Some lessons from my first 20 years as an investor (Part 2)

Last week I covered two of the biggest investment lessons I’ve learned in the past 20 years:

1. Begin slowly and carefully and
2. Exceptional results are more likely the result of luck than skill

I also mentioned how I’d sold everything at the bottom of the bear market in 2003 and, with hindsight, I think that blunder deserves to be highlighted with a lesson of its own.

Lesson 3: Don’t sell an investment just because the price is falling

Between 1995 (when I started investing) and 2000 (at the peak of the dot-com bubble) I had built up a retirement pot of about £20k and every penny of it was held in a FTSE All-Share tracker.

In 2003, after seeing the value of my pension pot decline by around 50%, I sold the lot and switched to the safety of cash. Of course, the market then turned around and gained 40% over the following year or two, which I completely missed out on.

So where did I go wrong?

My big mistake was to look purely at the price decline whilst paying no attention to what I was actually invested in.

Much like the famous painting which declares “This is not a pipe”, the price of the FTSE All-Share is not the FTSE All-Share.

The FTSE All-Share is a collection of several hundred publicly-listed companies, weighted towards large companies that generate hundreds of millions of pounds in revenues and profits every year.

The price of the FTSE All-Share is simply the price that other investors are willing to buy or sell a share of those companies for.

Looking at this idea from a different angle, if I’d invested in a buy-to-let property, with no mortgage, and had a happy tenant paying monthly rent that I put up by 5% every year, would it really matter if the market price of that house fell by 50%?

It might matter a lot if I had to sell the house in the near future, so price movements do matter to those who are looking to cash in their investments.

But what if I was looking to hold that property and receive a growing income (an inevitable capital gains) over the next ten or 20 years?

Why should I care if the price falls this year by 50%?

Okay, if the price falls by 50% because the roof falls in then fair enough. The roof falling in would either need additional funds to repair, or it would massively reduce the rental income.

But if the house is fine, the tenant is happy and the future looks little changed than before, why should I care about a 50% price decline?

My opinion is that I shouldn’t care about falling prices if the underlying asset is unchanged.

This buy-to-let scenario is a good analogy for the stock market and how long-term investors should view price movements.

In 2003, the FTSE All-Share’s dividend was little changed from the year before or the year before that. It would, in future, continue to pay a dividend that usually grows slightly faster than inflation.

The chart below shows how defensive and progressive the dividends and ten-year average earnings of the FTSE 100 have been for almost 30 years (the FTSE 100 is more or less the same as the All-Share for the purpose of this discussion).

The income-generating potential of the underlying asset (i.e. those large listed companies) changed very little between 2000 and 2003, and so as a long-term investor, the index’s price decline should have been more or less irrelevant.

In fact, the lower valuation and higher dividend yield should have enticed me to save and invest even more, rather than leaving the stock market and moving into cash. And that was my next big lesson.

Lesson 4: Buy low sell high

In 2004 I sat on the sidelines and watched the market shoot upwards once again. Dazed and confused, I started researching the stock market in order to understand where I’d gone wrong.

However, while I was proving to be a particularly useless stock market investor, my “investment” in property – i.e. the home I’d bought in 1996 – was doing almost ridiculously well.

Between 1996 and 2000 it doubled in price. Then, between 2000 and 2004 it doubled in price again.

If that isn’t ridiculous then I don’t know what is.

In trying to understand the property market I came across Nationwide’s data on house price-to-earnings ratios. Today the picture of house price to earnings (average wages) looks like this:

The basic premise was simple:

• The ratio of price to earnings (PE) tends to stay within a fairly narrow range around some long-term average value
• As the PE ratio moves away from the long-term average it becomes ever more likely that it will revert back towards that average
• The earnings side of the ratio is very stable over time (as it is with wages in the case of the housing PE ratio)

And the conclusion:

• If the housing market PE ratio is high (currently about 6) then that ratio is likely to revert to its long-term mean (about 4) primarily through a price contraction rather than a rapid increase in earnings

After some additional research, I felt that the housing market had little room for further PE ratio expansion, so I decided to up sticks and sell in 2004 to lock in those capital gains.

After a brief splurge (a few holidays, a Jaguar XK8) I reinvested what was left into the stock market, which I felt was much more attractively priced than the UK housing market.

And that was the beginning of my career as a value investor, following this simple principle:

Buy rock-solid assets at low prices (which typically means when everyone else thinks they’re a bad investment), wait a while and then, with a bit of luck, sell when other investors jump on the bandwagon.

Of course, finding a rock-solid investment which is available at a low price is the hard bit. In truth, it took me until 2007 before I found an approach (deep value investing) that I was happy with.

And even then there were many bumps in the road, especially through the financial crisis. In 2010 I’d had enough of deep value investing and switched to defensive value investing, and have been refining that approach ever since.

And that, I think, is the last big lesson that I have learned.

Lesson 5: Continually improve your investment process

Having spent 13 years as a software engineer I cannot help but think in terms of definable, repeatable processes.

Investing, in my opinion, should involve the methodical application of a well-designed process.

Pilots and surgeons don’t (or shouldn’t) make it up as they go along. Every predictable, repeatable action (whether landing a 747 or removing a patient’s leg) should have a defined process and an optimal way of doing things.

In many cases, these are written down as checklists that are used in real-time (as explained exquisitely in The Checklist Manifesto).

Investors should follow the example of pilots and surgeons and have a written plan which they can apply diligently, over and over again.

More importantly, the process should be improved – incrementally and carefully – at every opportunity, taking care to avoid changes that are too large, too frequent or poorly thought through.

Here’s one final tip:

When you’re investing, try to have the mindset of an airline pilot or brain surgeon, with the lives of many people in your hands. You may find that you raise your game and apply a higher level of professionalism to your investment decisions, and that is surely something your portfolio and its beneficiaries deserve.