Keeping in control

Undoubtedly one of the keys to successful investing is discipline. Rules are needed to consistently implement a strategy, while guarding against the influence of emotions and behavioural mistakes.

I have an investing strategy with some fairly clearly defined rules. The difficulty I, and most other investors, face is the lack of certainty as to whether the rules we are following are the right ones. As important as discipline is the ability to learn from mistakes. Things not going to plan may mean a rule needs updating. However, being open to updating the rules too readily can undermine them when you most need them. The balance is a tricky one…

Controlling fear

The fear of regret is the one of the most powerful emotions and the one that has the potential to cause the most harm investing. The pain of being wrong is stronger than most other emotions and in anticipation we’ll do almost anything to avoid it. This can lead to a whole range of mistakes. Fear of missing out can lead to buying too quickly into a new story or holding a losing position too long in case you miss the bounce. Fear of losing can lead to selling either winners or losers too soon.

Some investors are naturally better at regulating emotions than others but, unless there is something a bit wrong with them, nobody is immune.

The way to manage these fears is through having a strategy with a set of rules of what and when to buy and when to sell. For a strategy to work well, you need to be able to commit to it so you can rely on the rules in times of need. This means that the rules need to be sufficiently flexible and be able to deal with all contingencies, so you don’t feel the need to change them.

So how are my rules working out?

Weatherproofing my strategy

What to buy

What to buy is a decision where I think a bit of flexibility to apply judgment is beneficial, so that qualitative, less measurable factors can be taken account of in the round. It is a decision where pattern recognition or ‘gut feel’ can be helpful. Rules around what to buy need to be flexible enough to allow some judgment to be applied.

The key feature of my strategy around what to buy is that I limit myself to a watch list of high quality shares I am confident in long term. Monitoring the watch list disciplines me to get to know a set of companies and enables me to buy what is currently my best rather than just my latest good idea. I think this approach has worked well so far and I’m happy to keep it as is. The inclusion of European and US shares has grown the watch list substantially and created a bit of disruption, as I have tried to familiarise myself with a large number of new businesses, but this is settling down now.

I rank the watchlist according to different factors (see here). I think this is proving a good way to record my thinking systematically. It has had the effect of focusing my attention to those shares near the top of the list without overly restricting me. My benchmark portfolios show that the shares at the top of the list have performed better than the others.

This system has some flexibility to deal with changing market conditions by reweighting the factors according to what seems to be more important at the moment. For example, momentum and value work have been shown to work better at different points in the cycle. While in general I put much more weight on momentum as a factor compared to value, at the moment valuation seems to be growing in importance. Valuations in growth stocks appear high, shares seem to be reacting less to positive news and price volatility of the shares on my watchlist has risen. At this point, I’m minded to put greater weight on valuations than I normally do and I think it’s right that my strategy gives me the flexibility to do this.

When to buy

Previously, my approach to timing buys has been pretty straightforward – I was always fully invested and would buy a new holding immediately after a sale. I reasoned that I shouldn’t try to time the market.

This approach works well while the share prices of most of my watch list are going up, as I can shift to the best opportunities quickly. At these times the opportunity cost of holding cash is high. This approach may work less well in more volatile, choppy markets and can negate the benefit of stop losses getting me out quickly in a bear market.

I want to give myself flexibility to go to cash when the prospects of the shares on my watchlist are not good. I also need to make sure I don’t make rash decisions when prices are falling across my portfolio and my emotions are running high. Without rules, I have not been able to restrain myself from reinvesting too quickly, even if the opportunities are not great.

I suggested in my post last week that I should only buy new positions once a month. I think this would make it easier to resist the temptation to reinvest cash when this is not warranted. It would force me to be more patient and hopefully improve my decisions of what to buy. The downside is obviously that it severely constrains my timing, so I think it is something to be applied only when I need to be more cautious. To refine when this rule should be implemented, I’ve decided to think of it as a ‘circuit breaker’, for when things are getting too ‘exciting’. If my portfolio declines in value by 5% or more from highs, the circuit breaker will be triggered – I will make no new buys for a month and following that restrict my buys to once a month until performance has improved.

When to sell

When to sell for many is the most difficult part of investing. I have some pretty well defined rules for when to sell, which I feel have generally served me pretty well. My general approach is to run winners and sell losers fairly aggressively. I always sell on profit warnings or when shares lose momentum, using a notional trailing stop loss, and sometimes in order to invest in a better opportunity.

I’ve written before on stop losses, reviewing whether my approach to them was too aggressive. I found that my aggressive approach was actually working well as, while some of the shares I sold went on to do well, the ones I reinvested into did even better. Reflecting on this now, this was probably part luck and part the fact we were in a strong bull market. I think the right approach for more volatile conditions is to keep the discipline of a 10% stop loss but be more careful about what and when I buy, as discussed above.

I am prepared to give a bit more flexibility to a position in profit where I have high conviction, but only if long term uptrend is intact. Bioventix is a case in point at the moment, having fallen about 20% from high. It is facing raised uncertainty, with investors awaiting news of when its new troponin antibodies will start selling. This is reducing my current conviction in an otherwise excellent business, as I’d anticipate selling if news were bad, but I’ve decided to hold on while the long term uptrend is intact.

My strategy has generally been to hold as long as the share price is rising. I am wondering whether I might be better served by occasionally selling into strength, especially if the market is more volatile. I don’t want to always wait for the price to start falling before selling. I’m going to give myself flexibility to take profits on occasion, where I’m less confident about a share’s prospects or valuation or when the market is looking choppy. In general I won’t consider this unless I’ve made more than my average gain (currently about 35%).

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