10 principles to make you a better investor

Since I started writing this blog, I’ve written a lot of posts about the mechanics and implementation of my strategy. I wanted to write something more high level about what I think it takes to be a successful private investor. A post more about the  principles, or way of thinking, rather than how any particular strategy should work. I’m not a hugely experienced investor so take what I say with a pinch of salt – though hopefully my ideas are at least thought-provoking.

1. Stick to a strategy and understand why it works

A strategy is a set of guidelines or principles that tells you what to buy, when to buy it and when to sell. I think a crucial starting point for any investor should be to work out what their strategy is and why it should outperform. Having a well defined strategy gives several advantages over a more ad-hoc approach. Yet as far as I can tell, most private investors either don’t have a coherent strategy at all, or their strategy is implicit and not well defined.

A strategy can help put the odds on your side when deciding what to buy. There is a lot of research supporting that shares with certain characteristics (i.e. factors – momentum, value quality etc.) will outperform on average. Using guidelines that focus you on shares with these characteristics puts you at an immediate advantage.

Most investors who don’t have a strategy tend to default to ad-hoc research into shares they stumble across, and deciding whether to buy based solely on an idiosyncratic story. I certainly did when I started and it didn’t get me very far. You can be successful this way, but investing is competitive and you’re starting with the odds against you. For those of you that play poker, this is analagous to deciding which starting hands to bet on. One of the first things you learn in poker is that you should generally only bet with certain starting hands, as you stand a much better chance of winning. This simple strategy on its own allows you to consistently beat novices who bet on any old starting hand, hoping to get lucky on ‘the flop’. As in poker, why would you want to bet on investments that are statistically less likely to win?

Without a clear strategy you are also much more susceptible to making emotional decisions about when to buy and when to sell. Unfortunately, your emotions will tend to lead you to very poor investing decisions. A sensible strategy should give you the discipline to be contrarian and bet against your emotions. It can help you buy when a share price is at its highest point and looks expensive. It can help you buy when the markets are tanking at the point of maximum pessimism. It can help you turn paper losses into actual losses quickly rather than waiting to see whether things turn around. These decisions go against natural instincts and are much easier to make when they are part of a strategy.

A strategy does not need to be complicated. Buying and holding quality stocks forever (or until the story changes) is perfectly valid. But you do need to understand why it works so you can have conviction in it. It also helps if there is empirical evidence supporting it. Thinking about factors is a good place to start for inspiration for how to build a strategy.

2. Calibrate your ambition

When you are deciding on your strategy you need to calibrate your ambition. Before plunging straight in, it’s worth thinking about what are you hoping to get out of it and how much effort are you prepared to put in. Are you just looking for something sensible to do with your savings or do you think you might have a passion for investing? If the latter, you have to be prepared for the fact that it will take you a few years and a lot of study to hone your skills and strategy, and that you may not perform so well during this process. It is not realistic to expect otherwise no matter how smart you are. To have the motivation to develop successfully, I think you need to find investing genuinely interesting. It’s also possible that your personality means you’re just not well-suited to it full-stop.

There are a range of simpler more passive strategies available for those who can’t or don’t want to put the time and effort in to develop a more sophisticated active strategy. Some of these can be pretty effective, setting quite a high bar for someone that wants to manage their investments more actively. A question I think many investors should ask themselves is whether they should be using their favourite fund manager, or at least entrusting them with a large part of their portfolio. If you’re not reasonably confident of outperforming them over the long term, then why wouldn’t you? You need confidence in the fund manager’s strategy to do this, which is not trivial but obviously less difficult than developing your own strategy.

You also need to be realistic about what sort of returns to expect. If not you will become impatient and make yourself susceptible to mistakes. The best performing UK professionals only make returns in the low teens over the longer term (long term performance is heavily affected by occasional market crashes like the financial crisis). I think a private investor can do better and some shorter term trading strategies may do very well indeed, though you need to be realistic in calibrating the expected returns from your strategy. Psychologically, I think it’s better to be cautious when doing this.

3. Regulate your emotions and recalibrate your behaviour

Emotions cause mistakes. Successful investing is about regulating your emotions to avoid making these mistakes yourself and instead exploit those of others. The rules of your strategy should help you do this – but it’s also useful to think more broadly about how to regulate your emotions and recalibrate your behaviour.

