CHAPTER 12
Why you need a strategy
If you are going to invest in shares directly, you need to have a strategy. Your strategy should reflect your own circumstances, responsibilities and tolerance for risk. Your professional adviser can help you in developing this strategy — and you should seek independent financial advice from your adviser before making investment decisions.
A strategy can be thought of as a set of rules or guidelines that are adhered to consistently over time.
The strategy is always the focal point — and remember: it is not really a strategy if you don’t adhere to it. But having a strategy does not preclude you from losses and it is during periods of adversity that your ability to stick to your strategy will be tested.
This chapter provides some insights into the mindset required to follow the strategy that you have adopted. The key to having the right mindset is understanding how important time (especially a longer term perspective), consistency, discipline and patience are to successful investing. Such an understanding will help you to disregard short-term volatility and take a more objective, consistently rational approach to wealth creation.
You will also see that by having your own focused strategy you can diversify your investments more effectively — with the objective of improving overall returns, rather than simply diversifying for its own sake.
Time and volatility
Markets can go through periods of quiet when prices tend to not move much at all. At other times the market can be very volatile, with significant price movement up or down even on a daily basis. When markets experience periods of significant short-term volatility it can be very unsettling to investors, perhaps causing them to question their chosen investment strategy. This can be particularly so for novice investors who have not seen market cycles play out and have not acquired the discipline of seasoned investors.
Your investment returns will typically be less volatile over the longer term and by focusing on your longer term objectives you can better avoid making rash decisions as a result of short-term price fluctuations.
Speculation
Speculation can be described as the taking of relatively large risks in the expectation of making relatively large gains in the short term. Often it involves taking advantage quickly of what are seen as short-term trading opportunities.
While limited speculation with the right tools and risk-management techniques can be profitable, and even fun, it should not dominate the investment strategy of most investors. By limiting the role of speculation, spectacular losses are less likely to undermine your long-term wealth-creation goals.
Dividends
Dividends can contribute to making your overall investment return less volatile. A portfolio that includes some well-selected higher yielding stocks may provide for steady or increased dividend payments over time, which will contribute to your overall return.
Rates of return over time
The rate of return you achieve with your investments is going to be affected significantly by when you enter the market. The return on an investment that was bought during a downturn in the market will probably be significantly higher than if the same assets are bought during a market peak.
Of course, it is easy to say that it is best to buy assets when their price is low because the return will be higher than if you buy those assets when their price is high. But you need to have confidence that their price will in fact recover if it is low. Also of importance to note is that a company may be categorised as ‘expensive’ but its shares still continue to rise in price over the following years due to the quality of the company.
There are two points to remember. First, beware of rates of return if you do not know the starting and end points, particularly when comparing rates of return.
Second, if you are confident in the investments you want to make, your investment return will be helped considerably if you can time your purchase rather than rushing in during a market peak. It is rare for a company’s share to not pull back at some time for some reason. It could be part of a general market correction, there may be profit taking that causes the price to recede or there may be some market news that alarms investors even though the fundamentals remain very strong. This is sometimes referred to as a period of temporary weakness and you may see broker recommendations to ‘buy on weakness’. It is often recommended when a stock has had a pretty good run and that run is expected to continue. The broker is saying that if the shares take a dip, take advantage of this to buy in a bit cheaper. By purchasing shares when they are a bit cheaper you will be able to buy more of them than you would have if they were selling at a higher price. Should your investment view prove correct and the shares do perform well, you will be holding more of these well-performing assets.
Effective diversification
Diversification means not putting all your eggs in one basket. The way to do this is to spread your risk across asset classes and within each asset class. By doing this, if one element of the portfolio is doing poorly, some other investment may be stable or doing well and therefore should offset the adverse impact of the poorly performing investment.
Importantly, proper diversification doesn’t simply serve to have the gain on one investment compensate for the loss on another. Effective diversification should also see the combined total of all investments advance in value. Having an investment strategy can help investors to be systematic in their diversification — rather than randomly picking different investments.
A diversified approach does not attempt to have small amounts invested in many different pies — this is ineffective diversification, and when transaction costs are included it can be counterproductive. The better approach is to have larger amounts in a few, carefully selected pies. This is diversifying with a strategy.
Understanding correlation
Correlation is the degree to which the movements of two different elements are related. A low correlation means that only a small or minor relationship is observable in the movement of the two elements. A high correlation means that there is a strong relationship between the two. For example, if every time one stock moved up in price by $1 another stock also moved up by a similar amount, we could say that those stocks are highly positively correlated. They tend to move in the same direction at the same times.
