Don’t Let This Common Investing Mistake Limit Your Returns

When I first started investing (this was back in the 20th century), I had a very simplistic notion of the stock market. I thought profitable companies were good, and unprofitable companies were bad. I wanted to invest in stocks that were making money, and I wanted to avoid stocks that were losing money. All the investing books were talking about the price-to-earnings (P/E) ratio, so I was very concerned about my P/E ratios.

Meanwhile, Amazon.com (NASDAQ: AMZN) was going crazy. I mean, the darn stock was going up every day. And David Gardner and Jeff Fischer were talking about internet commerce and how cool it was, and how Amazon was “top dog and first mover” and it was very, very exciting. But Amazon wasn’t making any money. They were unprofitable, and that was bad. So I bought shares of Sealed Air (NYSE: SEE) instead.

Image source: Getty Images.

Oops

A manufacturer of protective packaging might not seem like a high-growth play, but try to stay with me. My theory on Sealed Air was that if internet commerce is the next big thing, then Sealed Air was going to take off. (Back in the 20th century, for instance, Amazon wrapped all the books it shipped in plastic.)

So I was very happy that I had outsmarted the stock market. While I wasn’t technically investing in internet commerce, I was invested in the No. 1 packaging company, and they were going to make a lot of money wrapping all those books in plastic. And Sealed Air was profitable, so I was taking no risks at all. Very safe investment. Unless maybe that P/E ratio was too high, and who knows if that was the case.

Meanwhile, I was still just flirting with Amazon. I put the stock on a watch list and watched it go up and up and up. And my primary argument against owning the stock was pretty simple:

Amazon is not profitable! They’re not making any money! That’s how you lose money, by investing in companies that don’t make money!

What was really annoying was that Amazon didn’t have a P/E ratio. All the investing books were talking about the P/E ratio. But you don’t have any profits, Amazon. So you don’t have a P/E ratio! And I had a little voice in the back of my head: “Maybe the books are wrong. Maybe P/E ratio sucks.” After a while I just wanted to smack the P/E ratio in the face. Stupid little math that doesn’t help me at all.

Finally I said the heck with it

After a time, I listened to that voice and bought some shares of Amazon.

Now, this was a very dangerous thing to do. All the smart money was telling me how awful it was, how stupid it was, how dangerous it was. A Barron’s cover story called the company “Amazon.Bomb.”

What they didn’t mention was how much fun it was. Yes, I was taking a risk. Yes, it’s dangerous investing in companies that aren’t making money (yet). But it was so much fun. And then Amazon started selling music, and I was jumping up and down with excitement. The store’s getting bigger! The store’s getting bigger! And I would work the Google — this was back when Alphabet was called Google — and I discovered how big the market was for music. And I’d share that with everybody and people would get excited. It was kind of contagious.

Now, Amazon stock did crash in 2000, and that wasn’t the only time. But it was the worst. The stock dropped 90% off its highs. Now that’s a discount, shoppers! And it took some time to come back. But today that 90% drop in 2000 is like a little squiggle that you don’t even notice anymore.

AMZN data by YCharts

Young companies are often unprofitable

What I know now is that every company has a lifespan. A company is born, a company matures, and sooner or later a company dies. If you buy early in a company’s journey, the upside might be amazing. It depends on how big the market opportunity is. Internet commerce is an insanely huge market opportunity (it’s still growing, comrades), and so Amazon has been an amazing stock to own.

A lot of companies, when they are tiny little baby companies, do crazy things like sell their products at cost in order to grab mindshare. This can upset the accountants and other people who worry about red ink. But if the company has high gross margins (say, 80%), you really don’t have to worry much about the lack of profit margins. Those will come later.

Amazon drove people crazy because it is a retailer. It was like an epithet. People would spit when they said it. “Amazon is a retailer!” They got so mad. That’s because retailers do not have high profit margins. There were a lot of people who said that Amazon would never make any money. And maybe in a parallel universe, Seattle was hit by a meteor and Barron’s was right.

Rich people take risks

Investing in any stock is a risk. You can lose your money. But it’s actually an excellent risk to take. It’s way better than gambling, for instance. The upside in stocks can be amazing and the miracle of compound interest can make you rich.

So that’s the mistake that many people make. They want to avoid loss, and so they avoid risk. But if you play it too safe, that’s another type of risk. If you had invested $1,000 in Amazon when it went public, you’d be a millionaire today.

In your portfolio, you want to allocate some fun money and take some calculated risks. In my experience, that’s how you beat the market (and the smart money).

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Taylor Carmichael owns shares of Amazon. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), and Amazon. The Motley Fool recommends the following options: long January 2022 $1,920 calls on Amazon and short January 2022 $1,940 calls on Amazon. The Motley Fool has a disclosure policy.

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