charting, diversification, Expected Value, falling knives, fear and greed, intrinsic value, investment checklists, momentum, portfolio allocation, position limits, stop losses, sunk costs, technical analysis, trading, value investing, value-trap
Continued from here.
I labelled as tricks some of the techniques I’m writing about here – which might have put off some readers. But surely you’ll try anything that might help combat the impact of fear & greed in your investing? Reconsidering, I’d now argue the five techniques I’ve already documented are actually essential tool-kit for any serious investor. Have another look, and I hope you’ll agree – to put it another way, it would be hard to argue your investing would actually improve if you omitted any of the following:
Learn To Love The Black Box: Document all your investments, and analyze & learn from your mistakes.
Checklist It: Develop checklist(s) for every stage of your investment process.
Valuation Orgy: Value your investments using as many different valuation techniques & metrics as possible.
Watch What They Do, Not What They Say: Focus on facts, figures & performance, not just the ‘story’.
Well, Are You The Right Size?: Set pre-defined position limits within your portfolio.
However, a majority of my remaining techniques do perhaps deserve to be called tricks. Which means they may, or may not, suit your investing style & personality. Trouble is, how will you ever know if they’d work for you, unless you give ’em a whirl..?! Or figure out how they’re best adapted to your particular circumstances? Right, let’s soldier on:
vi) Learn Some Bloody Voodoo
By which I mean – go out, buy a decent technical analysis book, and learn to read the chicken entrails! Uhoh, I think I heard some value investors gasp in horror… For them, pure (deep/quantitative) value investing has a certain austere beauty & logic. I should know, I went through that phase myself – but now I’m much more promiscuous! 😉 Because real life & investing are a hell of a lot messier – price action, momentum & sentiment, for example, can make all the difference.
I’m bemused when people ask me (in a slightly disappointed tone) how I could believe in something so irrational as technical analysis?! Well, I do… Because I’m trying to measure & evaluate an even greater irrationality – as displayed by other investors & sometimes myself! While fundamental value obviously dictates my overall investment theses & decisions, my resulting buys & sells can be guided just as much by technicals.
These days I (generally) avoid buy falling knives, or value-traps – which can be a common value failing – because I’ve realized value’s irrelevant in such situations, you need definitive technical confirmation before buying. I’ve also learned truly cheap & neglected shares don’t trace out V-shaped charts – they generally bottom out slowly & painfully for months, even years. Plenty of shares I’ve written up exhibit that exact chart pattern – the technicals help you decide whether it’s finally time to buy.
There are also relatively predictable chart patterns associated with market-moving news – recognizing them can hugely assist in your response (& timing). And in my experience, a share’s often just beginning to display momentum when it reaches your estimate of fair value – technical analysis is a great way to recognize momentum & keep you invested in a continued price rally. Most importantly, if you’re paying attention, technicals often provide the first & best confirmation you’ve actually made a good or bad investment…
OK, let’s move on. One final note: While I think a fairly comprehensive knowledge of technical analysis adds important context – when it comes to individual equities, simple is best. This is particularly true of small-cap/low-volume shares – they don’t have the price action to justify most technical studies. Scoping out key support & resistance levels, plus some simple charting, is frankly all you need most of the time.
vii) Average In, Average Out
First, we need to talk about size again… It’s astonishing how many investors take a position without calculating a specific fair value or price target (the two aren’t necessarily the same). When an investor hasn’t got a price target, I have to wonder at the breadth & depth of the analysis performed? I also wonder how they’re ever going to figure out when to sell? I think a price target’s essential – it identifies a stock’s potential upside, which allows you to then rank it vs. other existing/potential buys. [You’ll also need to consider potential diversification benefits].
Of course, a buy decision’s just the first step – position sizing based simply on cheapness can prove remarkably painful… You should also consider the company’s financial strength, the stability of its business, its market cap, plus the volatility & liquidity of the share price. Generally, the smaller & more volatile the company/stock, the smaller the position I hold. Once you determine a specific position size, you then have to pull the trigger – oceans of regret are wasted all too often second-guessing timing, price & volume! And then you wonder if you should have bought the other share you were considering…
Whether you’re trigger-happy, or trigger-shy, there’s a relatively painless way to deal with this: Average In, Average Out. You can achieve this in two complementary ways: i) only purchase a quarter to a third of your intended position at a time, ii) spread your purchases across your top 3-4 potential buys. [I’m presuming min. broker fees don’t pose a problem]. This takes the second-guessing & regret out of the equation, because: a) who knows which potential buys will perform the best, so just buy a selection, b) you average up in price – so you’re in profit every time you buy, or c) you average down in price – so you avoid a one-time buy at a higher price! It offers two other luxuries: i) if there’s a substantial change in a stock’s fundamentals, you can simply stop buying & stick to a smaller position, or just take what amounts to a smaller/less painful loss, and ii) you always have a rota of buys lined up & ready – overlay this with a trading plan (based on each stock’s technicals), and you can really add an edge to your investing.
