The best investors have this… Do you?

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The best investors have this… Do you?

 

As I’ve written the past, a lot of my success in investing has been attributable to studying other successful investors and learning from them.

 

My investment process started from basically nothing moved to technical analysis, which was not successful.Then onto the use of brokers for ideas, which was even less successful.

My returns improved substantially when it dawned on me to study other successful investors. I started reading Benjamin Graham, Warren Buffett, Peter Lynch, John Neff, Joel Greenblatt and numerous others.

From their returns I knew they were successful, but I could not quite put my finger on what exactly made them successful.

Until I realised, their success had a lot less to do with what they were reading or even what they were investing in, it had to do with a successful investment decision making process they have developed and the fact that they stick to the process through thick and thin.

But what is a successful investment decision making process?

The best research I could find on the subject is from an article called Decision making for investors (pdf) written by Michael Mauboussin, strategist at Legg Mason Funds Management.

The whole article is definitely worth reading but the basic point is this:

Investing is a probabilistic activity like gambling, betting at card games and horse racing, and if you look at who is consistently successful, over long periods of time, and learn from them you substantially increase your chances of success.

What he found was that the best performers in all probabilistic activities tend to have a similar approach, which consists of the following:

  • A focus on the process rather than the outcome
  • A constant search for favourable odds
  • An understanding of the role of time

Focus on process rather than outcome

Successful investors have to focus on process because, as in all probabilistic activities, good decisions will periodically result in bad outcomes, even if the probability of a good outcome was a lot higher then that of a bad outcome.

Think of you rolling a dice with one black side and the rest red. Your chance of getting red is high, 83% (5/6), but you may also get black with only a 17% chance.

If your investing process is good (with a high probability of success) good outcomes will be deserved and bad outcomes will be bad luck.

If this disappoints you think of the alternative…

You have a bad investment process (with a low probability of success) decision resulting in a good outcome will be because of blind luck and a bad outcome will be what you deserve.

Always look for favourable odds

In all probabilistic activities like gambling, investing, batting in baseball or cricket, opportunities come in the form of probabilities. 

Relatively few of these opportunities, be it the cards you received or the company you have read about have favourable odds of a successful outcome.

If you thus only invest or bet when the probability of success is in your favour, you substantially increase your chances of a favourable outcome.

How do you find companies with attractive odds to invest in?

Luckily a lot of academics and investors have done most of the work for us already.

The best place to look is studies that have determined what has worked in the past.

A good source I have found is a document by the fund manager Tweedy Brown called What has worked in investing (pdf) (updated in 2009).

The document lays out numerous investment strategies and then lists studies that have tested their returns over long periods of time.

Examples of the strategies tested are:

  • Low price to book strategies
  • Low price to earnings strategies
  • Significant insider purchases
  • A significant decline in the stock price
  • Small market value companies

The document for example shows the returns achieved with an investment strategy defined by Benjamin Graham. 

The strategy requires the following:

  1. An earnings yield of more than two times the AAA bond yield
  2. Total debt (current liabilities plus long-term debt) less than equity
  3. Hold for two years or a 50% gain, whatever comes first

In the six year period from 1974 to 1980 the strategy generated an average return of 38% per year versus a 14% per year return of the S&P 500 index (including dividends).

Another example would be the Magic Formula as explaining in the book The little book that still beats the market by Joel Greenblatt.

In the 10 year period from 1 October 1999 to 30 September 2009 the Magic Formula generated a total return of 288.9% versus a -1.5% return of the S&P 500 index.

 

 

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The importance of time

The key to winning at probabilistic activities is to stick to it over long periods of time.

Even if you have a larger than 80% chance of winning it does not mean that you will win every time. But if you keep at it, playing only when you have a greater than 80% chance of winning, it is a near certainty that you will win over the long term.

If you make the right decisions for the right reasons enough times the results will take care of themselves in a long run.

This is also unfortunately where the biggest risk lies. The risk that you will abandon your proven winning strategy on the first signs that it is under-performing.

With the increasingly short-term view of investors, focused on monthly and quarterly returns, very few investors or fund managers take the time to develop and stick to an investment process that leads to positive long-term results.

This can be seen from the increased turnover of mutual fund portfolios from 20% in the 1960s to over 110% today.

Joel Greenblatt in his book said that he is not worried that, in spite of its outstanding historical returns the Magic Formula has produced, it will be so widely adopted that its returns will be eroded. For the simple reason that the formula does not always work. The Formula sometimes experiences periods of three to four years of market under-performance, which will lead to most investors abandoning the strategy.

This creates a huge opportunity for you if you invest for the long term.

Investors with a proven investment strategy and a long-term focus have a huge advantage over short-term traders and quarterly performance orientated fund managers.

In summary what should you do?

  • Identify and study investment strategies that have generated outstanding long-term market out-performance
  • Choose one that fits with your investment style and draw up an investment process of how you will identify, analyse, buy and sell investments
  • Implement the process and stick to it through thick and thin

Also carefully document your investment process.

Do this not only to review and update it from time to time but more importantly to read it at times when you are frustrated and close to the point of abandoning your strategy.

The document should serve as a reminder of why you chose the strategy and motivate you to stick with it.

If your investment strategy is based on sound research and you stick to it over the long-term you cannot have anything else but superior investment results.

 

Prosperous investing

 


PS  Do you simply not have the time to formulate your own investment process?

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By | 2017-05-19T15:10:37+00:00 April 15th, 2010|Tags: , , |