How to be a great investor, by choice

Like any activity where the results are affected by talent, some people are born to be great investors; but most are not.  Most private investors fail to match the returns of professional investors, and most professional investors fail to match the returns of a simple index tracking strategy.

However, great investors do exist, and although you cannot change your innate talent, there are many things you can do if greatness is what you aspire to.

Greatness is largely a matter of conscious choice and discipline

I’m a big fan of Jim Collins, the author of several outstanding business books, including Great by Choice: How to Manage Through Chaos and Good to Great: Why Some Companies Make the Leap and Others Don’t.

What I like most of all is the way he breaks down complex questions into a small number of critical behaviours, and then structures and frames them in a memorable way.

His books have been massively successful, far beyond their original business sphere, because many of the ideas are applicable to life in general as well as business, and I think many of them apply to the world of investing too.

Here are some of the key ideas from Great by Choice, which are paralleled by the actions of many great investors, and which can be learned and applied by those who aspire to be great investors themselves.

Clear Eyed and Stoic

“Great [investors] accept, without complaint, that they face forces beyond their control, that they cannot accurately predict events, and that nothing is certain; yet they utterly reject the idea that luck, chaos, or any other external factor will determine whether they succeed or fail.”

The first lesson from Great by Choice is that the world is a harsh and uncertain place, and yet to be successful, you must believe that you are responsible for your success or failure.

This is an especially difficult idea to apply in the world of investing, where in the short-term, luck is as big a factor as skill.

Although luck may dominate the results of any individual investment (for example, my investment in UTV Media returned over 40% in just seven months, which was as much luck as anything else), in the longer term, your ability to make the right decisions will be the most important factor.

Because of that, your long-term results are down to you, regardless of how uncertain the market may be.

Fanatic Discipline

“[Great investors] display extreme consistency of action—consistency with values, goals, performance standards, and methods. They are utterly relentless, monomaniacal, unbending in their focus on their quests.”

There are two lessons here:

The first is that great investors are usually extremely consistent in the way they apply their investment process.

Those two benchmarks of mainstream value investing, Warren Buffett and Neil Woodford, have both been doing more or less the same thing for decades – buying good businesses at good prices.  Over many years they have both applied themselves with relentless consistency, which takes great discipline.

The second lesson is that this consistency isn’t just applied to the methods and systems used to manage their funds.  The same consistency is applied to their goals, or as Collins puts it, their quests.

Consistent, disciplined action will massively increase the chances that any goal will be reached, but if the goal keeps changing, it will undermine your chances of achieving anything.

In the world of investing, there is usually one goal which matters more than any other, and that is the goal of beating the market over the long term.  Look at Warren Buffett’s annual letter to shareholders, and the first thing you will see is the company’s long-term results compared to the S&P500 (including reinvested dividends).

The table of results goes back to 1965 and shows the results for each year, the total compound rate of return to date (19.8% for Berkshire and 9.2% for the S&P500 as of 2011), and the total return in that time (513,055% for Berkshire, 6,397% for the S&P500).

To say that Buffett has a relentless, monomaniacal focus on his quest to beat the market is perhaps an understatement.

The 20-mile march

However, at the same time, Buffett has avoided overextending himself and his company during good times, an approach that Collins calls the 20-mile march.

The 20-mile march is an approach to consistently achieving goals which focuses as much on not over-achieving as it does on never under-achieving.  Without this discipline, companies, investors and people often over-extend themselves in the pursuit of ever-greater gains.

In the world of investing, this mostly relates to using debt to increase returns.  As we’ve just found out during the housing bubble and the banking crisis, investment returns can be massively increased by borrowing money to invest.

But the downside is that if things turn against you while you’re over-extended – you’re dead, and once you’re dead, you can never come back.

Empirical Creativity

“When faced with uncertainty, [great investors] do not look primarily to other people, conventional wisdom, authority figures, or peers for direction; they look primarily to empirical evidence. They rely upon direct observation, practical experimentation, and direct engagement with tangible evidence.”

