Introduction
Have you ever thought, “if only I had bought Apple stock 20 years ago, I could be rich right now” (Apple is up 445 times in 20 years). That thinking is exactly why you get poor results from investing.
You’re always looking for the next big thing. You buy a stock, it doesn’t perform, so you sell it and buy another one… over and over again. You read to educate yourself on investing, but your thinking is often worsened by reading the news and about people who made it big – think Buffett and Insurance, Burry and subprime mortgages, Bezos and Amazon, Musk and Tesla, Mouton and Capitec, Bekker and Naspers. I’ll bet you have heard of someone on that list.
The impression created is that opportunity is scarce and you have to own the next big thing to get rich. That is not true. In fact, all you have to do to get rich over time is to: know yourself, get some investment knowledge and use a solid investment strategy. Let’s dig in.
Investment philosophy
Right about now you’re thinking “Philosophy! OMG, boring”. Luckily it’s not that kind of philosophy. It’s more about how to think about the stock market, how the stock market works and the kind of mistakes you think are going on.
The assumption beneath most investment strategies is that somewhere investors have made errors which have resulted in mispriced stocks. For example, if you like investing in value stocks, deep down you believe that stocks are priced too low because investors are ignoring some fundamental quality, which will later be recognised. If you like growth stocks, deep down you believe that there is more opportunity in these stocks than is being recognised by the market.
You might have different tactics to deal with the various market inefficiencies that you believe exist. For instance, if you believe that markets have overreacted to big news, you may decide to buy into stocks whose prices have fallen after negative news. Or if you believe that the market as a whole is too pessimistic, you may buy during dips. You might even look for neglected stocks if you believe that a lack of information is depressing their prices. Either way, there is always an assumption that mispricing has occurred because of some inefficiency in the market.
Good investment decisions require an investment philosophy, which becomes the basis of your investment thinking. The starting point of developing an investment philosophy is getting to know yourself and recognising what your market beliefs are. Once you have done this, you will no longer be on the endless rollercoaster of trying this strategy and that strategy and changing how you invest every day of the week. With an investment philosophy in place, you will have a consistent point of view from which to assess opportunities. If your philosophy is not working, you can change it systematically.
Tips on developing your own investment philosophy:
- Ask yourself why do you think opportunities are appearing? Which market inefficiency do you believe is occurring? How can you benefit from it?
- Try to understand your own psyche. What are you looking for when you invest? How do you feel when markets are in turmoil? How are you making decisions at that time?
- Most importantly, write all this down. You need it on paper so that you can use it as your North Star.
Once you have done this, you can get started with the business of implementing a solid investment strategy.
Risk management
Believe it or not, your number one job in investing is managing your risk, not find the best stock. There is no such thing as the best company to invest in. There are actually varying degrees of performance among many companies, and at any moment, one or other company can surge ahead of the others.
Diversification
This brings us to diversification – the only free lunch in investing. In this specific case, diversification means owning multiple stocks. As a risk management technique, it is your friend because you cannot know ahead of time which companies may surge ahead. Diversification helps you to participate in the success of companies because you own an assortment of them.
How many stocks do you need to own? The research shows that most diversification benefits are achieved by owning as few as 15 large cap stocks or 26 small cap stocks.
Position sizing
Let’s be realistic here, if 90% of your money is invested in one stock and 10% is invested in 20 other stocks, you are not diversified! What you have is concentration risk, which means that you are highly exposed to one stock.
How much of your portfolio should a single stock contribute? Based on the diversification numbers, a large cap stock can be up to 6% of the portfolio and small cap can be up to 3.8%.
Core-satellite portfolio
But… twenty six is a lot of stocks. It can be hard to know what to buy and it can also be prohibitive if you have a small amount of cash to invest. It is also difficult to follow the fate of that many companies closely.
One solution is to invest using a core-satellite portfolio strategy. In this method, the core of your portfolio is anchored using a broad index. This can be done by investing in an index like the S&P500 or the MSCI World Index. The benefits to index investing include low-costs and high diversification. You can also save on taxes because you don’t have to turn over this portion of the portfolio too often.
The satellite portion of your portfolio can be the stocks that you actively pick. They can be stocks outside the index or you can increase the concentration of some stocks which are in the index. Just remember to keep position sizing in mind. If the core index already has 4% exposure to a large-cap stock, you probably don’t want to add another 6% to that in the satellite portfolio. The benefit to the core-satellite portfolio strategy is that it allows you to exercise your investment philosophy while managing your risks.
Wrapping up
Successful investing is not about picking the next big winner, it is about creating a portfolio that will give you good investment returns over time. That is best done by having an investment philosophy which guides the creation of a portfolio, where the risks are managed. If you can do that, wealth is inevitable.
Subscribe to our newsletter by clicking here