Of course, you can take a similar approach with sales. This technique’s particularly suitable for stocks which have attained fair value, but are displaying positive sentiment & momentum you’d like to exploit further.
viii) Worship The Spreadsheet
I hope & presume you have an (Excel) spreadsheet to keep track of your portfolio? For most people, that’s a spreadsheet they’ve cobbled together over the years, and which they’ve always meant to sit down & completely re-do – to get that sucker just right. Well, now’s the time…
Let’s make it state of the art – go out & buy Office 2013. Before you even open a new spreadsheet, spend an afternoon – no, an entire day – getting your records in order, and mapping out the exact format & content for your new portfolio report. Then start from scratch – no copying & pasting & corruption here, thank you! Input everything afresh, use a multitude of fonts & formats (damnit, use conditional formatting!), fancy financial formulas (IRR, anyone?), check-sums, links to valuation spreadsheets for each stock, etc. etc. Now add a multitude of colour graphs & asset allocation analyses. And for Christ’s sake, if this guy can create beautiful Excel art, surely you can make can-can girls dance their way ‘cross your portfolio every time it rises 5%!?
OK, I haven’t really lost the plot here… This is an old trader’s trick – for them, it’s much simpler, it’s all about their daily P&L. Any good trader will hypnotize himself to believe his P&L’s got nothing to do with money for 364 days of the year – it’s purely a performance report. In effect, it’s a feedback mechanism confirming the success/failure of absolutely everything he does – which explains the old joke: ‘Do you want to trade/invest, or just make money?!’ Because theories don’t matter, opinions don’t matter, even how right you are doesn’t matter – if your P&L says you’re wrong….well, you’re bloody wrong! This is how good traders learn to become great traders, and it explains why you can’t tell if they’re actually making or losing money.
Obviously, the approach I suggest for investors is slightly different, but the same goal applies. I want you to create a friggin’ majestic portfolio report that’s so complex & removed from reality, it will hypnotize you into believing it’s purely an interesting academic exercise. It’s Monopoly money, at best… Ironically, the less you care about money, and profits & losses, the more abstract the notion of fear & greed will become – you’ll become far more rational & effective in your investment decision-making. And who better than my own wife to confirm the effectiveness of this strategy – she’s marveled to me before I don’t even blink at losing 20 grand in my portfolio, but I’d lie down & cry if I lost a 20 in the street..!
ix) Forget Your Purchase Price
Despite the multiple bells & whistles I suggested for your spreadsheet, there’s one piece of info. you need to omit for each stock – your purchase price. This is pure evil – and deserves 95% of the blame when investors end up running their losses & cutting their profits, a real recipe for disaster. Think about it – how often have you calculated & stared at gains you fear will melt away, or agonized over losses you can’t bear to take? Ugh, are you breaking out in a cold sweat?
Now, picture an alternative scenario: You don’t track purchase prices, you hold 15-20+ stocks, and you Average In, Average Out. Obviously, you’ll soon have absolutely no idea of the gains/losses on each of your individual holdings – your only hint is your overall portfolio total. So how are you going to evaluate your next buy or sell decision? A damn sight more rationally, I’d humbly suggest! You’ve essentially forced yourself to base all decisions on the current share price, vs. your latest fair value estimate and/or price target. Which is exactly how investment decisions should be made – by ignoring gains & losses, or sunk costs to put it another way, you effectively remove fear & greed from the entire equation.
x) Stop Losses
Here’s another idea value purists are sure to hate… Should you use stop losses? Well, let’s seek Buffett’s advice – ‘Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1’. Woaahh, foul you say – Buffett never uses stop losses (as far as we know)! Yeah, but how many friggin’ investing geniuses do you know like Warren?! For us mere mortals, a strategy that helps us live to fight another day is definitely worthy of consideration – stop losses may be the answer.
I think we all know the value argument against stop losses – if the value’s there, why on earth would you force yourself to convert a temporary mark-to-market loss into a permanent loss? In fact, do the opposite – buy more! Makes a lot of sense, in theory – and if you’re confident of your analytical skills, have a long investing horizon, and a v high pain threshold, perhaps you’ll enjoy superior investment returns. But I have to ask – have you ever bought a value-trap all the way down to zero? Have you ever mentally screened out any hint of bad news, facts or figures when it comes to a favourite stock? Have you ever been humbled to realize the market’s actually smarter than you most of the time?