At the core of most emotionally driven investment mistakes is an instinctive desire to receive the psychological reward of being ‘right’ and avoid the pain of being wrong. We have much less instinctive concern for exactly how right or wrong we are, when in investing this is just as important. This leads to a general bias for investors to want to sell winners early to crystallise a win and to hold on to losers hoping they can at least break even. More insidiously, it can also make it more difficult to buy a stock you’ve been following that has risen in price, as this involves implicitly admitting you were wrong not to buy it earlier. It’s psychologically much easier to label it as ‘the one that got away’ and forget about it. It’s very important to compensate for these instinctive biases by recalibrating your instincts around what is ‘right’ or ‘wrong’ to align with a more objective strategy.

Even if you have a very clearly defined strategy, there is generally still going to be room for emotions to wreak havoc with your returns. It only takes one moment of weakness for even the best laid plans to go to waste. I’ve found it particularly difficult to keep a clear head and stick to my plans when markets are falling and have found that fear of missing out makes it difficult to keep a cash balance in my portfolio. The main way I’ve tried to deal with this is to through more planning. I try to plan for contingencies and to pre-commit to certain courses of action. It can also help to not monitor your portfolio too frequently – something I hold my hands up to not being very good at.

4. Avoid excessive conviction

While you need to have conviction in your strategy, I strongly believe that it is better to avoid having much conviction in individual shares. This is a fairly controversial point of view. Often private investors are advised to carry out detailed research into the fundamentals of a business so they can have the conviction to hold onto their investment through thick and thin. Some more skilled investors can do very well through identifying opportunities with detailed research and betting hard on these opportunities with conviction. However, for most I think this is pretty bad advice.

Investing involves speculating about the future success of a complex organisation making a long series of complex decisions in a strategic environment, often largely outside of its control. This is inherently very uncertain no matter how much research you do. In most cases I think detailed research leads investors to an unwarranted degree of conviction. Conviction makes you more susceptible to wanting to prove that you are right and the emotional biases that follow from this. You are particularly vulnerable to confirmation bias – to subconsciously seek out evidence that confirms your view and ignore evidence refuting it. Nobody is immune from this. Once you’ve spent a lot of time researching a company you’re going to become more emotionally invested in it. Obviously some research and conviction is necessary, but I think the breadth of this research (i.e. across many companies) is as important as the depth. Stock picking should be about finding the best companies, not just getting to know the first business that catches your eye really well.

Instead, I think it’s very important to actively embrace uncertainty by thinking probabilistically and being ready to change your mind. A relative advantage that private investors have over professionals is that we can quickly and easily change our minds. Why not make the most of it?

5. Focus on risk

A key part of your strategy is how it deals with risk. One way to deal with risk is to do lots of detailed research to reduce the uncertainty you face in holding a particular investment. There are better ways. I use all of the three below:

  • Focus on quality: some businesses are inherently less risky than others. High quality businesses, i.e. highly profitable businesses with good track records, competitive advantages and growth prospects, operating in defensive markets are inherently less risky over the long term. They are often more highly valued but in general are less risky even accounting for this.
  • Diversification: diversification can be used to reduce risk without compromising returns. In that sense it is a free lunch. However, diversifying across equities can only mitigate against the idiosyncratic risks faced by individual shares rather than the risk that the market falls as a whole. The benefits of diversification diminish rapidly after about 15 shares or so and the costs of spreading your portfolio across shares you have less conviction starts to rise. I find that there is also a psychological benefit to diversification in that it makes you less vulnerable to making emotional decisions.
  • Money management: this means cutting losses quickly before they can do too much damage, for example with stop losses. As well as allowing you to take advantage of momentum, the discipline it imposes reduces the chance of you making any big mistakes. However, it works less well in more volatile market conditions, when lots of share prices are falling.

6. Measure your performance and monitor your trades

Another advantage of having a well-defined strategy is that you can see how it performs and improve it over time. It’s very easy to be deluded about how well you are doing if you’re not keeping track. For some reason (perhaps to protect their psychological well-being?) people tend to have a very optimistic bias about how well they are doing.

