When it comes to organisational strategy, research shows that having the best strategy in the world is not enough. What separates successful organisations from the also-rans is strategy implementation. A second-rate strategy which is implemented can be improved, whereas a brilliant strategy which is simply documented and filed in a CEO’s desk drawer is of little use to man, beast or corporation.
To address the implementation problem, businesses make use of management control systems such as budgets, balanced scorecards, and a strong corporate culture. Most of these systems are positive in nature, i.e. they empower employees to use their initiative, skills and creativity to achieve the goals of the organisation.
It is recognised, though, that empowerment is not enough; employees also need to know what actions and behaviours are out of bounds. The systems which spell out these limits are known as “boundary systems,” along the lines of the biblical Ten Commandments. Failure to adhere to the commandments of acceptable corporate behaviour can be disastrous, as evidenced by companies such as WorldCom, Enron and Arthur Andersen.
The same logic applies to the practice of stock market investing. Whereas success depends to a large extent on a successful positive strategy, there are also behaviours to be avoided. In their excellent investment guide, Koch and Gough (2008) identify a number of such actions. So, to prevent the investment equivalent of an Enron, here are the ten key behaviours you should steer clear of when implementing a successful investment strategy:
1. Avoid using OPM
When a trade goes bad in the dealing rooms of the City of London, the traders apparently shout out: “OPM, OPM,” to remind themselves that it is, after all, only “other people’s money.” (And you wonder why bankers are not that popular right now?)
In the case of our first commandment, OPM means borrowed money, which should be avoided like the plague. Only invest if you have the cash, and if that cash has not been earmarked for some other purpose. Borrowing money for investment purposes has ruined millionaires and billionaires alike. Don’t let it ruin you.
2. Don’t invest in equities in the short term
If you have money which is needed for a specific purpose in the next couple of years, be very wary of investing it in the stock market. Whereas the long-term record of shares is good, big falls are possible over a period of a year or two. Rather consider the bond or money markets; a fall is still possible in the short term, but the consequences are not likely to be as severe as those arising from a significant stock market correction.
3. Don’t over-diversify your portfolio
While diversification reduces risk, over-diversification can reduce risk and returns. As Warren Buffet says,” buy two of everything and after a while you end up owning a zoo.” The better you know and understand the businesses you invest in, the better your chances of success. Having too large a portfolio inevitably means having too little time to keep on top of all of your investments.
A portfolio of five to ten shares is probably your best bet. As Buffett has also pointed out, it is fine to put all your eggs in one basket, as long as you watch the basket.
4. Don’t neglect to do your homework
Be wary of being blinded by “hot” shares. Remember that it is the success of the business itself that is going to drive the share price in the long run. Be sure to study and fully understand the underlying businesses of any share that you are considering for your portfolio. This can involve the analysis of a number of factors; for example, when assessing the likely future performance of a GE subsidiary, Jack Welch used to ask the following questions:
• Who are the competitors in this business, large and small, new and old?
• Who has what share, globally and in each market? Where do we fit in?
• What are the characteristics of this business? Is it commodity or high value or somewhere in between? Is it long cycle or short? Where is it on the growth curve? What are the drivers of profitability?
Remember to consider the macro-economic environment as well; some shares thrive in the good times, while others are more likely to perform during downturns. Having a mix of shares tends to smooth your returns and reduce your portfolio risk.
Finally, don’t overlook the quality and experience of the management teams running your companies. In my experience, great managers have the happy knack of exceeding market expectations from time to time, and that does great things for the share price.
5. Never buy on tips
We’ve all experienced it – “inside” information on shares that are soon going to rocket in value. Aside from the moral issue of trading on inside information, buying shares on the strength of tips is almost always a recipe for disaster. Such dubious advice is often a means of boosting the price so that those already holding the shares can make a quick profit. Don’t fall for this ploy and get suckered into buying shares that you know very little about.
6. Don’t follow the crowd
If you do what everyone else does, you’ll get what everyone else gets. In terms of investing, this often means over-priced shares that fail to meet your expectations.