Figure 3.1 (see p. 30) compares BHP Billiton and Rio Tinto daily prices. These two stocks are highly correlated due to their earnings being affected by largely the same factors. Figure 3.2 (see p. 30) compares the materials sector with the health-care sector — this time we have two sectors with low correlation. Diversification is more effective when investments have lower correlation. Be cautious, however, before accepting the idea that low correlation is more important than smart share selection. It is very easy to be carried away with the study of correlation coefficients and build complex portfolios based around the interrelationships between the individual elements of that portfolio. The pursuit of low overall volatility may lead to mediocre results. You don’t want to purchase a bad investment simply because the share price tends to move down when the others are moving up. If all your investments are moving up, that is a good thing. Furthermore, you must remember that correlation analysis is based on historical price action and there is no guarantee that these relationships will continue. Always apply logic first and then ask if the additional element adds any real value to your existing portfolio.
Compounding
Compounding is a process whereby the value of an investment or series of investments increases exponentially over time through profits from the investment being reinvested and so attracting more growth and profits.
In chapter 13 we will explore the various techniques investors can use to attempt to outperform the market index and predict potential movements in share prices. For now, however, it is essential you understand that investing in the sharemarket is generally a long-term activity.
Consistency and discipline
Failing to act in a disciplined and rigorous way — and doing so consistently over time — may result in poor performance. Consistency and discipline are important keys to financial market success.
As James O’Shaughnessy wrote in the investment classic What Works on Wall Street:
Finding exploitable investment opportunities does not mean it’s easy to make money. To do so requires the ability to consistently, patiently and slavishly stick with a strategy, even when it’s performing poorly relative to other methods. Few are capable of such action.
Before we elaborate on consistency and discipline as the two keys to market success, we need to understand the market itself.
The efficient market hypothesis
The efficient market theory is used by some people to explain why many individual and professional investors fail to beat the market. It claims that there is no possibility, except by chance, that any person or group can outperform the market, and certainly no chance that the same person or group could consistently do so. But the problem with the efficient market hypothesis is that it assumes all investors act rationally and that all information is processed correctly — that is, that no-one makes mistakes.
Share traders do not always act rationally. During major market corrections — or worse, market crashes — fear takes over and people sell at prices they previously would not have accepted because they fear prices will fall further. And when people are desperate to get into a booming market they will pay much higher prices than the valuations put on those stocks in less bullish times. So even though a company’s fundamentals may not have changed much, the psychology of the market has caused valuations to change. Another thing to consider is that investors do not necessarily process information the same way or at the same time. For example, an announcement that is positive for a company may see its price quickly pushed higher by early buyers. Later, other traders may only just be hearing the news. If they act on that information, it may provide nothing more than an opportunity for the early buyers to sell. You will also hear that a company’s price recovered because it was oversold after investors overreacted to some bad news.
Given these examples, it is reasonable to assume that the efficient market does not always prevail and there are opportunities for investors to ‘beat the market’ by exploiting situations where they think shares are overpriced or underpriced.
Having said that, it is hard to do this on a sustained basis and investors who track the index will argue they are better off sticking to the index.
Be consistent
Sticking to a strategy just for the sake of it may not necessarily be the best thing if the strategy was flawed from the outset. I could have a strategy to only invest in loss-making companies. It is a strategy, but it is probably a bad one and sticking with it over the longer term is not going to make it any better. But if you have developed a strategy that is based on proper research that is cogent and perhaps has had the benefit of being reviewed by trusted advisers, it should be given time to deliver.
The biggest and best names in the sharemarket, and some of the wealthiest individuals in the world, are experts at being consistent. Warren Buffett and Peter Lynch are two world-famous fund managers who have developed their own models for share selection. They have very clear principles guiding what they will invest in and what companies they will not invest in. Their discipline and consistency of approach have at times caused them to underperform, but over the long term they have performed well.
At the height of the technology boom in 1999, Buffett’s Berkshire Hathaway was targeted by the financial media and the financial press for failing to take advantage of the astronomical prices being paid for technology stocks. US companies were trading at up to 500 times earnings per share. In 1999, 279 internet companies listed in the United States and their average first-day gain was 90 per cent. At the time, the media, the analysts and investors were lured into believing that the bubble would never burst.
Market commentators pronounced ‘this time is different’ and ‘this is a new era’. Buffett was told that he should retire, that he didn’t understand the ‘new economy’ and that the 0.5 per cent return on his fund in 1999 was confirmation that his strategies no longer worked.
