To err is human. To err financially is not only human, it happens to even the most astute. Here is a list of the ten biggest financial mistakes.
1) Spending Excessively and Accumulating Unnecessary Debt
We live in a consumerist world. Social media projects the image that happiness can be found at the bottom of a new pair of shoes or a Louis Vuitton handbag. Human beings are also suckers for creative advertising. Combine this with the easy availability of credit cards and you have a toxic cocktail that will lead many mortals into temptation. This has led to the narrative from financial advisers that credit cards are evil. Credit cards, themselves, can be powerful sources of cheap funding if used correctly. The problem is that most people use their credit cards irresponsibly and get in over their heads. They then spend the next 5-10 years trying desperately to dig themselves out of their debt holes at a time when they should be saving, investing, and building a foundation for financial freedom.
2) Making Poor Investments
Paul Samuelson put it best when he said investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas. The biggest mistake people make when it comes to investing is looking for sexy investments. These are companies that are always in the spotlight and always in the news. Sexy is great if you are looking for lingerie, a mail-order Russian bride, or an Italian sports car – but it has no place in investing.
Peter Lynch, in his book "One Up on Wall Street", provides a fantastic insight into the world of simple and common-sense investing. Lynch said that you should invest in a company any idiot could run because pretty soon an idiot would be running it. He provides the example of an undertaking business. What could be simpler than collecting dead people, slapping on a little rouge and eyeliner, presenting them to friends and family, and then tossing them into the ground or into an incinerator? The beauty of this business is that it is simple (any idiot with a black station wagon and a Mary Kay catalog could do it), it is not cyclical (people die regardless of whether the economy is booming or in a recession), and business is always guaranteed (the only certainties in life are death and taxes).
In addition to understanding the business, you also need to understand the financial statements and this is where normal humans lose their erections. The mention of balance sheets, income statements, and cash flow statements is used as a local anesthetic for minor surgical operations.
In Rebel Finance, we try to explain boring concepts in simple and interesting language, so don't go nodding off.
The balance sheet is a photo of the assets and liabilities (equity is the capital owed to the shareholders and therefore is seen as a liability in Ben Graham's eyes). Income statements are a record of the revenue, income, and expenses. Cash flow statements show cash that was generated and used in operations, financing, and investing. Understanding accounting is important to value a company because it is a scorecard of how the company is performing.
A few final points on what Buffett likes to look for. The biggest risk in value investing is that you misread the mood of Mr. Market. The company may, in reality, be a flea-infested swamp donkey. You, however, are off your game and believe it is an Arabian thoroughbred. You mistakenly believe Mr. Market is manic and offering the stock at a depressed price. In reality, Mr. Market is valuing the stock efficiently and the company is heading to hell in a handbasket. To avoid these errors, Buffett provides a handful of tips.
Firstly, he looks at the debt to equity ratio. Bad companies go broke because they stink. Sometimes good companies also go broke because they are unable to manage their debt. Cemex is the largest cement and concrete producer in Mexico. It almost went to the wall in 2008 during the financial crisis, not because it was a bad company, but because it had taken on too much debt in the years leading up to the crisis to acquire foreign businesses.
If a company has 10 units of assets, and 1 of debt, it is not going to go bust anytime soon. If that 1 unit of debt, suddenly shoots up to 8, while the assets stay at 10, there is an exponentially higher probability that the company could go broke. The advice from Buffett is to pay close attention to the total debt versus total liabilities. Try and keep that relationship below 100 percent which means that there should be more equity than debt in the business.
Buffett also has an affinity for monopolies and duopolies. He likes businesses that are like castles protected by moats that keep out the competition. He says owning a monopoly is like owning an unregulated toll bridge. You have the freedom to increase prices when you want and by as much as you want.
Facebook and Google are both monopolies but fall outside Buffett's wheelhouse. But we should not take Buffett literally. He is not telling us to only buy monopolies and duopolies. The Oracle is angling us towards companies with healthy profit margins and returns on equity. This means that they are dominant players in their space and are executing their strategy better than the competition.
3) Taking Bad Advice
Generally speaking, the financial industry as being dishonest and obsessed with self-interest. Many financial advisors make their money off their relationships with financial institutions. These conflicts of interest are particularly acute in the research that banks publish – the research on which many investors rely when making investment decisions. When a bank analyst recommends you buy a stock, the objectivity of the recommendation is always in question. The bank may be doing corporate finance work for the company. This may cloud the judgment of the analyst. If a bank is underwriting the initial public offering of Uber, what are the chances of the analyst publishing a negative report on the company? There is a better chance of winning the lottery, having a threesome, and being struck by lightning in the same afternoon. Conflicts of interest also live in the financial advice banks give to their clients. I sold a derivative hedge charging a 100 percent markup on the premium. The hedge cost 250,000 and I charged 500,000. I did this after hearing the client had no ability to value the true value of the hedge. The client was the Catholic Church. There is a special place in hell for derivatives traders, next to Ted Bundy and Jeffrey Dahmer. A client once said to me: "Ralph, you are a nice guy, it is always good to meet up with you, but going forward, I have decided to change my trading strategy. Every time your bank recommends to buy, I am going to sell". That client is now a multi-millionaire with a house in Monte Carlo. He recently got married to a Colombian supermodel and Beyoncé sang at their wedding.
4) Failed Relationships that Damage your Credit Rating – and Personal Guarantees
Love is blind, dumb, and stupid. When you get into a new relationship, common sense flies out the window, and close behind it flies sound financial discipline. Joint bank accounts and personal guarantees are a two headed monster that can come back and bite you on the rear.