It’s important to be honest with yourself and to track how well you are actually doing. If your strategy is well defined you can even use this information to isolate which aspects of your strategy are working less well. In my case, tracking my performance against my buy and hold benchmark separates the returns I’m getting from focusing on quality to those I’m getting from momentum. My ‘overtrading’ analysis tells me whether my sell decisions have been profitable. Both of these are covered in my last portfolio review.

Keeping good track of how you are doing allows you to focus on doing more of what works and less of what doesn’t. It’s much more difficult to improve over time if you don’t.

7. Ignore tips

This is a rather classic piece of investing advice I’ve read quite a few times – and it’s good advice. As far as I can tell most financial journalists are pretty clueless and will tip pretty much any old stock for any old reason. You’re no better following them than picking stocks at random. That much seems obvious. However, the effect of tips can be rather more pernicious – even if you don’t trust them, I think just the act of reading them can bias your judgment. Knowing that other people also support your positive view of a share can provide a false sense of security. At least if you’re wrong then you’re not the only one. This might seem obvious too but the effect can be entirely subconscious – I’ve sometimes caught myself irrationally feeling more positive about a share I was previously neutral on after reading a tip, even when the tip doesn’t contain any new information. I think you’re better off just avoiding reading tips altogether. The same applies to bulletin boards etc.

Instead I think you should use a more objective screening process. There are a lot of readily available resources online for private investors  to do this – I’d recommend Stockopedia as an accessible and easy to use platform for researching shares.

8. Make a watchlist and limit the number of stocks you follow

Another way to make your investment selection more objective and less arbitrary is to actively maintain a watchlist. There’s two benefits to this. First, it disciplines you to spend more time thinking about the relative merits of  different investments rather than  leaping into your latest great idea straight away. I think that quite a few of my early mistakes would have been avoided had I added them to a watchlist to mull over instead of impulsively buying them as soon as I ‘got’ the story. Second, while you may have identified a decent opportunity, quite often there will be a better opportunity to buy it later than right now. Particularly in the UK market, you’re quite often better off waiting to decide whether to buy till after a share issues a trading update. For some reason the UK market tends to be particularly inefficient at responding to news. A well-monitored watchlist can let you take advantage of the opportunities this creates.

9. Look forward rather than backward when assessing investments

All the quantitative information we have about potential investments is historic. This seems to bias most investors towards putting a lot of weight on historic performance and valuation and relatively little weight on the long term prospects of the business, when the latter is far more important.

Assessing the future is hard but is nevertheless what you have to do. Extrapolating from the past is a good starting point, but you can’t just look backwards. Historic quantitative metrics, such as high profitability, are indicative of future performance but you also need to consider more qualitative forward looking factors – how immune is the business to competition? What are the growth prospects for its market?

Don’t obsess about valuation metrics – this loses sight of the wood for the trees. The current valuation ‘multiple’, e.g. the price earnings ratio, is relatively less important in the long run. Whether a share is a good investment in the long term depends much more on its prospects for sustained profit growth.

10. Plan what to do in a downturn

Planning what to do in a downturn is a key element of a stock picking strategy and is worth focusing on in its own right. This is because watching your portfolio fall in value is painful, and there is strong pressure for you to want to take steps to reduce the pain.

Broadly, you need to be clear with yourself in advance whether your strategy is to raise cash or even go short when the market starts falling or to ride it out. The easiest strategy is just to ride out market volatility but if this is your plan you need to commit to it. I think it is reasonable to have confidence that the market will eventually recover. Selling shares to raise cash is much more difficult as it is very easy to get the timing wrong. The worse thing you can do is to sell at the bottom of a big crash – you need to make sure you definitely don’t do this! If you plan to raise cash in response to market volatility do it earlier rather than later.

My own experience, despite not having invested through a major crash, is that this is the trickiest aspect of an investing strategy. My thinking has evolved considerably over time and I’m not sure I’ve got it right yet. I lean towards thinking that it is much easier and safer just to ride out market volatility, but that this is easier to do if you make sure you hold a significant cash balance, either at all times or (more ambitiously) as soon as things start to look shaky. I think you are in a psychologically much stronger position if you can look at market dips as a positive opportunity to invest your remaining cash balance cheaply (even if it is fairly small), than if you are just regretting the losses you are suffering across your whole portfolio.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

w

Connecting to %s