Investing greats such as Warren Buffett and Benjamin Graham urge us to take a business-perspective approach to our share investments. Behind every share is a business and we invest in businesses, not in shares.
That advice forms the basis of my own investing strategy. Trying to understand the businesses, of which shares represent a small slice of ownership, is fundamental to investing.
However, my investing returns increased when I combined that business-perspective philosophy with a strategy for embracing the sentiment-driven gyrations of the stock market. We invest in businesses, yes, but we hold shares, so it makes sense to try to understand share-price behaviour, too, which can often seem illogical.
Follow these don’ts to improve returns
Doing our own research to identify attractive stock market-listed businesses is a good start. Rather than simply buying and holding such investments, I’ve found that it pays a premium to work to improve investment outcomes by eliminating poor performers. Following these tactics helps keep potential howlers out in the first place, and forces re-evaluation of those shares that fail to behave as we expect. Here are the five “don’ts”:
1) Don’t average down
It’s easy to start believing that averaging down is a good idea. When we’ve researched a firm and its prospects and calculated that the valuation is attractive, a lower share price is surely just ‘Mr Market‘ offering us a better deal. Buying better value is right on the button when following the advice of master investors such as Warren Buffett and Benjamin Graham. Isn’t it?
Maybe. However, averaging down fails to consider that we’ve already been wrong once. Why shouldn’t we be wrong again? Thorough research and valuation can lead us into a false sense of security. Jesse Livermore used to caution that opinions are often wrong. We arrive at opinions by appraising a firm’s prospects. A share-price move against us is confirmation that we are wrong, because we thought the share would go up! In his book Taming The Lion, Richard Farleigh has it that the market is smarter than we think — maybe the market knows something we don’t.
We don’t need to average down. If our opinion about a share is right, the share will move up in the end. Why not wait for that to happen with the original investment if we are so sure we are right and that the market was initially wrong? When the share price rises, the market move supports our opinion and we can then average up — that’s a much smarter idea.
2) Don’t buy a falling share price
In the hunt for good value, a falling share price can attract because it may indicate the likes of an out-of-favour sector or speculative froth coming off an attractive grower. However, it can be a mistake to buy on the grounds of an attractive valuation while the firm’s share price continues to fall. Richard Farleigh reckons markets tend to move much further than we think in either direction, which could mean buying on attractive fundamentals and value indicators could end up showing us a big loss as the share price continues its downward trend.
Why not watch an attractive share in freefall until the trend reverses? A share price moving up can be a signal that the bottom is in and it’s a good time to buy.
3) Don’t buy a flat-lined share price
A share not moving up or down can remain that way for months and years. The valuation might be attractive and there could be potential for growth, but buying sometimes leads to an investment sitting there as dead money.
Why not put the firm on a watch list and buy when the share price flickers into life? If it starts moving up, hop on. Share-price action often precedes news, so if the share price starts moving there could be decent news flow on the way and our purchase could prove well timed.
4) Don’t be too patient with underperformers
If a share does nothing for weeks, months and even years after we’ve bought it, despite its attractive valuation and forward prospects, there’s a good chance that our opinion about it is wrong. After all, we thought it would go up. The longer we wait, the longer our capital isn’t working for us. In such situations, it can be a good idea to sell up and move on. Maybe recycling into one of our better performers by averaging up.
5) Don’t over-diversify
Despite all our good practice with shares, if we over-diversify the gain can be very little. A portfolio stuffed with tens or even hundreds of positions is unwieldy and takes a huge commitment of time to manage. If we want such diversity, it can be better to go for a tracker fund.
On the other hand, concentration can build wealth. A small portfolio of carefully chosen positions opens the way to focused research and management, which can really drive investment gains. I’m comfortable with as few as five holdings and as many as ten, although everyone’s comfort level is different.
