Written by Alex Hughes, Equities Analyst, StocksInValue
We discuss an approach which may help some of you improve investment performance. The investment industry is fixated on the process of addition as the main source of investment returns. There is no shortage of commentators and advisers suggesting to buy this or that; the process of making additions to your portfolio in search of returns. However, sometimes a process of subtraction can be more beneficial. We call this simply avoiding the losers.
To provide an example, if we compiled all potential investments available today, it is likely to appear similar graphically to a bell shaped curve. The vast majority of investment returns will cluster around the average. There will be a few spectacular winners, and a few spectacular losers, represented in the upper and lower tails, however the majority of investment will be somewhere around average.
When investing in their own accounts, most people set out to make great investments, or returns that can significantly beat the market. However, when one opens themselves to the possibility of being different to the market on the upside, they also incur the risk of being different on the downside. However, instead of focusing on making great investments, perhaps a more reliable approach for the majority of investors is simply to aim to avoid making losing investments, letting the winners take care of themselves. Graphically, this approach would be akin to loping off the left side of the bell curve. If successful, this approach would produce mostly small gains, a few good returns and an even smaller number of fantastic ones; but importantly, the average return would increase.
To provide an example of the art of subtraction, let’s consider bond investing. Let’s assume we are assessing a range of corporate bonds that yield 5% to maturity. How should we spend our time? We know that if we buy a bond on the assumption that it will yield 5% to maturity, if everything goes right, the maximum we can get on our investment is 5% if the bond pays interest and principal as expected.
However, if the bond doesn’t pay as expected our potential loss far exceeds our expected gain. Therefore finding the best 5% bond is not the highest use of our time. There is no additional upside from owning the best 5% bond. Our time is best spent weeding out the bonds that appear to yield 5% today, that will ultimately not pay as expected.
So we propose to you to consider the approach of avoiding the losers as a primary investment consideration. To apply this to equity markets, Investors should review their own portfolios first. Perhaps the most profitable course of action for you is not adding another stock to your portfolio, but simply selling an existing holding that is destined to be a future loser. When assessing new investments, identifying the losers will be unique depending upon the individual investment. There is no blanket formula which applies in all cases. Today, many investors have selected investments based on their dividend yields. In this case, assessing the sustainability of earnings becomes all important.
This video was inspired by the writings of Howard Marks. I highly recommend his book, ‘The Most Important Thing’. For the time poor, the following video does a good job of addressing the main points.