Sharing a bank account may breed conflict. Whether it’s the roommate, spouse, or business partner, disagreements can arise, and having a shared account may create future issues. As all account holders can equally access the account, they can withdraw, deposit, change details, or transfer funds at any time without the consent or knowledge of the partner. In addition, if an account holder has a poor credit history, it can negatively impact the partner as well.
Then there is the issue of personal guarantees. Rule one is that you NEVER sign personal guarantees and rule two is NEVER forget rule one. The moment you sign personal guarantees is the moment you compromise your asset protection. However, avoiding personal guarantees is easier said than done. If you are starting a business, you have no credit track record. For the banks, you are a rookie at business although you may have a strong personal credit record. Bankers, therefore, require that you pledge your house or other assets to guarantee your business credit. The strategy you need to pursue is the following. You need to build a solid credit record of accomplishment in your company. You then need to start fighting with the banks to release those personal guarantees. I know businesspersons who have signed personal guarantees when they start their businesses and then forget about them. Do not forget about them – this is not like your wedding anniversary. You need to fight with the banks to release them as soon as the company's credit can stand on its own two feet.
5) Neglecting Insurance Cover
The selling of insurance is the biggest scam since snake oil during the California gold rush. The product is awesome but the way it is sold is the capital of Dodge. There are good reasons for this.No one likes to buy insurance. It is not an impulse buy. No one is filled with joy and satisfaction when the policy on their car needs to be renewed. We don't want insurance but we know that we need it. It is prudent to transfer specific risks to a third party, but prudent does not sell. Insurance companies know their product is unsexy. They, therefore, need to inject it full of collagen and silicone and dress it up in an underwire bra and leather mini skirt.
The job of selling insurance is as attractive as sitting in a toll booth in the middle of a dark tunnel surrounded by incontinent bats. To sweeten the deal, insurance companies need to incentivize these salespeople. I have friends who sell insurance. They spend half their time traveling to exotic locations to attend insurance "conventions". All expenses are paid by the insurance companies. We are talking about three to four trips a year to ski in the Swiss Alps, desert camps in Dubai, island hopping in the Mediterranean on private yachts, and private game reserves in the Serengeti.
Now that I have had my little insurance tantrum about how insurance is sold, let me reiterate that insurance is awesome and you should have lots of it. In the previous tip, I said that risk is good and you should embrace it and give it a big wet open-mouthed kiss. However, let me clarify this. I am talking specifically about investment risk. Also, I am not saying that you should take risks just for the sake of taking risks. You take risks when the odds are in your favor and the way you know that the odds are in your favor is through education and research. You also need to think of risk in terms of potential return. If an investment opportunity presents 3 points of risk and 10 points of return, then you want to go all-in – you want to sell the house, the wife, the kids, and the pets and fill your boots. If an investment presents 3 points of risk and 2 points of return, you want to run for the hills.
Let’s now bring this back to insurance. Let's say that you buy a $50,000 car. Let's assume that insurance on that car costs $1,000 per annum. At this point, you can do one of two things – you can decide to insure the car or your car decide not to insure the car. Let’s now look at the risk-return relationship. Your risk is that some scumbags will take a shining to your new automobile and decide to steal it. That event would result in the realization of a $50,000 loss. You can eliminate this risk by spending $1,000 on insurance. By spending $1,000, you can avoid a $50,000 loss. This is an absolute no brainer. You need to have car, medical, life and as many other insurances as possible.
Having said this, do your homework when you buy insurance. Let me give you a quick crash course in insurance. An insurance policy pays a determinable amount of money in the event of a certain event taking place such as wrapping your brand-new Ferrari around a telephone pole. The premium of this policy will depend on several factors. One will be the probability of wrapping the aforesaid motor vehicle around that pole.The more volatile the underlying asset, the higher the probability of that insurable event taking place. Insurance companies do not want men with small phalluses to claim the damages for wrapping Italian sports cars around telecommunication equipment. You may have noticed that I change the wording on the Ferrari. I did not say that insurance companies do not want drivers to crash. I said that they do not want drivers to CLAIM. There is a subtle difference.
In 2010, in Mexico, a car insurance company released a marketing campaign with the following message. The byline of the campaign was that the client could tell the insurance company how much they wanted to pay in premium. The insurance company would then design a policy for them.I thought this was marvelous. I gave them a call and said that I was prepared to pay 1 peso in premium. They asked me how much my car was worth, I said 300,000 pesos. They offered me a policy with a deductible of 299,000 – the value of the car minus the 1 peso I was prepared to pay. The higher the deductible on the policy, the lower the probability I will submit a claim. For example, my deductible would have been 299,000.Back to my Ferrari example, assume the deductible is 50,000 pesos.I bump the car against a concrete wall after one too many beers down at the pub with the boys. The damage is 20,000 pesos. That loss is for my account because it is below the deductible. You need to pay very special attention to the amount of the deductible. In many policies, this deductible is either expressed in monetary terms or as a percentage of the insured asset. For example, let us go back to the $50,000 car. Assume the excess is 5% which is $2,500.Assume now you ram the car into a tree and the damage is $3,000. The first $2,500 worth of damage (the excess or deductible) is for your account and the insurance company will pay the rest ($500). The rule of insurance is quite straightforward – the higher the excess or deductible the lower the insurance premium and vice versa. When you buy insurance, you are well-advised to take the time to read the small print.
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