Buffett’s strategy did not allow him to invest in internet or tech stocks so Berkshire Hathaway did not enjoy the exponential returns technology stocks were providing to more aggressive growth managers — at one point shares in his Berkshire Hathaway fund were down 30 per cent from US $65 000 per share to less than US $45 000 per share.
Despite the ongoing talk of ‘the end of the old world economy’ further reinforcing the idea that old economy company shares were dead and high-tech shares were the way of the future, Warren Buffett did not change his strategy.
In April 2000, when the NASDAQ took its first dive and the subsequent sell-off was labelled ‘the tech wreck’ by the media, the spotlight turned back to Buffett. The Berkshire Hathaway share price began to recover strongly and Buffett was asked to explain how he did it and what his secret was.
His answer was that there is no secret. All he did was act consistently. It is difficult to stick to a plan that is apparently not working. It is even more difficult when the world’s financial media is telling you that you are wrong.
A plan should have financial targets in place to tell you when to reduce your activity or reassess your plan. Until those targets are met, it is generally beneficial to stick to the plan.
Following any methodology consistently means that you are likely to go through periods of poor performance, or what is referred to as ‘drawdown’. It is extremely difficult to continue employing a method that is not working well — particularly when someone you know is enjoying a solid period of growth at the same time. Most people will be tempted to change their method or switch to a new method entirely. Provided you have thoroughly researched your technique, you should be aware of previous periods where the technique did not perform exceptionally well. What you are experiencing now may simply be normal in terms of the strategy’s behaviour.
Drawdown
Drawdown is the period during which the equity in your account is falling because you have entered a period of losses.
A lack of consistency may result in underperformance. Following the recommendations of newsletters or of television personalities or magazines may be effective. However, the only way to determine whether those methods are effective is to follow them rigorously. And perhaps that is the most important advantage of a consistent approach: the ability to objectively assess whether a tipster, newsletter or television host is actually any good.
Having a strategy that is applied consistently may help free an investor from the emotions involved in the investing process.
Be patient
Part of a disciplined approach, and an important aspect in investing and trading, is patience. It may take time for the market to recognise what you may already have realised about a company’s shares. It may take time for the company to generate profits and pay those out to shareholders. So if it takes time for all these good things to happen, why is it that we find it hard to wait for the time to pass?
A lack of patience is one culprit and fear is the other. Some investors may lack the patience to ride out the storm when investments are not performing as expected and they fear that things may never improve. Both are emotional responses. For many investors, selling out will be justified by explaining that the shares will be repurchased at a lower price. More likely, the investor will wait until things improve and the improvement is confirmed in the press. By this stage, any good news is already ‘priced in’.
Even in short-term trading, patience is important to success. Traders must feel comfortable about allowing prices to trend long enough for an acceptable profit to accrue. During a period or string of losing trades, traders must be patient and continue to follow their plan through to the next winning trade.
Once a strategy has been researched, adopted and implemented, a healthy dollop of patience may help you to be more successful. However, before you decide to trade (or not to trade), you should carefully assess your experience, objectives and financial situation — and discuss your particular circumstances with your broker or professional adviser.
Further benefits of having a strategy for your share trading are discussed in the next chapter.
Appropriate asset allocation
Once you have determined your risk profile, current financial position, investment objectives, time frame and liquidity requirements, you need to work out what proportion of your total capital you want to invest in shares, property, fixed interest and cash. This is called ‘asset allocation’.
Your risk/reward profile
Every investor has a different risk/reward profile. Taking the time to identify your own risk/reward profile will help you and your adviser choose the best investments for your needs. The three most common types are outlined below.
The cautious investor
Cautious investors seek better than basic returns, but insist that the risk must still be low. Typically older investors, they seek to protect wealth that they have accumulated. They may be prepared to consider growth investments that are less aggressive.
The prudent investor
Prudent investors want a balanced portfolio to work towards medium- to long-term financial goals. They require an investment strategy that will cope with the effects of tax and inflation. Calculated risks aimed at achieving greater returns, in the form of both income and growth, are acceptable to them.
The aggressive investor
Aggressive investors are prepared to take greater risks in pursuit of potentially higher long-term and short-term gains. They may take on a higher level of gearing and business risk.
Aggressive investors tend to view risk as an opportunity rather than a threat. They are driven by the potential for capital gain. Most of them are prepared to borrow money to invest. In terms of composition, their portfolios are very growth oriented.
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You are unlikely to get very far along your investment journey without encountering the term ‘fundamental analysis’. Looking at a particular company, its competitors and its sector, as well as the economic climate, are all part of this type of analysis. There are some key financial ratios used in fundamental analysis and chapter 13 introduces these.