I don’t think a strong conviction about value’s enough – price, sentiment & timing are just as important. If you get those completely wrong, and suddenly you’re 30-40% down on a stock – how can you still be so sure of your value analysis & conviction? A trader would put the question more bluntly: ‘So, if you’re so damn smart, how come you’re losing money?!’ In my opinion, there’s an awful asymmetry to losses – you face two problems: i) as Rumsfeld famously said ‘There are things we don’t know we don’t know’, and ii) losses are far more problematic & difficult to recover from (the age old problem – once you’re down 50%, you’ve got to make back 100% to break-even).
Personally, I’m happy to potentially handicap my returns, if it saves me from catastrophic error or loss. Obviously, a version of Average Out can be implemented. One rule of thumb would be to sell a third of your position upon suffering a (25)% loss, another third at (35)%, and a final third at (45)% – basically ensuring you never lose much more than a third on any one holding. [You may want to exclude 1-2% stock holdings from this strategy – on the basis they’re less meaningful/painful (hmmm?!), and presumably they’re more volatile risk/reward stocks anyway].
Again I’d note – if you’re making those kind of losses on a stock, it really does suggest there’s something seriously wrong with your investment thesis. Why on earth has it fallen so far – have the fundamentals changed substantially, is it a value-trap or a falling knife, or have you simply closed your eyes & are now just hoping it bounces back? Anyway, a stop loss strategy’s ultimately about risk control, it doesn’t mean one strike & you’re out. As I mentioned before, stocks usually don’t trace out a sudden V-shaped recovery – sure, you’ll have realized a loss (to possibly avoid further losses), but you’ll probably have another opportunity to buy into the stock (at a price far better than your original purchase) – dependent, of course, on seeing improving technicals & fundamentals.
xi) Sell One, Buy Another
Still finding it difficult to ditch your losers? Here’s a good trick, stop thinking about your losses altogether – instead, contemplate the following choice: Do you want to sweat over a bad position for months, even years, simply to make it back to break-even – or would you prefer to be invested in a better company with higher upside potential? Kind of an easy choice, eh?! Invariably, I have attractive potential buys lined up, but I’m always juggling to free up cash as well – so selling a loser occasionally to fund a new high-potential position is a v palatable & compelling trade to make. And I swear, you’ll inevitably forget that loser stock a day later! 😉
Perhaps an even better version of this trade is a sector switch. This may be down to luck, or simply because the whole sector got hammered (meaning your great stock analysis was all for naught). In this scenario, presuming you still like the sector, you finally have a chance to switch your loser – which was probably one of the cheaper sector stocks – into a far higher quality stock. I promise you, this is the closest you’ll ever come to being happy about selling a losing stock. 😉 Because you’re ending up in a high quality stock you never expected would become cheap enough to buy. And if the sector keeps declining, you’re probably far safer in your new holding – while if it rebounds, who cares how much your loser stock rallies, you’re sure to be making out v nicely with your new stock anyway…
xii) Average Up, Not Down
For many years, I averaged down with all the desperate enthusiasm of a drowning man. Generally, it proved to be a long, painful & unrewarding exercise…fortunately, it was also a learning curve I finally conquered. Because averaging down really is a terrible approach to investing – for a v simple & obvious reason: Good shares rise, bad shares fall! If you’re progressively buying into good shares, then by simple logic you will inevitably expect to pay ever higher prices. I can also present this in a somewhat more analytical framework: Pay up for confirmation!
Now, I should note here, this is not intended to conflict with Average In, Average Out. Selecting an initial position size & then averaging into that holding can be considered a relatively mechanical & technical exercise. [Unless it’s interrupted by a substantial setback in fundamentals]. But after that, there will probably be plenty of opportunities to contemplate adding to your position. This should be a far more discretionary exercise – after all, you already have a decent position. Trouble is, you’re now emotionally invested in that company, so there’s a tendency to ignore all hints of bad news & to treat every (price) setback as a chance to gobble up more stock. A bad position can quickly swallow a hell of a lot of money that way, and still seem like a great buy.
The answer is to treat any & all bad news, no matter how innocuous, with appropriate suspicion. As Buffett says: ‘There’s never just one cockroach in the kitchen.’ But lots of news is just noise – how do you separate the wheat from the chaff? I’ve a simple rule – if there’s any kind of bad news, and the share price is declining, don’t buy more. Instead, you need to actually embrace the idea of paying up for confirmation.
To explain: I believe people regularly under-estimate good news, just as much as bad news, at least in the short term. From good companies, you’ll regularly receive further confirmation of your investment thesis, and sometimes news of a substantial (positive) change or step-up in their fundamentals. You’ll probably pay up after such news, but confirmation of improved growth, new business opportunities, greater financial strength, the unlocking of shareholder value, etc. can be worth far more to you in terms of improved upside, safety & conviction.
