In practice: First steps

Part 3 of a series of 4 articles on beginning value investing, originally published in the gleaming new-look Interactive Investor mothership’s Trading and Investing Strategies pages. If you’re new to value investing, or a seasoned bargain hunter, I’d like to know whether you think I’ve done a good job explaining the basics.

No matter how many guides you’ve read, every company is different. Investing, which may seem comprehensible in theory, suddenly looks complicated and uncertain when you put it into practice.

The only way to get experience is to invest, but plunge right in and your first years as an investor will probably be the riskiest. If you’re lucky you’ll pick winners and survive long enough to develop the skills you need. If you’re unlucky you’ll pick lemons, lose money and give up.

To add to the dilemma, the standard defence against stupidity and bad luck is diversification, owning shares in lots of different companies. The more shares you own, the less severe the impact if one or two do badly. But to buy lots of shares you must commit lots of money at the riskiest time of your career, and you must know about many different companies when you’re profoundly ignorant!

It’s a Catch-22 situation, but there are ways around it:

Phantom portfolios

To set up a phantom portfolio, you pick stocks but never buy them. Instead, you track the shares in an online portfolio like Interactive Investor’s, or an Excel spreadsheet, or even a piece of paper, and see how you do.

It sounds like a painless way to learn from your mistakes and you don’t need any money to do it, but there are two big disadvantages. It takes years, five at least, to establish an investment record you can credit to skill, as opposed to luck, and people behave differently when their children’s’ inheritances rest on the decisions they make.

Run a phantom portfolio by all means if you’re very patient, and prepared to take it very seriously.

Investment clubs

Clubbing together with other investors means you can pool your money and your talent. Setting up an investment club is fairly easy; an organisation called Proshare sells a guide. You’ll be risking only a fraction of the money required to build a diversified portfolio of your own, and the sum of your intellects may be greater than the parts.

The only problem is you’re investing with other people who make decisions about your money by show of hands in monthly meetings, so you must get on with them.

Start an investment club if you can gather enough people you trust who are committed to researching shares, learning about investment and administering the club.

Fund plus ‘fun money’

You can commit a small amount of ‘fun money’ to a small portfolio of say four or five shares, and remain diversified by investing the rest of the savings you have earmarked for shares in a sensible fund. Choosing a sensible fund can be as difficult as choosing a sensible company but the advantage is you only have to do it once, rather than twenty times to fill your portfolio.

I apply the same principle to choosing funds as companies; I want a good fund at a cheap price. The price, in this case, consists of the fees you pay the fund manager and the broker. The easiest solution is a global or FTSE All-Share index tracker which guarantees diversification and average performance at low cost.

Many experienced stock pickers continue to use funds to diversify their portfolios. Nearly 75% of my pension is in individual companies, but the rest is in Fundsmith. Its manager, Terry Smith, follows value investing principles like mine, but applies them to the world’s biggest companies, while I focus on small UK companies. The charges are low, so it meets my criteria of a good fund at a cheap price.

Invest in a fund plus ‘fun money’ if you can afford to put aside enough for a diversified portfolio. Realistically, that’s about £20,000 or £1,000 for every company, with the balance in a fund.

Mechanical investing

Finally, there is a way to invest in a portfolio of shares relatively quickly without throwing darts at the companies and markets page of the Financial Times. You let the computer do the leg work by programming it to find good companies at cheap prices using financial data from company accounts.

The ‘programming’ is far easier than it sounds as there are sites and software that do it for you. The difficulty is finding a system you can trust. That’s because all systems do badly at times and if you give up then, your investments will have done badly too. Your only defence is to understand the system well enough to stick with it for better and worse.

Joel Greenblatt‘s Magic Formula is a good example because it targets good companies at cheap prices. Greenblatt is a respected value investor, and his bestseller The Little Book That Still Beats The Market explains the system well. His site only covers the US market, but various companies offer Magic Formula picks for the UK.

Only follow a system if you understand it, are prepared to follow it through thick and thin, and invest enough money to fund a diversified portfolio.

Taking your first steps:

• Start a portfolio on Interactive Investor

• Start an investment club with Proshare

• Read The Little Book That Still Beats the Market by Joel Greenblatt

• A review of Magic Formula data services