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…Portfolio management is hard work. It’s difficult picking out a set of positions that you can confidently hold for a number of years. Then, along the way, you run into issues of how to deal with positions getting too large, dealing with losers and overreacting (or not reacting enough) to news that is good or bad and what action to take. Awareness of these “habits” can be the first step in fixing, and hopefully rectifying, these problems to boost long-term wealth.
Market timing is hard
…A study by Dalbar sheds some light on how consistently and accurately investors guess the overall direction of the market. They measured inflows and outflows into equity funds over time compared to the performance of the S&P 500 at those times to determine a “guess right” ratio, or how consistently investors could “guess right” the market direction. What’s interesting to observe from the data is that:
- investors are often able to correctly guess the markets direction 60-70% of the time in most years BUT
- they generally guess the market direction wrong at the worst possible times, such as in 2002 and 2009, where “guess right” levels dropped to between 30% and 40%.
Incorrect timing costs money
Guessing market direction wrong is incredibly costly. The average investor has under-performed the S&P 500 by almost 3.5% annualized over a period of a couple of decades. That’s a lot of lost returns.
I was a victim of this type of market timing thinking in my early 20s but I’ve since reset my own investing strategy to be one of high conviction – buying fewer positions with a much higher level of confidence and being able to sit tight and get through whatever the markets dish up.
The possible upside from getting into and out of markets at the most optimal time to generate excess returns just isn’t worth the 0.8% per in year in return difference if it can be done consistently well and consistently right. I’ve thus consciously made the decision to sacrifice maximum possible returns in my portfolio management.
Picking terrible businesses
I have tried to line up the odds in my favor by deliberately picking business that overindex on this important metric and stacking my own portfolio with those names that have the highest ROIC. In my own portfolio, businesses like Visa (V), Adobe (ADBE) and Facebook (FB) all have returns on invested capital near 20% or more, and I’ve dropped businesses that have deteriorating trends in this measure.
I have tried to line up the odds in my favor by deliberately picking business that overindex on this important metric and stacking my own portfolio with those names that have the highest ROIC. In my own portfolio…[I own companies that] have returns on invested capital near 20% or more, and I’ve dropped businesses that have deteriorating trends in this measure.
Resist “Taking Profits”
…As a group, most investors want to trim winners and persist for longer than is advisable with losers. We always want to “get back to even”, and numerous studies have shown time and time again that as a group we are far more sensitive to losses then we are to seeing investment gains. The pain of a loss is 2X the joy of a similar gain. However, this is precisely the wrong thing to do.
Research suggests that stock market return performance is heavily reliant on just a few companies that become home run stocks. Specifically, research has concluded that:
- just 4% of all listed stocks are responsible for ensuring that the stock market’s overall returns are higher than those on treasury bills,
- 58% of stocks failed to beat T-bill returns over their lives,
- and only 38% of stocks actually beat T-bills by modest amounts.
The lesson here for individual investors who maintain their own portfolios is clear; stocks that keep winning should be kept, and capital from losers should be recycled into better ideas.
There’s evidence that suggests that as investors we tend to overreact to information, both positive and negative. Ultimately, markets have a way of reverting back to the mean, which suggests that if an otherwise good stock has had a couple of negative quarters, that shouldn’t necessarily be a reason to dump the stock.
Source: Journal of Finance
In a research experiment, a portfolio that consisted of large groups of past loser stocks happened to significantly outperform previous winners in subsequent periods…suggesting that certain negative events result in overreactions in otherwise good businesses and that, to the extent that there is only temporary disruption to a business that is otherwise leveraging strong secular tailwinds, aggressive stock reactions to the occasional bad earnings result don’t need to become a cause for panic.
Many conventional practices for investors destroy long-term wealth.
- The idea that you can “never go broke taking a profit” tends to cheat investors out of the few chances that they have to own significant wealth creators and outperform markets.
- Efficiently timing markets can no doubt make a difference to returns, but being able to do it consistently well is challenging, and the risks of getting it even slightly wrong can destroy returns.
- Investors shooting first and asking questions later on poor pieces of news also creates the tendency to turn over businesses that may have had 1 or 2 bad quarters too quickly, many of which then subsequently go on to generate massive returns.
Awareness of the above “habits” can be the first step in fixing, and hopefully rectifying, these problems to boost long-term wealth.
Editor’s Note: The original article by Integrator has been edited ([ ]) and abridged (…) above for the sake of clarity and brevity to ensure a fast and easy read. The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor. Also note that this complete paragraph must be included in any re-posting to avoid copyright infringement.
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