This seems particularly obvious when it comes to anticipated events & news-flow – too many investors bet in advance of such events, thinking they’re getting a cheap price. But they often forget the additional risk they’re taking on… In my experience, and estimating the expected value of returns, buying (& paying up) after an event/good news is confirmed often proves the better deal.
OK, that’s it, all comments & perspectives greatly appreciated. If there’s some positive feedback, perhaps I’ll boil this down (quite appropriately) to a brief checklist in due course – so you don’t have to wade through a few thousand words again if you’re incorporating any of these techniques into your investing process. 😉
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Investing Sidekick said:
Have to say I agree on technical analysis. With experience you soon learn that its is a useful tool to avoid buying at the wrong time and missing a better opportunity.
Never going to come around on stop losses though, I always think its better to make the decision as a human.
Yes, stop losses are tough – except for humans are v good at dreaming up reasons to hang on to losing stocks… 😉
Thanks for the blog.
Having stumbled across it in a bit of google-research (FBD) I’ve greatly enjoyed reading back through the posts. It’s frightening how many times in this article I found myself wincing at familiar errors.
My own spreadsheet is a bit of a gothic masterpiece, and could do well with a rip-up and re-start approach. Forgotten worksheet pages are a particular revelation (I found I had one from ’07 with a justification for buying Anglo at 15.40… let’s not go there).
I’ve had flashing red stop-loss boxes… but can’t bring myself to act on them, even though I’ve sworn in the past that I’l never let it get to a 60% loss again.
I’m sure Anglo prob. looked cheap according to your analysis, as it did for most people. Unfortunately, if banks relax their lending criteria, raise their effective leverage, and rely on wholesale rather than deposit funding, they can pretty much target any kind of earnings growth they want…well, until that growth turns massively ‘negative’, that is…
These days, I’m sure you could add a really annoying siren noise to your stop loss boxes. 😉
After some thinking: some arguments you made sum up nicely, what I have seen works for me in the past, but never made it to my checklist or investment strategy. Have to update it urgently and wanted to say thank you for the nice post.
Thank you, Covacoro – hope it helps! – cheers, Wexboy
Excellent article, wexboy!
I have followed your advice of paying up for confirmation by purchasing some Sirius Real Estate shares after the debt restructuring, although I think the convertible issue put small shareholders on a disadvantage compared to Karoo Investment Funds and fear there is more to come.
Yes, I am delighted to see the EUR 45 mio bond – it’s still leverage (which I’d still like to see reduced), but it’s far more flexible & long-dated than bank debt. I agree that Karoo seems to be in the driving seat these days, and they seem focused on turning Sirius into a more conventional property opportunity – so an eventual sale/liquidation appears less likely now than I’d perhaps have hoped for before. On the other hand, activist investors continue to have a substantial aggregate stake in the company, so there’s certainly potential for turmoil here still – nice turmoil… 😉
Despite my skepticisim about “checklists approach” at your previous post last week or so, I have given it a try with following first observations:
– I have moved the most important excel data gathered during my “normal” research process to my checklist: although data is more or less the same, there is lot more focus now and probably in the future helps me to “get in to the core” faster
– Gathering lot more data from footnotes: reading them with lot more focus
– Added points where I have to write short comments about each observation with date -> easier to backtrack thinking and mistakes. So if I blow up for example because of pension liabilities I can check afterwards wtf was I thinking. And just the point that you have to check/comment the issues brings, again, lot more focus/attention to the issue
– The checklist is currently very ugly and rudimentary (you have to start somewhere?), but I have about gazillion ideas how to improve it
– Overall I see that checklist can help enormously in bringing focus to research and attention to small details:
– I would encourage everybody to at least give it a try to see if it works for you
I think that the key to actually bringing in the point&trying was your comment that investors have “unlimited time” so the checklist doesn’t have to be neat&fast, rudimentary&slow will do fine if it just rings the bell. I should have thought that by myself, but somehow was wired against it. Its more of risk management tool to find those things that are easy to miss and can potentially kill you.
I think this might be a game changer for me in terms of improving the research process. Currently it feels that it could be a real tool and not just fade away after first excitement. Its lot of work.
I’m delighted to hear all of this, John. Sounds like it’s going to work out well for you. I hope more people give it a whirl – as you highlight here, you have to buy into the idea yourself, and the checklist you build has to be suited to your investing style, personality & circumstances anyway.
I suspect what holds people back is the perfectionist impulse – how on earth do I come up with an effective & complete checklist? Simple answer is you don’t… Just sit one down & bang one out – you’ll prob. be 80% right immediately, you’ll quickly get to 90% in another month, and the real learning & the last 10% comes much more slowly. And of course your checklist(s) will also evolve over time.
Again, I’d ask, what has an investor got to lose by trying to incorporate checklist(s) into their process? At worst, they lose a little time…as they learn that much more about a company (& investing)!