Overcoming the Deadly Pitfalls of Investment Finance: Insights from Financial Expert Andrew Stotz

Financial intelligence is an underdeveloped skill in most individuals, which is often responsible for their likelihood of success or failure in their personal, social and professional lives. A fundamental aspect of this skill is the ability to recognize and use opportunities even when there is a shortage. Remember the three motives for wanting money according to Maynard Keynes which include; transactional, precautionary and speculative? The speculative motive embodies the idea of ​​financing investments, and it is generally accepted as the basis for wealth creation.

Invariably, investment finance is often thought of or learned from the perspective of desirable skills to possess. However, an equally or even more rewarding approach has been observed to approach the subject in terms of the undesirable things that we often take for granted in our day-to-day lives.

Financial investment expert and writer, Andrew Stotz, in his personal account of his financial investment failures titled my worst investment identifies key markers of an investment likely to fail and how a potential investor can circumvent these mistakes. The short book started from sampled opinions of the author’s friends and acquaintances, detailing their worst investment experience. It turned out that each respondent had such a vivid story to tell. The author describes the inspiration for the book as follows:

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“In the world of finance, we always talk about our earnings, the history of our returns. But we rarely talk about failures. Thus, the book talks about investment failures.

Stotz dissects the key drivers of successful investing into four broad levels. At each level are decision errors that often cause the investor to lose the investment.

The first thing to consider is to deal with the basics. This involves a thorough understanding of the business enterprise; both its outlook and internal realities, including its operating models, leadership team and culture. According to Stotz, to avoid failure in the early stages of business, focus on getting the fundamentals in place.

The following decision errors arise from not being able to process the basics:

  1. Buying into an illiquid investment that is hard to sell
    According to Stotz, investing in unlisted private companies poses a unique challenge because it is very difficult to exit them when one is no longer satisfied with the management.
  2. Buying into an illiquid investment where you have no influence over management
    Here it is stated that owning a minority stake is very risky because as a minority you have little or no influence on how the business operates. For example, when you are an employee, it happens that management offers you your own shares in the company. In this case, it is better to avoid it since you will have no control over the management of the company. Also, you will have deferred compensation and if things go wrong, there may not be a buyer for your shares. Therefore, the investor suffers due to a lack of control.
  3. Trusting an unproven leadership team
    Here, Stotz contextualizes a common belief that the familiar devil is far better than the unknown angel. According to Stotz, the change in management is crucial for the survival of the company. This was new management taking over a family business. In such cases, investors expose themselves to the risk that the new management will not be able to grow the business. Therefore, the lesson here is to stick with proven management if possible.
  4. Investing in people you don’t know and not reviewing their past and credentials
    Although this is similar to the previous case, however, it is different because it goes beyond mere trust in management to other things that inform our biases and irrational decisions. For example, some people make investment decisions based on how gracefully a pitch appeals to them or based on the culture, class, or race of the people they invest with. Efforts should be made to thoroughly research or do what is called due diligence on the person’s past decisions and relationships.

The second factor is to keep an open mind so that you can easily overcome the hureus. Firms evolve with major and minor changes in the mode and social relations of production. A combination of macroeconomic and microeconomic forces could disrupt the market and create a new order. Therefore, the rational investor must keep an open mind and be prepared to give up his favorite business if necessary. It’s just about “knowing when you have to kill your darling” according to Stotz.

The following decision errors result from not having gone beyond residual knowledge:

  1. Being oblivious to or deliberately ignoring a major change in an industry One of the main risks of investing in an individual stock is the risk that something major will change in the industry in which the company operates. These changes may start small at first and may seem to have little impact. But they can accumulate steam. For example, during the Covid19 lockdown, investments in real estate, especially office space financing, and transport declined due to remote working.
  2. relying too much on professionals The author noted that one of the lessons of his career is that finance professionals are driven by many different factors than the investor’s concern, which is simply the performance of their investment. Also, brokers are often stock cheerleaders rather than thoughtful analysts. Therefore, one should never eliminate the conflict of interest in the financial world. You should seek financial advice from individuals who disclose their conflicts of interest.
  3. Buy the dip without a second thought
    You will definitely face high risk when deciding what to do when stock prices fall. Referring to the prospect theory of Nobel Prize-winning economist Daniel Kahneman and Amos Tversky, Stotz proposes that when, for example, as an investor, you buy a stock at 100 and it goes up to 110, you feel good, but when it hits 90 you feel about twice as bad as you felt good when it went up 10. This will cause you to make mistakes when prices go down.
    Also due to overconfidence, when stock prices start falling, we think that if we liked him at 100, we should like him even at 90. However, a better way to think about this is that even though the analysis may be correct, the timing may be wrong. The author argues that if a stock drops 20-25% in most markets, it’s best to sell it and hold cash.
  4. Ignore the reality that things are changing for businesses. Sometimes we are blinded by love – we love companies and their management so much and know them so well that we think they will always succeed and be a good investment. But things are changing for businesses. It must be understood that past glories do not guarantee success, it is the future.

Michael J. Birnbaum