Building a better investor

It’s tempting to look back on the good performers in a portfolio and wonder why you didn’t buy more. I rationalise that thought with the knowledge that if I had bought more of XYZ Ltd I wouldn’t have had enough resources to buy other companies which may have delivered similar or better results.

But it raises an interesting issue. When should you add to an existing position? I recall a conversation I had some years ago with a professional technical trader – let’s call him Ed – who was day-trading local and international markets long before the term was invented. Ed was always on the lookout in his charts for signs of strength. He was, and still is a momentum trader but he got very excited on finding one of his winning positions was showing what he termed a second buy signal. When this happened Ed would usually more than double his existing stake and promptly head out for a long lunch secure in the knowledge he was onto a major winner.

The discipline of technical trading systems is to my mind a major strength when compared to standard fundamental analysis approach. Often there is a psychological barrier of having bought at a much cheaper level and then not wanting to buy more until it returns there, even though it makes no sense.

Similarly, how often have you had your confidence shaken when, after buying a stock, it promptly loses 10-15%? If nothing has changed why wouldn’t you buy more? After all, your expected return has just gone up. Barton Biggs dealt with this question in his excellent story of life in the markets Hedgehogging. One of the trading rules of his hedge fund was that if a position lost 10% they either had to sell half or buy more. Whatever the outcome, the position is reviewed so the rule works by forcing action whereas the default outcome for most investors is to cross appendages and hope for the best.

I found another example of strange investor behaviour during the Telstra 3 float last year. I asked people who planned to subscribe whether they would have considered buying Telstra on market if it fell to $3.30-$3.40 (the approximate present value price of T3) and all replied in the negative. Most saw T3 as a totally separate trade even though it’s the same company, they didn’t see it as adding to an existing position. The souped up yield probably helped. And yes, I bought T3 too.

Perhaps the issue is best dealt with as a simple rate of return problem. Upon calculating the value of a stock I can therefore estimate what my total return should be, assuming the market price eventually moves toward the target price. Therefore provided the returns available from the stock in question exceed the return trade off from the other companies under review I should buy more. Otherwise I may as well buy something else to diversify my risk.

Quirks in the human decision making process such as I have described contribute to the wide but interesting field of study known as behavioural finance. There’s plenty of research available that’s worth exploring further and at least one well known Australian fund manager uses behavioural finance themes in their advertising campaigns. I think the topic also has some relevance in the context of the “Mr Market” story made famous by Benjamin Graham.

Understanding your investment inhibitions is, I believe, a good step towards becoming a better investor. The lesson I’ve drawn from Ed (and Barton Biggs) is the benefit of introducing discipline and removing emotion and preconceived ideas from decision making. At the very least be aware of your own drawbacks and develop systems to counteract your natural tendencies.