Avoid These Five Common Portfolio Mistakes

Editor's Note: This article ran originally in May 2002.

One of the things I like most about writing for RealMoney is the dialogue I have with readers. They send me all sorts of interesting comments and opinions, and in return, they get inside the head of an active money manager, one whose opinions are outside the mainstream -- or should I say maelstrom -- that is Wall Street.

I have to ask my readers to forgive me on this one, though: Sometimes I use your emails as a contrary indicator. When I solicited suggestions last October for a list of promising stocks, roughly 80% of the names proffered were tech and telco names. I considered the amazing level of interest in those sectors to be one more indication that last cycle's excess has yet to be purged.

In a previous column, I noted that much of my research effort is focused on evaluating the risk of particular equities. I'm more concerned with prospective downside than with prospective upside. Correspondingly, individual investors would do well to concentrate on avoiding mistakes in their portfolios. In my emails from investors, I'm seeing and hearing about many portfolio mistakes that readers are currently making. Here are a few of them:

Mistake No. 1: Going to cash

I get lots of emails from people who are fully invested in cash. I know that many market pundits are in cash as well. In terms of basic investing philosophy, I disagree with this position.

While I understand the need for a reasonable amount of cash in a portfolio, I'd rather purchase undervalued businesses that generate free-cash-flow yields well above the 2% yield that money market funds earn. Several of the companies that I've highlighted for RealMoney readers fit the bill, such as Liz Claiborne (LIZ), Ethan Allen (ETH) and Raymond James Financial (RJF).

Mistake No. 2: Owning an S&P index fund

I know this market is tough, but don't make the mistake of socking your money away in an S&P 500 index fund and forgetting about it. This cycle is all about selectivity. You can make a buck or two if you're in the right companies at the right price. But buying into a broad-based fund that's excessively exposed to overvalued big-cap growth -- like S&P index funds -- is a prescription for mediocrity at best and for substantial capital losses at worst.

Mistake No. 3: Owning companies with suspect management

There are enough compelling ideas in this market to warrant eliminating companies with suspect management. I've warned investors in blunt terms -- in a column last November and again in early March -- to avoid Tyco (TYC). I can't measure the underlying business value of a company whose management and numbers can't be trusted.

Mistake No. 4: Owning companies with phantom earnings

There's no reason to own companies that produce low-quality, suspect earnings. The last cycle was marked by the unreal; this cycle is about "real companies" with "real earnings." Real earnings, at least according to the accounting that I understand, means that I have to say no! to companies that do the following:

• Include gains in net income, like Intel(INTC) does.

• Emphasize pro forma earnings, like Amazon(AMZN) does. You can get cross-eyed comparing Amazon's pro forma profit with its GAAP losses.

• Exclude material stock-option expense. For example, Cisco (CSCO) would've had 40% lower earnings a year ago if it had deducted stock options as an expense.

• Include gains in selling, general and administrative expense. IBM (IBM) can get away with this because, well, it's IBM.

• Include pension income. General Electric (GE) will have pension expense to report soon enough.

Mistake No. 5: Not following your money managers

Mistakes are part of the game in investing. If you're unwilling to make a mistake, then don't invest. But money managers make some mistakes that are difficult to sanction -- mistakes of ineptitude or laziness. Take a look at the stocks in the portfolio of your mutual fund for the past few months. It will tell you a lot about how your money manager thinks and how he or she approaches a difficult market.

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