Investment horror stories and the lessons they teach

Gather round and hark these tales of terror, these thrilling financial horror stories, from our finest minds.

A Nightmare on Wall Street
by Peter Bull, Head of Equities, Morningstar Investment Management Australia

Around December 2007, a lot of the big Wall Street firms were trading very cheaply relative to where they had been over the preceding years and even during the run up in 2000. I was living in the United States focusing on non-U.S. stocks for work, and I listened to some very well respected and famous investors recommending these firms as being incredibly cheap. And so, I invested in my personal accounts in some of them. It wasn't more than I could afford to lose, but of course it doesn't feel that way when you only recover 50% of your investment. Watching statements come through the mail with new and strange-looking stock identifiers for companies that have gone bankrupt is an experience I'll never forget. I didn't even know how to get rid of them.

What I learned
There were several important lessons, of course, like always do your own research and don't listen to pundits or stock stories. The best stock story is a list of everything that can go wrong that turns out to be quite boring.

The most important consideration I think is that when you look at companies to invest in, your mental checklist should include thinking about the business completely independent of its price. People get overly excited by price action because it's so accessible and easy to correlate with interesting stories in the news or exciting developments in the future. But looking at price in this way can be a terrible mental short-cut to take. Some businesses are robust to 90% of the bad things that can happen, while others are a complete coin-toss if they will even survive the next bad thing, whatever it is. It requires real thinking to get through it because it's not obvious in many cases. Appropriate position sizing is also key to surviving your mistakes -- and there will be mistakes.

A good and practical thought process is to really think of what your required return is for a given investment instead of jumping straight to what its recent price history is or what its short-term expected return is according to some model. Different investors can have different answers to the same questions about risk preferences and required returns and still be correct. They definitely don't need to let the market dictate what's fair compensation for risk. Ultimately, investors who want to build wealth slowly with stocks, or those who have more modest expectations of them, are in the end more likely to be successful with them. Consider the alternative -- we all know how "get rich quick" turns out.

The Haunted House
by Dan Kemp, Morningstar Investment Management Europe

While I have made countless investing mistakes, in most cases the impact has been fairly minor as I have primarily missed out on gains rather than experienced losses. The most significant of these is that I didn't get around to buying a property until recently and so am now facing a large mortgage on a property I could have bought 15 years ago at a much lower price.

What I learned
While there are many reasons why I didn't buy a property earlier, this experience has reminded me that long-term investors benefit from being optimists rather than pessimists. However, this does not negate the importance of always focusing on valuation and demanding a margin of safety.

Paranormal Activity: Sears Edition
by Adam Fleck, Regional Director of Equity Research, Morningstar Australasia

I bought shares in Sears (SHLDQ) in July 2007 at a price of about US$153. I thought I was getting a good deal -- the company was trading at a low price/sales ratio, and domestic comparable sales, while still declining, were showing signs of getting less bad -- down about 4% in fiscal 2006 versus 5% the year prior and 11% in 2004. My investment hinged on the strategy that Eddie Lampert had formulated in merging Kmart and Sears in 2005, which I thought held promise for potential scale-based cost advantages. With the stock falling from a high of US$190 a few months before my purchase, I believed there was a margin of safety to capitalize on this long-term opportunity.

I realized my mistake less than a year later. By May 2008, the share price had fallen to below US$100, and I began to re-test my thesis. The ongoing economic slowdown certainly didn't help matters, but I also became increasingly concerned that Sears would be unable to compete over the longer term with the likes of larger, better-run retailers as well as emerging pure-play online sellers. After a few weeks of work, I sold my shares in late May 2008 for about US$87, good for a loss of nearly 45%. But I'm glad I did -- shares suffered through 2009 as the Great Recession took hold, and while the stock bounced back in 2010 to briefly get above $120 again, we all know now where the story eventually ended.

What I learned
The main lesson I learned is that management alone isn't a source of an economic moat. Despite what I thought was a solid strategy, built by very intelligent hedge fund manager Eddie Lampert, Sears's problems were larger, more structural and longer-lasting than any one owner or executive could have dealt with. Instead, I decided in early 2009 to purchase stocks in a number of companies we rate as having an economic moat, including  Berkshire Hathaway (BRK.B),  Walmart (WMT),  Caterpillar (CAT) and  Automatic Data Processing (ADP).

Get Out!
by Christian Charest, Editor, Morningstar Research

In the summer and fall of 2007 the Morningstar (MORN) stock nearly doubled in price, and I came really close to selling at the top. Close, but not close enough. In those days, as part of our compensation package, Morningstar employees were awarded company stocks, and I had a decent-sized batch that was ready to be sold. Each day I would watch as the stock price went up, and one day in November I decided to pull the trigger. Around noon I went on the website of my discount broker, but rather than place a market order I decided to be cute and place a limit order at a price of US$85. The stock had started the day at around US$81, but I had seen several days in the recent past where it had gone up by $4 or $5, so while my ask price was ambitious, it didn't seem extravagant to me at the time. I was already dreaming of all the things I would do with this windfall.

The stock went up to US$83, but then it just froze there until the market closed. No big deal, I thought, I'll try again tomorrow. And that's where the story devolves into a horror film. The following day the stock opened down several dollars, and just kept dropping. I thought it best to sit tight and wait for it to bounce back, but day after day, week after week, it just kept falling and falling, and I could only watch in terror. Four years later the stock still hadn't fully recovered, but I needed the money so I sold at US$60.

What I learned
Momentum investing is tricky. You think you can identify patterns by looking at charts, but instinct plays a large part. When a stock's price moves that much in such a short time it's not based on fundamentals, but market exuberance. I was ready to sell the stock in November 2007, and even at US$80 I would have made a healthy profit, but I got greedy. This was my one and only attempt to time the market at such a granular level, and it backfired on me.

The above stories are for illustrative purposes only. Investing in securities involves risk. Please work with your financial professional before making a financial decision.