The ‘smell test’: when an investment doesn’t feel right

The other day, I caught up with a family friend — a young investor, in her late twenties, who has been fortunate enough to inherit a fairly sizeable sum.
 
Periodically, we chat about her investments, and about the investing journey on which she’s been travelling over the past few years.

It’s not all been plain sailing. Doubling down on failed construction company Carillion, for instance, was a useful — if expensive — lesson. On the other hand, a £20k investment in investment trust Scottish Mortgage has turned into a holding worth over £71k.

Gut Feel

What struck me about our latest conversation was her application of the ‘smell test’. As we chatted about potential investments, it was clear that she’d undertaken a lot of research. And, consequently, had very firm opinions about where certain potential investments might go wrong.
 
To be sure, I didn’t agree with her in every case — and said so. But I’d far, far sooner see investors reject potential investments based on ‘gut feel’, than plunge in unthinkingly.
 
Or, almost as bad, over-rely on a couple of key metrics such as yield or the price-to-earnings ratio. Such measures are useful, but on their own, a fairly poor means of assessing what will be, in most cases, complex and large businesses.
 
I often apply a ‘smell test’ in the case of my own investments, and have no issue whatsoever with other investors doing the same.

The Loser’s Game

For ordinary investors like you and me, a smell test can be invaluable.
 
That’s because — as investment adviser Charles Ellis famously pointed out in 1975 — investing is like tennis. For professionals, it’s a winner’s game. But for amateurs, it’s a loser’s game.

“Professionals win points, amateurs lose points. Professional tennis players stroke the ball with strong, well-aimed shots, through long and often exciting rallies, until one player is able to drive the ball just beyond the reach of his opponent,” wrote Ellis.

“Amateur tennis is almost entirely different… the ball is fairly often hit into the net or out of bounds, and double faults at service are not uncommon. The amateur duffer seldom beats his opponent, but he beats himself all the time. The victor… gets a higher score because his opponent is losing even more points.”

And if applying some kind of smell test helps investors to make fewer mistakes, then they will be improving the odds in their favour.

Sure, they might be rejecting investments that wouldn’t in fact have gone wrong, but that’s not the point. By raising the bar, they’re selecting only the surest bets.    

Take a Shower and do Nothing

Maybe you think that I’m exaggerating: investment can’t really be a loser’s game, can it? Oh yes, it can.

Consider the research of Brad Barber and Terry Odean, for instance, which analysed 10,000 brokerage accounts of individual investors over a seven-year period, and came to a sobering conclusion.

On average, they found, investors failed to beat the market. And those investors who traded the most, it transpired, did even worse, earning an annual return of 11.4%, during a period in which the market returned 17.9%.

As I’ve written before, Nobel prizewinner Daniel Kahneman compellingly summed up their research in his 2011 best-seller Thinking, Fast and Slow.

“On average, the shares that individual traders sold did better than those they bought, by a very substantial margin: 3.2 percentage points per year, above and beyond the significant costs of executing the trades… It is clear that for the large majority of individual investors, taking a shower and doing nothing would have been a better policy than implementing the ideas that came to their minds.”

A Better Plan

Taking a shower and doing nothing, however, seems a little extreme. It certainly doesn’t help to expand a portfolio.

So in my view, a smell test is a useful half-way house: a means of looking at a prospective investment – and a business – ‘in the round’, pulling into the investment decision a whole series of non-quantitative judgements and views.

And if those non-quantitative judgements and views serve to put you off from making a particular investment, so be it. There are plenty of others out there.