In the course of my career managing money, mentors have suggested several successful paths to pursue, and maybe even more significantly, many paths to avoid. My “Yodas” have always preached it is the absence of mistakes that helps a portfolio manager rise to the top of the peer group.
When I try to draw analogies to other professional activities, I’m hard pressed. Many other professions accommodate the reversal of errors, but the classic “Hail Mary Pass” is rare in my world. Instead, a careful, thought-out strategic plan almost always has the best probability of returning satisfactory long-term investment gains. Mistakes are unavoidable, but are usually traceable to violating articles in a short list of commandments.
Here’s a short list of the important points to think about as you manage your money with a goal of building wealth. As you read these, please take time to think about the mistakes you have made with past investments, and I’m certain in your post mortem you will be able to trace mistakes to one (or even worse—several) of the items on the list.
Regardless of your own psychological profile, this is becoming more difficult every year. You’ve probably noticed that the world expects daily breaking news updates on all your portfolio holdings. The 24-hour news cycle, along with our natural biological tendency to “check on the nest” has driven us to extreme news-seeking behavior. Do I constantly check my holdings during the day? Of course, but I’m totally aware of my own behavior and never place unnecessary emphasis on intra-day fluctuations. Even if bad news suddenly surfaces, studies have shown that it is almost always preferable to allow a quiet time-out period, gather your team, and carefully analyze the new information before you take any action. Most decisions made under duress are wrong.
Think for yourself
The herd mentality is alive and well in every field. Trend following doesn’t end in middle school; just take a look around any country club, cocktail party or parents at Saturday morning soccer games. Investing is different only in that you cannot see the collective groupthink, you can only see the results of their collective thought by the ways they drive individual stock prices. When it comes to investing, don’t think marching bands or synchronized swimming, think mountain climbing or solo swimming across the English Channel.
This includes shrinking yourself as well as making projections about the macro market participants. Be as truthful as you can about your risk tolerances, ability to be objective & analytical in uncertain conditions, and how you behave “in the clutch.” Every investor should be able to recognize when the heart overrides the brain. Each of us has different thresholds for this, but once we cross over, decision making is no longer analytical. That’s when rationality breaks down and the probability of losing money increases. It’s a fine line between grit and stubbornness and it’s up to you to recognize the difference.
Play out the scenarios before you commit
I presume you want to marry the stock when you first decide to include it in your portfolio. But with that marriage proposal, please include the prenuptial agreement. If you enter into a new relationship with a stock, be prepared for the unexpected. Most stocks don’t follow a straight path. They behave in an erratic pattern that hopefully trends upward over the long term. If you identify what can go wrong a priori rather than analyze the surprise a posteriori, you will be far more prepared to make tough decisions if your worst expectations are realized. You want to have a plan of action if you get punched in the face.
Know your shortcomings
There are some pundits that advocate to be successful in a career, you should ignore you weaknesses. This is a very dangerous suggestion for stock investing! You must be hyper-aware of your blind sides and incapacities. This is why we use the team approach to investing. I like to pick people that are completely complementary in their skills. If you are right-brained, pursue a left-brained opinion. A value-based discussion always can benefit from the perspective of a growth minded stock picker, and so on. I gauge how successful a stock discussion is by how close I come to breaking up a first fight among the group.
Play to your strengths
This may sound contradictory to the last paragraph, but here I simply mean know what areas of investing you are best at, and leverage those areas to the best of your ability when looking at companies. For example, a colleague of mine has considerable knowledge of adolescent epilepsy, and is quite current with the latest developments in the field, talking with physicians about new medications and potential breakthroughs for treating the disease. Sometimes this can lead to discovery of potential stock investments. On the other hand, if you are a sales rep for a leading manufacturer and notice early adoptions in the field of new products, that can be an edge for picking stocks. Stock analysts can never beat the knowledge of a field practitioner.
Communicate to your clients
When you manage a portfolio of stocks, there is always a client, even if it’s yourself. Most clients like to be informed about the thought process behind the stocks you decide to hold. Many clients enjoy learning more details about the analytic process and how their portfolios are constructed to achieve excess returns. It is very useful to conduct the following exercise when you review your own investment statements. Imagine how you would present your portfolio to a client. What would you highlight? How would you explain your individual positions? Why did you add new stocks or sell existing positions? How do you expect your portfolio to respond to a range of market conditions? This formal process really forces you to focus and distill your stock picking rationale so that you will always know why you own what you own. You can be your own client. The best stock investors I know have themselves as the toughest client.
No doubt there are variations of these seven habits I outline above, but I postulate that they are the building blocks of all other best practices out there. Broader mistakes are simply disguised as compound infractions of the above principles. For example, holding on to a losing stock is a familiar folly that we have all practiced at some point, but that’s just a combination of “understanding psychology“ and “knowing your shortcomings” etc.
There are several paths to being a successful stock picker-- just like any other career. I suspect all careers have guiding principles with similar themes. Come to think of it, even Yoda probably followed similar principles, too.
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