Principles of the Intelligent Investor

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To ensure that our investment philosophy is not just good intentions, but actually guides our behavior, it must be translated into practical principles. Not all principles are necessarily relevant to you, but will nonetheless be a good starting point if your goal is a long-term returns based on the fundamental value of the companies. 

The principles below are built by studying a wide range of the best investors of all time and putting their principles into practice. These include Benjamin Graham, Warren Buffett, Charlie Munger, Howard Marks, Joel Greenblatt, Mohnish Pabrai and Seth Klarmann. Standing on the shoulders of giants is rarely a bad thing. Or as Charlie Munger once said: 

You don’t have to pee on an electric fence to learn not to do it.

10 good investment principles

1: Create an investment strategy and stick to it through the ups and downs


For any approach to investing to work in the long run, it’s crucial that you think about the type of investor you are (or want to be). There are as many ways to invest as there are investors. Some are day traders and trade on small daily price fluctuations, others own the same companies for decades. Some buy based on momentum (price development) – others based on an assessment of the company’s fundamental value.

The key is to think about your time horizon, the distribution of your funds across different asset classes (stocks, cash, bonds, real estate, etc.) and how much time you’re willing to spend. Most importantly, find an approach to investing that suits your personality and temperament so you can sleep soundly at night. Through the ups and downs.

A good tip: Although it may seem both redundant and overwhelming, you should write down your investment strategy. It will help you, especially when the market goes against you, but also to hold on to your winners rather than taking a quick win.

The aggressive, intelligent investor with a long time horizon (over 10 years) should invest 70-90% of their portfolio in equities and hold the remainder in bonds or cash. If you are less risk-averse or have a shorter time horizon, e.g. 5 years, your allocation should be more conservative. Typically up to 60% shares. If you have a time horizon of 1 or 2 years before you need your funds, they should not be invested in shares at all. You can read more about allocation here.

Tip: Make a pie chart with the distribution of your total wealth and set a goal for how you want your funds to be invested plus/minus 5%. There are basically 5 asset classes: cash, bonds, stocks, real estate and commodities (gold, oil, etc.).

The moment you press the buy button and get a new share in your portfolio, you become a co-owner of that company. It may not feel like it because it’s so easy to trade stocks today. But you are now a co-owner with the legal rights corresponding to your number of shares.

Buying shares in a company is very similar to a situation where you want to buy into a business within your own industry. Here you will often have in-depth knowledge of the industry, products on the market and the competitive landscape. You would carefully examine the company’s financial statements to assess what a fair price for your ownership stake should be. And you would have a series of meetings with the other owners to make sure they are qualified and matched your preferences.

If these criteria don’t meet your expectations, you’re unlikely to invest a significant amount of your money and time in the business. Similarly, few would go day-to-day and assess the cost of their business. It wouldn’t be possible to sell anyway.

Think like a business owner. Invest when you know the company, management and industry and have a time horizon of at least 2-3 years and preferably 10 years or more.

A word of advice: There should always be a minimum of two years from the time you buy a share in a company until you are allowed to sell again. If you have to live with your decision for the next several years, it has quite a positive impact on your investment discipline. If you trade as a private investor with free funds (not pension), you also have the advantage that you save on trading costs and can defer your tax until the day you sell the shares. This allows you to earn compound interest on the entire amount before tax.

A good investment offers a high return without a correspondingly high risk of loss. In practice, what we’re looking for is a game of ‘heads or tails’ where heads – we win. Flat – we don’t lose much.’

But that’s easier said than done. So the best thing we can do as investors is to buy companies where we get more than we pay for. That is, when the value of the company is higher than what we have to pay (the market price). In other words – buy a quality product when it’s on sale.

A sensible rule of thumb is to only buy a company if the market price is at least 20% below the company’s fundamental value, also known as the “margin of safety” (see also Benjamin Graham’s The Intelligent Investor).

HintYou’d be surprised how much fluctuation there is in the market price of even very large and stable companies. Take a look at the share price of Novo Nordisk, Carlsberg or Apple. They often fluctuate by 30-50% over the course of a year (!).

When we buy or sell a stock, we are also trying to make a prediction about the future. Consciously or unconsciously. When we buy a company, we seem to believe that the company in question will generate an acceptable future return. But as we all know, predictions are difficult – especially about the future. What do we do?

The best way to minimize the uncertainty in our estimates of the future is to prioritize companies with stable and reliable key figures over a minimum of 10 years. In practice, revenue, earnings and free cash flow should be stable and increasing year on year. Or as Mark Twain once wrote, “history doesn’t repeat itself, but it does rhyme”.

Remember: Buying shares in an Initial Public Offering (IPO) is rarely a good investment. There are many reasons for this, but the main ones are a) the incentive structure (owners and banks do everything they can to sell the company, which drives up the price) and b) there is typically limited history to base the value of the company on. The opposite is typically true for spin-offs, where part of an existing business is spun off into a new company.

