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

Applying a commonsense ‘smell test’ can help — even if it results in over-caution.

| More on:

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

Three generations of joyful Asian family celebrating Chinese New Year

Image source: Getty Images

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

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.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Malcolm Wheatley owns shares in Scottish Mortgage Investment Trust. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

More on Investing Articles

Passive income text with pin graph chart on business table
Investing Articles

Yields of up to 7%! I’d consider boosting my income with these FTSE dividend stocks

The London market has some decent-looking dividend stocks right now, and I’m tempted by these two for growing income streams.

Read more »

Young mixed-race couple sat on the beach looking out over the sea
Investing Articles

I’d put £20K in an ISA now to target a £1,900 monthly second income in future!

Christopher Ruane shares why he thinks a long-term approach to investing and careful selection of shares could help him build…

Read more »

Mature couple at the beach
Investing Articles

6 stocks that Fools have been buying!

Our Foolish freelancers are putting their money where their mouths are and buying these stocks in recent weeks.

Read more »

Black woman using loudspeaker to be heard
Investing Articles

I was right about the Barclays share price! Here’s what I think happens next

Jon Smith explains why he still feels the Barclays share price is undervalued and flags up why updates on its…

Read more »

Investing Articles

Where I’d start investing £8,000 in April 2024

Writer Ben McPoland highlights two areas of the stock market that he would target if he were to start investing…

Read more »

View of Tower Bridge in Autumn
Investing Articles

Ahead of the ISA deadline, here are 3 FTSE 100 stocks I’d consider

Jon Smith notes down some FTSE 100 stocks in sectors ranging from property to retail that he thinks could offer…

Read more »

Young female business analyst looking at a graph chart while working from home
Investing Articles

Why I think Rolls-Royce shares will pay a dividend in 2024

Stephen Wright thinks Rolls-Royce shares are about to pay a dividend again. But he isn’t convinced this is something investors…

Read more »

Investing Articles

1 of the best UK shares to consider buying in April

Higher gold prices and a falling share price have put this FTSE 250 stock on Stephen Wright's list of UK…

Read more »