Many investors worldwide have lost a lot of money due to a variety of factors.
Stock exchanges are platforms where companies raise money from investors to expand and increase their productive capacities for strategic reasons. Investors include retail, institutional, and corporate buyers, as well as foreign investors.
When a company’s internal financial resources become inadequate to fund its growth prospects, it may issue additional shares or launch an initial public offering (IPO) to solicit funds from the public.
To do so, the company must first fulfill the requirements of the Companies Act and then apply for admission as a member of the Johannesburg Stock Exchange (JSE) or another relevant exchange to list its shares. All legal processes and listing requirements must be complied with.
Investors have incurred losses on the stock exchange due to the following factors, among others:
Lack of Financial Literacy
Financial knowledge is crucial for making informed and educated decisions about allocating funds efficiently according to one’s risk appetite and objectives. Knowledge is an asset, as it gives one independence and the ability to make informed choices among alternative stocks. Some investors have lost a lot of money due to a lack of necessary knowledge and skills, basing their decisions on rumors or news without adequate due diligence. Some investors cannot distinguish between illegal and legal trading and investment platforms. Due to this lack of knowledge, they end up committing their funds to bogus online platforms promising high, abnormal returns. In some cases, they may choose the correct legal brokers but opt for the wrong product or instrument, which results in losses or inadequate returns.
Other investors may buy overvalued shares without a sufficient margin of safety, increasing the likelihood of losses in the event of a crisis the company may face in the future.
A current example is the two-pot system, in which eligible pensioners are withdrawing part of their retirement savings. Retirement savings are meant to support individuals after retirement, so withdrawing before retirement can lead to compounding effects, losses, and other costs. The future of pensioners who withdraw now for consumption purposes is bleak, especially those who are withdrawing without carefully analyzing the future impact.
Duration of Investment
Investing in the stock markets is volatile, as share prices fluctuate. In the short term, the ability to weather volatility is limited and costly, as the probability of incurring losses is high. Long-term investing, however, allows time to ride out volatility, as the share price is more likely to recover and move positively toward its intrinsic value and fundamentals. This type of investing tends to reward the patient investor, especially if their initial purchase was made with a large margin of safety. Compounding effects help increase wealth over time for long-term investors.
Exiting at the Wrong Price
Some investors buy at high prices and sell at low prices, exiting positions at a loss. This often happens during crisis situations like COVID-19 and recessions. As long as the company’s fundamentals remain intact and sustainable, an informed investor should continue buying as share prices decline. This strategy is known as dollar-cost averaging or rand-cost averaging, depending on the currency.
Buying the Wrong Companies
A knowledgeable investor should buy shares from companies with strong economic moats and the durability to withstand competition. The moat can be in the form of a company’s ability to produce products at lower prices while maintaining demand and market share. The moat can also result from specialized knowledge, skills, or technology that competitors cannot easily replicate, which strengthens the company’s brand and ensures its durability. Some technology companies, however, face the risk of obsolescence, as new innovations emerge every year. For example, Apple Inc. releases new cell phones annually that should outperform their competitors’ models and be accepted by the market. However, if a competitor with better and superior technology emerges, Apple could be outpaced unless it quickly adapts or is acquired by a competitor seeking synergies.
Investors should conduct thorough analyses to understand the company’s core operations, revenue drivers, and sustainability. They should evaluate whether the company can survive future competition and technological advancements before committing their funds.
Lack of Diversification in Portfolios
Diversification helps minimize losses in the event of company-specific and economy-wide challenges.
Diversification should occur at the personal, company, and industry levels to preserve capital and reduce risk. Putting all your investments in one asset or company can result in significant losses if that particular company or industry faces an economic downturn.
Personal diversification refers to varying the risk profile of investments based on individual preferences.
Company diversification involves investing in shares from different companies across various industries.
Industry diversification means investing in shares from different sectors with varying life cycles.
Diversification reduces overall risk and increases the potential for returns.
Moreover, the diversification across companies and industries should be negatively correlated, so that economic fluctuations in one area don’t significantly impact the performance of the entire portfolio.
An undiversified portfolio is exposed to significant and potentially catastrophic losses.