Next to Lemmings, investors are perhaps the worst group you’d want to follow.  They have a terrible habit of finding the biggest cliff and jumping straight off it.

There is only one reliable antidote to the madness of this particular crowd, and it is to be found in the disciplined application of hard evidence and research which has been conducted over the best part of a century.

In effect, when you manage a portfolio of stocks, you are conducting one long research study into how good you are as an investor.

Collins uses the term “Fire bullets, then cannonballs” to describe an approach to taking small learning steps before committing fully.  In other words, take many small, low-risk steps to find out what works, and only then go in with conviction.

In the same way, investors can learn as they go by firing “investment bullets” – small bets on investment ideas which allow them to learn about investing while having real money at stake, an important psychological factor that cannot be replicated with virtual trading accounts.

And the learning never ends.  In my opinion, one of the benefits of holding 20 or 30 companies instead of 5 or 10 is that the number of opportunities to learn is so much greater, and the risks of each lesson are so much smaller.

I still follow this approach today.  With a target of 30 holdings in the UKVI portfolio, it’s highly unlikely that any one stock will reach even 10% of the total amount.

This means that I have more “experiments” running at the same time, giving more opportunities to learn more lessons with less risk than if the portfolio were more concentrated.

Productive Paranoia

“[Great investors] maintain hyper-vigilance, staying highly attuned to threats and changes in their environment. Even when – especially when – all is going well. They assume conditions will turn against them at perhaps the worst possible moment. They channel their fear and worry into action – preparing, developing contingency plans, building buffers, and maintaining large margins of safety.”

The future is uncertain, but what we can be certain about is that, at some point, things are going to get very ugly.  That’s easy to say in 2012, as we’re five years into the biggest slump since the 1930’s.  In 2006 such concerns would likely have fallen on deaf ears because Gordon Brown had, apparently, broken the cycle of boom and bust.

The world is a cyclical place; it’s just a fact, and because it’s a fact, we should hope for the best and prepare for the worst.

The first step in risk reduction in the stock market is to diversify enough so that a total collapse of any one holding won’t be enough to scare you out of the market.  I prefer to be diversified enough so that a 100% loss in any one holding will probably be replaced in a single year by the dividend income from all the other holdings.

When an economic crisis occurs, it’s often geographic in nature, affecting one country or region of the world more than others.  The obvious response is to use diversification to reduce the risk and to have a portfolio which generates cash from around the world.

Sometimes a crisis can occur in one industry, such as the music industry.  Again, the obvious response is to diversify into many different industries, as unrelated as mining and music.

Sometimes everything takes a beating.  In some market environments like March 2009, every stock drops by a huge amount, regardless of its industry or where it operates in the world.

This risk can be offset by using cash as a buffer by holding enough cash so that you can ride out a colossal market crash, avoiding the worst of all possible mistakes: selling at the bottom.

The death line

Having a highly concentrated, high-risk portfolio is akin to investing near what Collins calls “the death line”; the point at which one small mistake, or piece of bad luck, can send you spiralling into the grave.

For investors, the grave is replaced by the act of selling at the bottom, which, although not quite as bad as death, is still a traumatic event for many, and it’s something that few can come back from.

Never come anywhere near the death line.  In a few years, the economy may look fine, and you think that your portfolio is safe, but things could turn bad again very quickly, and most people will only realise they’re carrying too much risk when it’s too late and they cannot stop themselves from pressing the sell button.

My personal approach to productive paranoia is to mix aggressive diversification with quality holdings, only owning companies that are highly successful market leaders with outstanding track records of success, combined with strong balance sheets, all bought at low valuations.

Think risk first, returns second.

By accepting that the future will be very unpleasant at some point, you can take proactive measures to ensure that you are in it for the long haul and in a position to reap the rewards of being greedy when others are fearful.

Consistent, disciplined, researched, cautious action towards a consistent long-term goal

These principles can help to form the foundation for any investor who wants to beat the market and go on to become a great investor.

Without this foundation, beating the market is simply a game of luck in which the odds of success are tiny.  With them, the task becomes achievable and within the investor’s control.