Guarding against ego risk
Posted on October 7, 2009 by Richard Beddard
Filed Under Investing, Markets, Thrifty 30 |
In practice:
Up fell, down dale
I’ll start today’s blog more or less where I finished Monday’s appraisal of Anite, a profitable software company, with strong finances that is maybe, kind of, but not certainly, cheap.
Like most value investors I think much more about safety, than I do about returns, taking the view, contrary to conventional thinking, that the fewer risks you take, the greater the rewards that follow.
There are three big risks, by which I mean factors we can know about now, that make it less likely that we will do well out of a share:
- The shares are expensive
- The company’s finances are so poor it could go bust, and…
- …Its business is deteriorating irrevocably. It’s product is, say, obsolete.
If any of those risks apply, then it’s a bad idea to invest, even in a portfolio of up to 20 to 30 shares like the Thrifty 30. Arguably, you wouldn’t be investing, you’d be gambling because you wouldn’t have much confidence in the outcome.
But, if the company is well financed, it’s product is in demand, and its shares are cheap, very likely it’s a good investment.
Running down Coniston Old Man on Saturday, and especially running along the shores of Coniston Water, I began thinking about a fourth factor that can influence an investor’s returns, and fittingly in the blustery conditions, it’s much more slippery.
I was running in an organised event, one of a series of four Lakeland Trails.
The typical course profile is a simple mountain-shaped ‘V’. The race sets off up a fell, and somewhere around half way it turns down. Coniston added a small variation to the formula, the last few kilometres being flat. Other races are more ‘W’ shaped, or ‘WWW’, but this isn’t a blog about the economic outlook.
As we trailed up the fells I chastised the organisers for leading us up the steepest section of the course single-file along a narrow path. All it took was for one runner to walk, and the rest of us were stuck in a time-sapping procession. If these people didn’t want to run, I shouted internally, why had they entered a race?
Then, up on the fells the field stretched out, the path broadened and a friend, a proper fell runner, joined me. My spirits lifted, I strode out, galloping past the halfway mark.
But running fast down rocky slopes for mile after mile can be a leg-sapping experience, especially for a runner who’s done most of his training in Cambridgeshire. Gravity ensures that you don’t realise how much life has been leached from your legs until the downhill ends, but running along the flat Cumbria Way that day I realised the battery had gone flat, and the tyres. Stopping myself falling on my face with every new step was an effort.
Every ill-disciplined runner has stories like this. The hubris and the subsequent shame of an ill-judged race. The very people I’d mocked on the way up, cantered past. Who knows whether they scoffed at me, perhaps they weren’t so uncharitable.
While receiving my athletic comeuppance I began thinking, probably deliriously, about the stockmarket and in particularly the wisdom of setting up a model portfolio in September when the market had already risen 45% from its March lows.
Many of the shares I’d picked, I’d previously identified at lower prices so perhaps I was in a similar mindset to the one I experienced as I exuberantly began the descent from Coniston’s fells.
Frustrated that I had not started the portfolio earlier I ‘bought’ all of the companies I’d uncovered (eight of them) that still fitted my criteria.
But, since rising prices will have sucked some of the potential out of these shares, and worse, many commentators fear it’s a sucker’s rally anyway, perhaps this portfolio will suffer the fate I did in the race and limp home to an unsatisfactory result.
I tell this story not just because I enjoy wallowing in self-doubt but also because I read that private investors are piling back into the stockmarket, I hope not out of frustration that they hadn’t done so earlier.
Such ‘ego risk’ belongs to a subset of risks pertaining to the investor, rather than the investment. Like complacency, sloth, pride, gullibility and a host of deadly and dangerous sins, it blinds us to the more prosaic risks I mentioned earlier.
As for the Thrifty 30, I’ve protected it as much as I can:
- The companies must meet my criteria (see the checklist), so even if the stockmarket is no longer cheap, they should be.
- Two thirds of the portfolio is still in cash, so perhaps I haven’t been egotistical enough and…
- I’ll be entering all four Lakeland Trails again next year, plus the Great North Swim, so there’s plenty more opportunity for me to learn another lesson about humility.
Let’s hope it’s the mountains, and not the markets that dish it out.
_
As I said in my inaugural podcast, which sounds a bit like it was recorded using a tin and a piece of string, the level of the stockmarket does not tell us much on its own. It’s only when we compare the price of the market to what we’re getting in return, company profits for example, that we can tell whether share prices are cheap or expensive.
Very broadly speaking, when the market price is between about ten and fifteen times earnings (implying an average return of between 10% a year and just under 7% for UK stocks), shares are a reasonable long-term investment. Below ten, they’re a bargain, and above 15 investors should be cautious. It’s creeping up towards 15, but it isn’t there yet:
Which is probably why there’s so much disagreement about which way the market will go next. Since the answer is, obviously, either way, Business Week’s cover this week is especially clever (turn your monitor upside down to appreciate it fully, Hat tip: The Big Picture).
In theory:
Another lesson in humility
‘Iron’ Mike Tyson could teach investors a thing or two about humility.
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