Investing Paradigms
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Stock Picking based on long term business expectations
If you are seeking higher returns, and are prepared to spend a considerable amount of time searching for and analyzing opportunities then picking investments based on long term business expectations may be something you can consider.
It is important to note that picking individual investments well enough to surpass an indexing approach is very difficult. The vast majority of active fund managers cannot beat an indexing approach in the long run. Further it is not obvious that managers that often beat an index approach are not just lucky. There is a significant amount of commentary that suggests those that can consistently provide a market beating return could just be statistical outliers, and happen to be lucky, not that they have an ability to do so. Further it should also be noted that many people work full time, in some cases close to 80 hours a week, and they are unable to consistently beat the market. It could be that no matter the skill level, experience, and effort, delivering consistent market beating returns may not be anything more than general good luck. Generally, these sentiments should dissuade most people from active investing, and are a warning if you are thinking about becoming a more active investor.
Assuming you believe that there is more than luck to achieve long term market beating returns there are several qualities and characteristics that successful active investors tend to have. You must also remain committed to constant learning and development as while many concepts in the market remain the same over time, market insights generally come from learning new things.
Humility
Humility is probably the key trait. Overestimating your abilities and believing you are more capable than you are can lead to large problems in investing. If you believe you have insights which you actually do not, you will act on incorrect information and this will inevitability lead to lower returns or outright losses depending on the severity of the issue.
Self awareness
Similar and related to humility, you have to know what you know and don’t know, which requires high levels of self-awareness. This can be challenging in the stock market because you will always have incomplete information, and a significant amount of information is either irrelevant or misleading.
Emotional awareness and control
Emotions tend to be a significant problem for most investors. If you have emotional attachment to the funds you have in the market, this will quite often severely impact how you make decisions regarding those funds, very often leading to poor returns or losses. This is a key reason most individuals should not be actively investing in the market: emotional detachment from funds invested is a rare quality.
Independent thinking
It is very important that you are able to think for yourself in the context of the market if you are seeking market beating returns. By definition, following the crowd will not lead to market beating returns. This quality has two sides. First and more obvious is that you cannot have a significant urge to follow the crowd. Second, and perhaps more subtly, is that you equally cannot have any compulsion to go against the crowd or prove the crowd wrong. You should be sufficiently independent in your thinking that you are fine either going with or against the crowd depending on the merits of your own thinking and assessments.
Objectivity
Very often you will make a decision in investing that will go right or wrong for reasons that had nothing to do with you. You must be able to identify when you made the right decision, yet achieved a negative outcome, and when you made a poor decision yet still achieved a positive outcome. If you are unable to do this, you will learn the wrong lessons from your activities and ultimately your long run returns will be less satisfying.
Interesting point to note with this trait, is that sometimes you will make an investment that works out extremely well, perhaps exceeding your expectations. When this happens, it is likely you were right about the opportunity direction, but wrong about the magnitude. Having something work out better than expected does not mean you are a great investor, it means you got lucky. It is important to know when this happens so you do not learn the wrong lesson or become overconfident.
Logical
Related to not being emotional when investing. When making investment decisions it is important to make decisions based on facts and factors and not the latest and greatest story or trends. While sometimes narratives or trends will be part of the factors you should consider when making an investment, they will generally only be a small part, and other business characteristics will dominate the decision to make an investment. Not having a reasoned, fact-based approach to decision making will lead to less than optimal investing returns.
Patience
To succeed in the long run you must have the patience to do so. This is both the patience to wait for the right opportunity to pursue as well as the patience to wait for the right opportunity to work for you. An excellent paradigm regarding investing is that you are not compensated when you buy, and you are not compensated when you sell, you are compensated to wait. This quality will greatly assist in achieving high long run returns.
If you don’t have the interest, qualities and desire to spend time doing this, Strategy 1 is probably better for you. Strategy 2 is something you can do to start out and keep your risks lower as you learn. Alternatively, you can engage a professional or a service to do this, but you then need to be careful about selecting the professional or service to ensure they know what they are doing and are broadly aligned with your goals.
If you are undeterred, firstly there is a high probability that you are wrong in your pursuit of picking stocks, and secondly there is a very large amount of information you will need to learn to start doing this effectively.
Key Paradigm
This strategy is not one of diversification. If you are looking to spread risks, then an index fund is hard to beat. It is very difficult to have one good investment idea at any time, let alone 20 or more. Alternatively, it is unlikely that your 20th best investing idea is as good as your 1st or 2nd. With this approach you are looking for a small number of great opportunities and concentrating your actions on those opportunities that provide the best returns. Some of the best investors in the world only average one really good opportunity about every 5 years.
There is no perfect answer to how many businesses you should own simultaneously. Theoretically, you should be all in on your absolute best investment idea as the purist form of this strategy. However, there will always be things you don’t know and can’t see. You are taking risks with unknown unknowns, so a minimum of three different investments at any time would likely be the least number of investments to own at one time. Further, you should factor in your own characteristics, preferences, and self-knowledge to know what you personally could be comfortable with. It is likely that if you have 10 or more different investments you are diverging from an effective strategy, so something around there is likely to be a good upper limit. It is also very difficult to have more than 10 great ideas or opportunities at any one time. Taken together, this means that depending on your circumstances, somewhere between 3 and 10 individual investments is likely to be about right, perhaps converging on 5 to 7, depending on opportunities and circumstances.
You also cannot be afraid to make large moves when you see the opportunity. Once you have done all your homework, verified all your thinking, and fundamentally understand something is a large opportunity, you cannot be afraid to make large moves. This suggests 10% or your investable funds minimum in any opportunity where this applies, pushing perhaps closer to 20% to hit the 5 to 7 range in terms of number of investments you own. Ultimately, when you see a great opportunity, you have to go big if you want long run market beating returns.
The points outlined regarding this key paradigm are guidelines, not hard and fast rules. As you progress on your investing journey you will discover what works best for you, which may or may not fit exactly within these guidelines. However many people starting out are interested in details regarding a specific number of investments to own, so these guidelines are a reasonable start for this strategy. It is also reasonable when you are first starting out to use a more diversified strategy while you learn as a risk mitigation approach, knowing that once you are comfortable you will focus your portfolio appropriately.
Many will say this is unnecessarily risky, and for the most part that is correct. It is perfectly acceptable to follow a diversified strategy, attaining market level returns in the long run. That will for the vast majority of individuals lead to substantial long run returns allowing most to live whatever style of life they desire. However, a component of this strategy is the goal to make outsized returns to attain very high levels of wealth, and concentration in a limited number of great opportunities is required in order for that to be possible. This is not too different than the business owner who puts everything into their business with the goal of a significant pay off one day in the future. From that perspective, owning a small number of investments is perfectly reasonable, so long as you fundamentally understand them, have done all your diligence, and have a high degree of confidence in them.