We’ve all been there. Picked some great stocks with conviction. Run our winners. Been delighted with the gains. Only to see those gains drain away.
It hurts, it’s galling and you are left wondering where you went wrong.
Worse than that, by the time it happens you may have started counting on those gains as part of your future planning. How are you going to pay for that big ticket item – that home purchase, a children’s education, or that early retirement. It’s very real.
In this piece, I’ll introduce the three mistakes we can all make, and the three solutions.
But first, a personal tale…
(NB – If you’re curious how to build a smarter, rules-based portfolio, join me for a live webinar on Thursday 22nd May at 5pm (BST) – and read on to learn more).
An early education
For me, my big lesson came in the global financial crisis. I was young enough to be reckless, but old enough to have known better.
I had a silly amount of my capital riding on two big picks. Both were AIM listed stocks. One was called Renesola (SOLA) – a solar energy company that was absolutely smashing it on sales growth. The other was RC Group (RCG) – a biometrics company. I’m sure some of you remember these stocks.
I’d bought really well. And I’d bought more as they rose. At their peak, I had 50% of my portfolio in RCG, and probably 30% in SOLA. They really were motoring – they had both already tripled. I couldn’t have been more confident.
It was 2007… what could possibly have gone wrong?
The mistakes we all make
There’s an eye-opening academic research paper by Barber and Odean titled “The Behaviour of Individual Investors”. When I first read it I was gobsmacked. It was a mirror of every mistake I’d ever made, and hugely influential in shaping my future mindset.
I’ve thought long and hard about their findings, and grouped them into three themes:
1. We suffer “perverse stock selection”
That quoted phrase is their words. We often pick risky stocks for the wrong reasons.
We often talk about the perils of story stocks at Stockopedia.com. Stories are how the human mind makes sense of the world, but projecting a hollywood ending onto a share is not rational.
Whether we’re chasing headlines, themes we know a lot about or jumping on a bandwagon so not to miss out. We seem to have a “taste for stocks with lottery-like payoffs”.
But lottery tickets have negative returns!
2. We underdiversify
We buy a share and get to know the theme. The price goes in the right direction, and we buy more. We buy another benefiting from the same theme.
One highlight from the paper showed that “on average investors hold only four stocks” which tend to be “highly correlated” – i.e. too few stocks in too few sectors.
I ended up in 2007 with a portfolio 80% in Chinese AIM stocks. Hindsight is wonderful isn’t it.
3. We buy and sell recklessly
We’re human. We’re prone to want to do something. This action bias might have helped when we were chased by lions, but in volatile markets it’s an extremely expensive tendency.
It’s so easy to buy and sell these days. A trade is just a thumb press away. But ease of trading does not a disciplined investor make. 20% of investors turn over their portfolio almost three times per year – which is not only hugely costly in terms of transaction and tax costs, but can’t be good for mental health.
Beyond this, we’re terribly prone to hanging onto our losers, and snatching at profits. And even worse, we tend to pull all our capital out of the market at lows, and reinvest at highs.
The 3D framework that solves for these
I’m sure we can all recognise some of these behaviours in our own habits. But as John Templeton once said “If you want to have a better performance than the crowd, you must do something differently from the crowd”.
So in this vein, I propose three dimensions of intelligent investing that can guarantee you invest contrary to the three mistakes that almost all investors make.
- Invest in stocks exposed to proven Return Drivers.
- The simple solution to “perverse stock selection”.
- Buy good (quality), inexpensive (value), rising (momentum) shares.
- These kinds of shares are highlighted by the Stockopedia StockRanks – which score every share for their quality, value and momentum. These kinds of shares are remarkably ignored by the crowd, but have consistently outperformed over the last decade.
- Ensure you have enough Diversity in your portfolio construction.
- In ten years of tracking portfolios the highest probability shares, only 7% are likely to double in a single year. So we don’t diversify just to reduce risk, we diversify to maximise our chance of owning a big winner. These are the stocks that can make a real difference to your portfolio.
- Own at least 14 stocks to give yourself a better chance of holding a multibagger.
- Own stocks across at least 6 (out of 10) sectors, and make sure you own both cyclicals and defensives. Think of your portfolio like a football team – you need strikers and defenders. And be careful going all-in on a favourite theme – we are not so smart!
- Avoid huge positions. Start with equal weights.
- Pre-commit to buy and sell Discipline.
- Have a plan for every share purchase – a plan actively helps you avoid reactive over-trading and snatching at profits. This includes having a sell plan. Whether that sell plan is based on time (e.g. after a one year holding period – to accrue gains), thresholds (e.g. when value is realised, or the StockRank falls below a certain level), or events (e.g. selling immediately on a profit warning).
- Only hold for the long term the highest quality securities. Be extremely wary of just holding because you’ve grown familiar with the story. The numbers must back it up. As Jim Slater would say – “be first in the line of disappointed enthusiasts” if something goes wrong.
- Don’t hang onto your losers – have a bias to selling them (using a stop loss, or after a fixed time), or average down (but only if you have genuine insight – which you probably don’t). Doing nothing creates opportunity cost, and can turn a small loss into a big one.
The consistent application of simple rules is extraordinarily powerful. As Van K Tharp once said:
If you don’t have rules, everything you do is a mistake.
Putting the rules to work
At Stockopedia, we’ve run a portfolio based on these principles for a decade. It’s an equal weighted 20 stock portfolio, populated with the highest quality, value and momentum stocks, refreshed once per year. There’s no stock picking. It’s a simple rules-based approach that works.
Known as the “NAPS” Portfolio – as it’s a “no admin portfolio system” – the portfolio has beaten every single fund manager in the UK over the decade to 2025.
To learn more about putting these ideas to work in your own investing, or to learn about how the NAPS Portfolio works – join us for a live session this Thursday 22nd May at 5pm – “The Smarter Way to Build a Market-Beating Share Portfolio” – or catch up on the replay if you miss the date.