Every now and then it’s useful to step back and look at your investment process to see what’s working and what isn’t working. Here are four good habits which we think investors should try to adopt.

1. STAY FOCUSED

One of the most common mistakes investors make is to spread their bets too thinly across too many companies or funds in the belief that they are creating an ‘all-weather portfolio’.

Modern portfolio theory says that by diversifying your assets you are reducing your risk. In fact, you reduce risk by buying superior companies and holding onto them. Less is more, and all you are doing by owning more stocks than you need is diluting your returns.

The case for running a concentrated portfolio (such as 20 to 30 stocks, rather than 200 to 300) is obvious from the above-average performance of firms like the Warren Buffett-run Berkshire Hathaway and funds like Fundsmith Equity (B41YBW7).

It is also well documented in modern academic studies. In Diversification Versus Concentration, published by the Paul Woolley Centre for the Study of Capital Market Dysfunctionality, Danny Yeung and his colleagues analysed the relative performance of nearly 5,000 US mutual funds and found the funds with concentrated portfolios achieved better returns.

The authors concluded: ‘This highlights the potential for investors to diversify across concentrated funds rather than have the funds do the diversification themselves. It also highlights that the stock selection skills of the managers may be lost by their portfolio construction endeavours.’

Another study, Best Ideas by Anton, Cohen and Polk, found that the stocks in which active mutual fund or hedge fund managers showed the most conviction, namely their best ideas, beat the market and the other stocks in their portfolios by between 2.8% and 4.5% per year, depending on the benchmark employed.

That level of outperformance or ‘alpha generation’ is striking, and if compounding were applied over say a 10-year period the gap between the best stocks and the average would be vast.

The authors somewhat provocatively conclude that since most of the other stocks the managers hold don’t perform as well, ‘the organisation of the money management industry appears to make it optimal for managers to introduce stocks into their portfolio that are not outperformers. We argue that investors would benefit if managers held more concentrated portfolios.’

2. DON’T TRY TO TIME THE MARKET

If the last two years have taught us anything it’s that trying to time the market is nigh-on impossible. Not even the highest-paid market professionals could have seen the pandemic coming or predicted the extent of its impact on the market, and even if they could it’s not likely they would have predicted the speed or the size of the stock market rebound.

Similarly, this year’s sudden repricing of risk caught most investors on the hop. While it was common knowledge the Federal Reserve would tighten monetary conditions, the precise timing of the knee-jerk sell-off was a complete unknown.

However, the long-term performance of stocks beats just about any other asset class, real or financial, and this is helped in large part by dividend reinvestment and compounding.

Investors who understand the importance of time in the market will always beat those who try to time it. Far better to leave your money where it is, look in on it now and again and make sure you are still happy with your choices, and let your investments grow steadily.

Taking money out of the market wholesale risks missing significant upside moves. According to Investing.com, there were over a dozen moves of more than 2% in the FTSE 100 index between the start of March and the middle of April 2020.

If investors had capitulated halfway through March, after the initial fall in the index, they would have missed every one of the up days including a 9% rally on 24 March. Investors who held their nerve and stayed put reaped the gains and the full extent of the rebound.

3. RUN YOUR WINNERS

It may seem at odds with the current mood given the nervousness in global markets, but investors should resist the temptation to cash in their winners when things get hairy.

Convention wisdom says nobody ever lost money by taking profits. While that’s true, it misses the bigger point that nobody ever got seriously rich by cashing in early. Building real wealth takes patience, which means letting winners run.

Lawrence Burns, co-manager of Scottish Mortgage Investment Trust (SMT), makes a crucial point. He says: ‘A client is unlikely to be unhappy or indeed notice if a fund manager sells a stock that subsequently goes up significantly. That loss – of forgone upside – isn’t captured in performance data, but perhaps it should be.’

Burns turns conventional thinking on its head: ‘For the client, equity investing is asymmetric, the upside of not selling is near unlimited, while the downside is naturally capped. It is often not just wrong to take a profit, but it can be the worst possible mistake.’

He gives the example of Masayoshi Son, the founder of Softbank, who in early 2000 invested $20 million in a Chinese e-commerce company. At the same time, US investment bank Goldman Sachs was offered a 50% stake for just $5 million, although it eventually invested just $3 million.

Five years later Goldman sold its stake for $22 million, a seven-fold return, on the basis it’s never wrong to take a profit. Today that stake would be worth over $200 billion. Son, who held onto his stake, now has an investment worth over $180 billion.

4. CUT YOUR LOSERS

If running winners can often take nerves of steel, selling loss-making positions is even tougher. All investors find it difficult to face the possibility they may have screwed up, hence the need to fact-check your views now and then and make sure you still have conviction                                                                 in a stock.

Thanks to evolution we are hard-wired to feel pain more intensely than pleasure. If we put our hand in a roaring fire and it hurts, self-preservation kicks in and we are less likely to do it again.

Most of us research stocks so that we can invest in them for the long term, but as Joachim Klement says in his book Seven Mistakes Every Investor Makes, there are risks to performance from being ‘the wrong kind of long-term investor’.

Say you buy a stock which on the face of it is uncommonly cheap, with a pessimistic growth outlook and few buyers, on the basis the market is wrong, and you are right.

If the share price fell by 20%, you need the stock to rally 25% just to get back to where you bought it. That’s not impossible, but if the share price lost another 20% you need it to rally 50% to get back to breakeven, which is a lot less likely.

‘A long-term investment approach is highly recommendable,’ says Klement, ‘but there comes a point when losses in the interim become so large that it is virtually impossible to ever break even again. If you then still stick to your investment, you are no longer a long-term investor, you are just stubborn.’

There is an old market adage: the first cut is the cheapest. If something you own starts losing you money because the investment case has changed, do something about it. Or as Keynes would say, when the facts change, change your mind.

Disclaimer: The author Ian Conway owns shares in Scottish Mortgage and the editor Daniel Coatsworth has a personal investment in Fundsmith Equity

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