Failure to Value Company Shares
Before buying shares in a company, an investor should calculate the intrinsic value of the shares based on their assumptions. Comparing the intrinsic value to the current share price will reveal whether the shares are undervalued or overvalued. If the current share price is below the intrinsic value, the shares are undervalued; if the price is above the intrinsic value, the shares are overvalued.
The decision is to buy undervalued shares with a large margin of safety, protecting the investor from downside risk in future crises, and to sell overvalued shares. This decision should be made after thorough analysis of various valuation and qualitative metrics. However, some investors buy shares without first valuing the company or its stock.
Failure to Analyze Annual Financial Statements
Financial statements include the income statement, balance sheet, and cash flow statement.
The income statement shows the company’s profits or losses.
The balance sheet presents the company’s assets, liabilities, and equity position at a specific point in time.
The cash flow statement shows the company’s cash-generating ability and its sustainability, including the uses and applications of that cash.
The ability to analyze and interpret financial statements provides investors with crucial information for making decisions based on concrete facts.
Failure to analyze financial statements has led some investors to invest based on hearsay, which often results in losses.
Ideally, a business should generate consistent revenue and profit, making it easier to predict future financial statements.
Inconsistency in these financial results raises concerns about the sustainability of the business model.
Investors should be cautious of exceptional items that distort the core performance of the company. Exceptional items should be excluded to gain a clearer understanding of the company’s operations.
Lack of Free Cash Flow Analysis
Free cash flow is the cash left over after capital expenditure. A company can use this cash to reinvest in its business, pay dividends, repurchase shares, or fund new projects that generate returns for shareholders. Investors should examine the trend of free cash flow and how it is applied. Positive free cash flow provides flexibility for a company to invest in opportunities.
Shareholder Structure
Some investors fail to consider the major shareholder structure of the companies they invest in. This metric helps investors understand the composition of the company’s investor base, whether it’s made up of institutional investors, corporations, or retail investors. The type of investor base and their shareholdings can indicate sustainable demand for the company’s shares.
Debt to Equity
Some investors fail to understand the debt-to-equity ratio and other important metrics from the balance sheet, which can lead to poor investment decisions.
Companies funded primarily by debt are more likely to face liquidity and solvency issues during economic downturns or internal crises. For instance, during COVID-19, many companies faced difficulties in servicing their debts, leading to breaches of financial covenants unless lenders relaxed loan conditions.
Self-Sustaining Growth
A company that funds itself through internally generated resources is generally better equipped to withstand crises. It will have a stronger balance sheet and greater resilience to external shocks.
Recommendations
- Investors should consider investing in their financial education to create wealth for themselves and future generations. This will help drive economic well-being.
- Regulatory bodies should ensure that investors have access to free educational resources on investing.
- Governments should consider introducing share trading and investment education at primary school levels.
- Funding should be allocated to organizations that equip the public with financial knowledge and skills.
- Companies should maintain large pools of professional liability insurance to compensate investors in case of financial misconduct. Regulatory interventions should be prompt and efficient to prevent prolonged investor losses.
- Investing in the stock market can be a viable means of self-employment, generating tax revenue for governments. Governments should encourage youth participation in the investment space to provide constructive alternatives to illegal activities.
- Continuous learning and development are essential. Investors should invest in their skills to stay informed and adapt to changing market conditions.
- Seek advice from registered financial service providers. Only authorized entities operating within the boundaries of the Financial Advisory and Intermediary Services Act (FAIS Act) should be consulted.
Commentary
Companies with debt aren’t necessarily a poor investment choice. Growth companies often rely on debt to finance operations, and some may have negative free cash flow. As long as the debt is manageable and within the company’s capacity, these companies can still present viable investment opportunities after thorough analysis.
New Innovations
New technologies, such as automated trading platforms, are being used to buy and structure portfolios. However, these technologies should be registered with regulatory authorities and reviewed for compliance with investor needs.
Cultural Shift
In some cultures, people fear legal investments and instead turn to illegal lending markets. There is a need to educate community leaders about the benefits of investing in the stock market, so they can share this knowledge with others. Local government agencies can play an important role in encouraging communities to explore legal investment opportunities.
With the right skills and knowledge, some investors have made significant fortunes in the stock market, such as Warren Buffett.
Sources: Value Investing in Growth Companies by Rusmin Ang and Victor Chng
