I have been in this business for almost 20 years now, and what I have found is that most investors want the CliffsNotes: a shortcut to success.
They latch onto things like P/E ratios and book values to judge whether a stock is worth buying and really don’t dig much deeper than that to make their decision. It helps quite a bit if someone they know that uses another method like Price to Sales ratios or Multiple of User Units as their guide mentions a stock they like over cocktails or dinner.
If that happens, then the move becomes a no-brainer. You would be a fool not to buy. Of course, that is where most people end their due diligence on a trade.
The decision to hold or sell a stock becomes mostly a function of market price versus purchase price. The sell discipline for these investors has little to do with how well the company is performing or meeting its corporate goals and quite a bit to do with how much over or under the purchase price their stock has moved.
Talk vs. walk
If you asked these same investors what they think are the most important aspects of successful investing, many of them would talk about diversification and risk management, sustainable earnings growth, market advantage and corporate culture.
There is no doubt that these are important functions of the investment process, but in the real world, most individual investors talk the talk much more than they walk the walk. Then they ask me why they aren’t doing as well as the professionals.
The fact is that it is hard to stay on track. Emotions are the enemy of good investing and emotions are one of the main reasons why individual investors under-perform their professional counterparts.
Confronting the enemy
There is only one way I know to cut the emotional aspect out of your investment decision. That is to create a process that you use for every investment decision and force yourself to apply it regardless of what your gut, neighbor, drinking buddy or co-worker says.
It starts with an Investment Policy Statement (IPS). Most professional investors rely heavily on their Investment Policy Statement to guide their actions. If an investment doesn’t fit into their IPS they either have to pass on it or change their IPS to include that type of investment. You can’t make a rash decision if you follow the process.
If your investment idea passes the IPS test then you follow the process to the next step which may be the allocation part of the process. Now you have to make sure your new idea doesn’t mess up your allocation model. If it does, then you have to make changes in your model to accommodate your new investment or you can’t buy it.
After each part of the process, you move to the next step until you have pushed your way through the entire process. Then you have the ability to make an informed decision. It’s not as easy as the “my friend has a hot tip” process, but it is why the average professional investors tend to outperform the average individual investor by a fairly large margin.
Seeing how it works
I understand that most of you are not ready or qualified to put together your own investment process without some help, so I have a suggestion. Find a professional group and get involved in their investment committee. I know what you are thinking. You can’t just find a professional investment group and join their investment committee, but it may be easier than you think.
Most people don’t realize that professional investors include many non-profit groups that have enough money to require a high level of investment service. Groups such as your local United Way may have reserve funds or an endowment fund that is being run through an investment process. If your church is large enough, they may be investing their money through a process. And most companies that offer retirement plans have an investment committee that is required to oversee the investment process for their retirement plan. In many cases these groups would love for you to volunteer for their investment committee. It can be a great way to learn how to invest your money through a higher quality process.
Anyone who is handling someone else’s money has a responsibility to do it properly. That doesn’t mean that all of these groups are doing it right. As a matter of fact, a lot of them need to be updated. But they are part of the group we call professional investors and they have a standard of excellence they should be striving to live up to. And I think it is a great way to learn the ropes without having to pay to go to class. Not only that, you will have the satisfaction of knowing that you are helping someone while you learn.
The United Way is a good place to start looking because even if they don’t need someone on their investment committee, they may very well work with an agency that does. Once you start to learn how to handle other people’s money, it can make a big difference in the way you handle your own.
Contact MBJ contributing columnist Scott Reed, CIMA, CWA, AIF, of Hilliard Lyons, member NYSE & SIPC, in Tupelo at firstname.lastname@example.org.