t punish yourself for that.

Instead, you should learn from your mistakes and try not to commit those mistakes again.

Here’s Warren Buffett’s take on investing mistakes:

There’s no way I’m going to make business and investment decisions without making some mistakes. I may try to minimise them. I don’t dwell on them. I don’t look back.

When you come to know of your bad investments, act upon them as quickly as possible.

You could ask an expert or an adviser to cross-check your thesis for selling a stock. Doing so, you would be sure about your decision.

Happy investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

Note: Equitymaster.com is currently not accessible due to technical reasons. We regret the inconvenience caused. Meanwhile, please access our content on LiveMint.com. You can also track us on YouTube and Telegram.

This article is syndicated from Equitymaster.com

Adblock test (Why?)

Source link