Field of play
Like a business
The purpose of this post is to say a few words about investing in common stocks and hopefully provide some encouragement to other investors.
When I started investing, I put all our savings into an all-stock mutual fund and opened a practice account with a broker. The practice account had enough money in it to keep my attention but not enough that total loss would be a disaster. After ten years I decided I could manage my own investments. I cashed in the mutual fund and have been managing our family portfolio since. Over the last fifty years our default asset allocation has been 100% stocks.
It’s harder than it looks
As Ben Graham wrote: “To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.” (Graham, The Intelligent Investor, fourth revised edition. 1973) p. 287 Superior returns would be beating the market.
Sound investment process
The main thing is to develop a sound investment process, stick to it and do your homework.
Roger Lowenstein reports: “Most of what Buffett did, such as reading reports and trade journals, the small investor could also do. He felt very deeply that the common wisdom was dead wrong, the little guy could invest in the market, so long as he stuck to his Graham-and-Dodd knitting. But people, he found, either took to this approach immediately or they never did. Many had a “perverse” need to make it complicated.” (Lowenstein, Buffett, The Making of an American Capitalist. 1995,2008) p.331
By ‘Graham-and-Dodd knitting’ he means a sound investment process.
Businesslike
There is only one way to achieve this. Benjamin Graham tells us: “Investment is most intelligent when it is most businesslike. It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings. Yet every corporate security may be viewed, in the first instance, as an ownership interest in, or claim against, a specific business enterprise. And if a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success.” (Graham, 1973) p.286.
A game that requires study
Here are some wise words from Jesse Livermore, a famous stock market operator, written in 1923: “The average American is from Missouri everywhere and at all times except when he goes to the brokers’ offices and looks at the tape, whether it is stocks or commodities. The one game of all games that really requires study before making a play is the one he goes into without his usual highly intelligent preliminary and precautionary doubts. He will risk half his fortune in the stock market with less reflection than he devoted to the selection of a medium-price automobile.” (Lefevre, Reminiscences of a Stock Market Operator. 1923,1993) p.121.
I never tire of saying that individual investors are at no disadvantage to the professionals (as Warren Buffett suggests above). Indeed, I believe they actually have an advantage as they have no career, client or peer pressure. But they will only succeed if the venture is treated like a business.
The S&P 500
I much prefer to invest in individual stocks rather than an index ETF.
If the S&P 500 were a portfolio it would be thought hopelessly over diversified and filled with a lot of underperforming companies that would be pruned by a competent investor. The stocks in the S&P 500 are chosen by a McGraw Hill Financial S&P index committee based on standard criteria such as market capitalization, liquidity, public float, sector balance, financial viability and domicile. Looked at this way one would think it not too difficult to outperform such a portfolio.
The main advantage the index has over investors, whether individual or professional, is that the S&P 500 doesn’t suffer from market psychology/behavioral problems because it doesn’t buy and sell in the usual sense. Stocks are added and removed from the index based on fairly objective criteria. The market index doesn’t try to time the market.
I firmly believe the stock market is essentially inefficient. I would put it this way: the market is value inefficient because of Mr. Market. For individuals and pro’s alike, markets are hard to beat because of our human frailties. Ironically, in many ways, the stock market is essentially inefficient because investors believe it is efficient; i.e. they tend to think the price is right, which is why they get things wrong.
The main drawback with index funds is that one cannot practice value investing with index funds. Value investing involves investing in superb companies when their price is temporarily depressed. This happens regularly through the stock cycle, not only when there is a general bear market. Some funds claim to value invest by investing in value stocks. They do not value invest. But that is another story. However, investing in index funds you can’t beat the market. With index funds you can achieve satisfactory results, just not superior.
Do we have to identify the next Apple, Microsoft, Amazon etc.?
Some statisticians have argued that positive skew, as they call it, makes it virtually impossible to beat the indexes. Positive skew is the impact that stocks like Apple and Amazon have on an index. It is thought that unless you are able to identify and invest in these wildly successful stocks you can’t hope to keep up with the index.
Barry Ritholtz on July 29, 2019 in a Bloomberg Opinion piece reports: “Just 1.3% of the world’s public companies account for all the market gains during the past three decades. Outside the U.S., the gains are even more concentrated, with less than 1% of all equities driving all of the net appreciation in share prices.” And: “Just five companies — Apple Inc., Microsoft Corp., Amazon.Com Inc., Alphabet Inc. (Google) and Exxon Mobil Corp. — accounted for 8.3% of global net wealth creation.” The suggestion is that: “investors who index broadly may be more likely to hold the rare and outsized winners that drive much of the market gains over time.”
While this data may be accurate it does not mean that investors have to identify and invest in the stocks that will act as the next Apple, Microsoft, Amazon, Google and Exxon over the next decade to beat the market. The concentration of the market gains is essentially a function of the oversized market capitalization of a limited number of stocks. That does not mean that there aren’t a good number of super performers with market caps that are not so super sized.
One way to come at the issue is to reflect on the performance of Warren Buffett over the years. He recommends a concentrated portfolio i.e., a small number of stocks. He stresses investing only in superb companies, what he calls the seven footers. He had never tried to identify the next Microsoft or Apple or Netflix. Berkshire Hathaway did invest in Apple in recent years but by that time it was already a mature company. Warren Buffett has beaten the market for decades with this approach.
And as I say, if the S&P 500 were a portfolio, it would be thought hopelessly over diversified and filled with a lot of underperforming companies that would be pruned by a competent investor. The S&P 500 contains many superb companies but also a lot of ‘also ran’ companies. I have never tried to identify the next Microsoft or the next Netflix. I don’t invest in these kinds of companies. I stick with the kind of superb companies described in Part 6 of the Motherlode which is titled The Hallmarks of Superb Businesses. I have written several posts on the subject.
Superior return
The total return on our family’s investable assets (retirement savings) has beaten the S&P 500 over more than fifty years, i.e. over the long haul. Our portfolio has been pretty conventional. I haven’t taken any big sector bets. For example, since I started investing, I have never had more than a 20% weighting in natural resource stocks, or tech stocks or any other sector for that matter. In the last forty years, I have always owned more than ten stocks and less than 30. I have never owned a gold stock. I’ve written posts detailing our portfolio. It’s relatively boring.
Work involved
I spend Saturday mornings looking at news related to our stocks and reading analysts reports. I take a quick look at closing markets every evening. I read books on investing from time to time. Altogether, I have probably averaged about one book on investing a year. I read the business section of our newspaper in Toronto and subscribe to The Economist magazine. I buy and sell infrequently. My longest holding at this point is a stock I bought in 1998.
Conclusion
My message is that a well-diversified, well-balanced and well managed portfolio should be able to beat the market. One has to follow the sound principles of operation described in Part 4 of the Motherlode, so your homework, avoid the behavioral gap and take advantage of the behavioral edge. Or at least, that is one way of doing it. Others may have their own approaches.
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Sticking with your knitting also means keeping it simple. Here’s an earlier post on the KISS approach to investing:
My take on simplicity in investing
To dig into the development of a sound investment process a bit deeper, take a look at the Motherlode Chapter 27. Sound Principles of Operation
That Chapter continues with these Sections:
27.02 Sound Principles of Operation
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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