Last Updated June 1, 2012
I’ve made my fair share of investing mistakes and I’m sure that, despite my best efforts, I’ll continue to make them. The trick is to be honest with yourself and learn from them and learn to recognise them before you make the same ones again. For me, the biggest offender is overconfidence.
Overconfidence can make you very poor, very fast
When I started out as an active investor I chose ten holdings as my target. I figured that if I could find the top 30 investments (by price to book ratio, or price to earnings, or some other ‘value’ metric) then surely owning the top 10 would be better than the top 30? After all, various academic studies had shown that, on average, the lower the price to book or the price to earnings ratio, the better.
Well, perhaps. But investing is rarely that simple. What if one of the companies goes bust, or gradually loses value with no hope of a recovery? With 10 holdings that’s would be (and has been) around 10% of the portfolio down the pan, never to return since nothing ever rebounds from a 100% fall.
It’s all well and good looking at back-tested results and how they returned such and such with only a few holdings. But that’s very different to actually sitting there, watching a sizable lump of your financial future disappear forever.
A strategy like this may or may not have produced stellar returns over a 30 year investment lifetime, but if it’s too emotionally difficult to handle then you’ll quit and never see those returns.
I was watching Charlie Rose the other day and the author Jim Collins (Good to Great; Build to Last) said something like this:
Over time, luck balances out between good and bad. It’s like flipping a coin. So if you flip the coin 2,000 times you’ll get about a 50/50 split most of the time. But, on the way to that 50/50 split you might toss tails (bad luck) 10, 20 or 30 times in a row. You might have a massive run of bad luck. In order to get to the good luck, to the point where the luck evens out, you have to be able to survive prolonged periods of bad luck otherwise the bad luck will kill you.
So how do I control my overconfidence now? For me it comes down to accepting that the future is a wild and unpredictable place. No matter how much I think I know about an investment, the reality is that of all the factors affecting that company’s future, I probably know about the equivalent of one grain of sand in the Sahara desert.
Once I took that mindset, a few things sprang from it:
I think it’s much more reasonable and humble to own somewhere between 20 and 50 companies so that each investment idea makes up only a few percent in a portfolio, rather than 10% or more. This is an obvious way of admitting that you cannot know how the future will work out and that instead, you’ll use the old egg/basket system.
If a mechanical strategy is being used, perhaps 50 to 100 holdings is a better number. That’s certainly what Ben Graham did when using his famed ‘net-net’ strategy to outperform the market decades at a time. That way when there’s a total loss it’s only one or two percent and shouldn’t cause too many tears.
Buy companies that are virtually certain to survive a 5 year holding period
Generally I’d expect to hold a share anywhere from one to five years, although I don’t have any hard rules about this. It makes sense to only buy companies that are very, very, very likely to survive that sort of time span. There are various ways of accessing a company’s chances of survival, including products, management, size, market dominance, but for me it mostly comes down to stability of earnings and debt.
If a company has stable revenues and earnings over a prolonged period then generally I’m happy. The stability may be because it sells consumer non-durables like underpants, toothpaste or electricity; or it may because it has a very diverse revenue stream. Generally though, these are good traits to have so stability is what I look for and wildly volatile earnings are something I try to avoid.
In theory, stable companies should also be able to handle more debt. That’s not to say that more debt is better because I don’t think a lot debt is ever worth the risk. But even once you have an upper limit on what’s an acceptable level of debt, the more volatile or cyclical a company’s earnings are the less debt and more cash you should expect on the balance sheet.
For example, a company with an interest cover of seven or eight may look fine, but if they are the peak earnings in the cycle then you may be in for a shock when earnings drop by 80% for a year or two, the banks step in and shareholders are wiped out (see Luminar).
Of course, being relatively debt free isn’t a panacea, but it sure does help.
Invest where a zero return over 5 years seems impossible
This is where sustainable dividends really come into play. Dividends are perhaps the only sure thing in the stock market (once it gets paid into your account anyway). That’s because the value of cash is not up for debate with Mr Market and once it’s in your hand it can’t be taken away, even if the company that paid the dividend subsequently goes bust.
But more than that, a large and growing dividend builds a return that requires an ever more improbable Mr Market to undo.
Let’s say I can get a 5p dividend from a big, stable company that grows that dividend at 5% a year. I pay 100p for the shares for a 5% yield. After 5 years I’ll have received about a 27p return in cash, regardless of what Mr Market thinks. Just as importantly, the shares would have to drop by 27p in order for my return to be zero.
In fact, they would probably have to drop by more than that as I would have invested that income back into some other company which might also have yielded 5% growing at 5% a year. All in all, that would have returned me about 29p in cash.
So at the end of 5 years I’d have 29p cash which I’ve reinvested (and diversified), and the original company is now yielding 6p instead of 5p due to their dividend growth policy. If the shares dropped to 71p and wiped out my cash gains, the yield on that share would be over 8.5%. If the company is large and relatively stable, how long is that situation going to last?
Not long I’d say.
Just remember the old maxim that dividends are to growth what the bird in the hand is to the bird in the bush.
Eat humble pie, frequently
Overconfidence is totally understandable. Once I’ve read the instructions on my toaster I know how it works and what it will do in future (most of the time anyway). So when I read Vodafone’s annual reports it’s natural for me to think that I understand the company and how it will work out in the future. That’s totally natural, but it’s also very wrong.
The reality is that I don’t know what’s going to happen to the economy. I don’t know what’s going to happen to interest rates. I don’t know which sectors are going to do well in the next few years and I certainly don’t know which shares are going to do well in the next few weeks, months or years.
All I do know is that nobody else knows those things either, it’s just that most of them haven’t realised it yet and that is a big advantage to value investors.