The Motley Fool

What you don’t buy matters, too

In the hunt for superior investing returns, most investors focus on what to buy.
This share, or that share? This sector, or that sector? And even this country, or that country?
Their logic: the investment returns that they achieve will depend on them making the best possible buying decisions.
Which, on the face of it, makes excellent sense.

Capital allocation

Today, I want to make a subtly different point.
Namely, that while investment returns will indeed depend on what you buy, they also depend on something else: what you don’t buy.
In other words, investment returns can be dragged down by poor capital allocation decisions.
A newspaper tip that sounded good at the time. A foray into emerging markets when they seemed buoyant. Or an AIM-listed oil explorer that looked set to make a big discovery.
Or even buying that share, when you should have bought this share.

Buffett said it first

Now, this thought isn’t exactly revolutionary.
Warren Buffett made much the same point years ago, with his so-called ‘investment rules’, and the importance of not losing money.
Novice investors interpret the remark simplistically: don’t lose money. Period.
Which is actually very difficult. An investment bought in good faith may go on to hit a rocky patch years later, leaving investors underwater until management achieve a turnaround.

Relative choices

But Buffett’s ‘rule’ has a deeper meaning, too.
Because ‘don’t lose money’ also has a relative meaning. When you allocate your capital by making an investment decision, you are making a choice. A pound invested in this investment can’t also be invested in that investment.
So, if this investment underperforms that investment, relatively speaking, you are losing money. Your investment returns would have been higher, had you made a different choice.

Work the numbers

And over time, the ‘drag’ caused by underperforming investments can be considerable.
Consider, for example, a portfolio of 20 shares, held in equal amounts, with each share delivering a 10% return. Contrast this with an identical portfolio, apart from one share that delivers a 5% return instead.
The first portfolio delivers, as you would expect, a 10% return each year. But the second portfolio delivers only a 9.75% return.
Now imagine that there are two underperforming shares. Or three. Or four.

Minimise the downside

What to do?
Simplistically, choose carefully. Evaluate shares carefully. Seek advice, and undertake research.
More practically, perhaps, I find it helpful to have an investment strategy, to which I try to stick. If I’m tempted to stray from it, this usually prompts some introspection.
Usefully, too, if I am persuaded to dabble a little, I tend to do so in relatively small amounts. This minimises the upside, to be sure. But it also curtails the downside risk.
Another handy tip is to be very aware of the risks of ‘doubling-up’ on investments that seem to be temporarily cheap. A bargain is always tempting but be aware you could be catching a falling knife.
And finally, remember that you can only allocate each pound of capital once. If in doubt, sit on your hands. A more convincing investment proposition will come along.
So, just wait for it.

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