I recall a fund manager telling me some years ago that he had to follow all significant share purchases by an industry “star.” If these shares performed, my fund manager friend did not have to explain to clients why he had seen fit to ignore them. If the performance was less than stellar, however, he could always fall back on the excuse that even the “star” performer had seen value in the shares.
Herein lies one of the advantages of being an individual investor. You don’t have to follow the crowd; develop your own share-picking system based on a solid understanding of the underlying business. This is far more likely to lead to success, and into the bargain you will have the satisfaction of beating the professionals at their own game.
7. Be wary of “averaging down” when the market is falling
“Averaging down” means adding to the holdings of a share that you already own, but at a reduced price. On the face of it, this makes sense. If you liked the share in the first place, then why not buy more when the price falls? The problem is that a falling share price is often the result of significant bad news. True, the market often over-reacts to bad news, but there is also the possibility that the market has got it right. The fundamental principle still applies; it is the future prospects of the company that will determine the share price in the long run. Only if you are certain that the fundamentals are still solid should you average down.
Koch and Gough also caution against buying while the price is still falling. If you are determined to add to your holdings, they recommend that you do so only once the price has been stable or rising for at least three consecutive trading days, so that you include at least one day of a price increase.
If in doubt, avoid averaging down. Bad news is quite often worse than the market anticipates; in these cases it is a very long time, if ever, that the share price recovers.
8. Don’t be afraid to sell at a loss
Rather than adding to your holdings when the price of a share in your portfolio falls, how about ditching the share instead? Curiously, humans have a problem with this. Behavioural finance suggests that we are more likely to sell our winners than our losers; perhaps this is because we only lock in our losses when we sell, and in our minds there is always the hope that the falling price will recover.
Koch and Gough note that some astute investors believe that you should always sell if a share drops by a predetermined amount, normally in the range of 7% to 10%. As a general rule, if a share has fallen by a greater percentage than the market as a whole, Koch and Gough suggest that you must have a very good reason for holding on to it.
9. Beware of penny shares
“Penny” shares are low value shares, often priced below one rand. They have sometimes performed very well at the top of a bull market, but there is little evidence that they represent long-tem value.
There is generally a good reason why penny shares are so cheap. They are often associated with poorly run, underperforming companies. Or, as Koch and Gough point out, they are sometimes just “the last resting place of once-great companies before their formal burial.”
Watch out, though, for penny share companies that bring in a competent CEO who is able to assemble a new management team. If the underlying business is sound, good things can result. However, as a general rule, you would do better to give penny shares a miss.
10. Don’t ignore your blind spots
You would do well to analyse your investment behaviour, and the performance of the shares you have bought. By identifying the winners, losers and average performers (relative to the market as a whole), you should get some insight into the factors which are common to each of these three categories.
What characteristics do your wining companies share? What types of businesses are they? Why did you buy them in the first place? How well do you know them? By asking these and other questions you will hopefully develop a better understanding of why these shares have performed well.
If you repeat the process with your average shares and, particularly, with the losers, you should gain insights into your investing behaviour that will allow you to make better decisions in future.
Koch and Gough illustrate this point well by revealing the lessons they learnt by applying this process. Winners were mainly companies that they knew personally, were in industries they understood, and were run by people they knew. Losers on the other hand were penny stocks, technology stocks they did not understand, and tips from friends.
Thousands of years ago, Hippocrates provided advice to the physicians of the day that is still heeded by doctors in the 21st century: “First, do no harm.”
In this article we have tried, in similar fashion, to identify those behaviours that can be most harmful to your investment returns. Ignore them, and even the best positive investment strategy will be dragging its anchor. Follow the commandments, though, and you give your strategy wings!
Reference: Selecting Shares That Perform (4th Edition), by Richard Koch and Leo Gough. Published by FT Prentice Hall, 2008.
We have added a new exciting seminar to our popular forex and equities seminars, "Introduction to the Markets" specifically designed for beginners to kick-start their trading and investing future. Book for any of these great seminars by clicking here.