For better or worse, we humans are not built for modern society. Our brains haven’t evolved at the same speed as the world around us, which means there are a whole host of psychological characteristics that work against us when making investment decisions.

For example. we humans tend to consider ourselves far better at a given task than we typically are. We take shortcuts and jump through hoops when we need to make decisions or are faced with a difficult task. The most effective way to address these human characteristics in an investment context is to:

1) understand how they affect our decisions and

2) Use a checklist to ensure we always cover the most important questions before making an investment decision.

By using a checklist before we buy or sell, we can limit the number of mistakes and it gives us the opportunity to learn from the mistakes we will inevitably make.

You can read much more about human characteristics in Daniel Kahnemann’s excellent book “Thinking – fast and slow” and Michael Mauboussin’s“More Than You Know“).

A great tipResearch in the field shows that people feel a loss about twice as much as a gain. Since stock prices generally fluctuate down as much as up on a daily basis, you will therefore be negatively influenced if you follow prices on an hourly or daily basis. Do yourself a favor and only track your companies on a weekly or monthly basis. It’s easier said than done, but will serve you well in the long run.

No matter how many skilled advisors you use or which world-renowned investors you follow, it’s ultimately your money and your decision. You have to decide how much you save in pension and discretionary funds, how they are allocated to different asset classes and how much risk you can take before you no longer sleep well at night.

Similarly, you choose which advisor, fund manager or CEO will manage your funds on your behalf. Trust your own knowledge and expertise and don’t be seduced by market hype about a new IPO or the many media opinions that “tech stocks can only go up” or “this time is different”. It very, very rarely is.

Incentive management is a very powerful force and something you should always be aware of. Seek advice from people who genuinely want you to succeed and who don’t benefit from you acting in a certain way. This could be an independent advisor, a good friend or another investor.

Remember: Many Danes use their bank as their sole advisor when investing their funds. Because that’s where the money is. Of course, there are skilled and sincere investment advisors in banks, but unfortunately, there are also many who recommend that you buy their own shares or shares in a company they are helping to take public. Here, both the advisor you’re sitting across from and the bank will have a financial incentive for you to act in a certain way.

You don’t have to find new, unique investments to generate a good return. On the contrary, there is a veritable goldmine of knowledge and investment ideas hidden in studying the best investors in the world. The reason is that in both Europe and the US, professional portfolio managers are required by law to disclose their portfolio and buy/sell. In the US, it must be done quarterly for all portfolios over 100 mUSD (13F filings).

Find managers whose investment philosophy matches your own. Study their portfolio and track which companies they buy and sell each quarter. If you want to learn more about the rationale behind their actions, many of them publish a ‘letter to shareholders’. Either quarterly or as part of their annual report. A well-known example is Warren Buffett’s annual letter to shareholders in Berkshire Hathaway’s annual reports.

No matter where or from whom you get your investment idea, you should always do your own analysis and complete your checklist. And why should it be necessary, you might ask? Two simple reasons:

1) Even super-investors sometimes make mistakes or their choices may not align with your portfolio or values. You owe it to yourself to know the rationale behind the investment in question. It will also act as a psychological shield, especially if the stock drops significantly in value after you’ve bought it. Remember, it’s ultimately your decision and your savings.

2) If you don’t self-assess and document your investment decisions, you have no way to learn from your mistakes.

Hint: For inspiration, check out my list of legendary investors I follow. Here you can see their current share portfolios and which companies they have bought and sold during the period.

Nothing in this world is free. And yet. In fact, it turns out that it’s possible to achieve high returns without increasing risk accordingly. Simply by splitting your portfolio into more companies rather than fewer. Also known as diversification. This is exactly the model that underpins index funds such as the S&P500.

But how many companies is optimal? The more companies you have in your portfolio, the less risk is associated with each company’s performance. However, this also removes the opportunity to achieve a higher return than the market. Modern portfolio theory shows that the greatest benefit is achieved by increasing the number of companies to 10 or more.

The right number will vary from investor to investor, but somewhere between 10 and 20 companies should be the guideline. In practice, this means that you will have 5-10% of your portfolio in each company. If a company goes bankrupt, it’s a limited loss and you can move on.

However, this doesn’t mean you need to buy 10 companies on the first day you start investing. But it does mean that over a longer period of time or when you have saved a larger amount (typically more than a year or over DKK 250k), you should have a minimum of 10 different companies in your equity portfolio and preferably more. The more experience and insight, the fewer companies can be kept in the portfolio. An extreme example is the Daily Journal, which is managed by Charlie Munger. Daily Journal has (as of August 2020) 3 companies in the portfolio and more than 50% in one company. It’s a portfolio that requires insight and courage.

A word of advice: Diversification with a range of companies is good. But it’s even better if you also diversify across industries (Technology, Industrials, Consumer Goods, Banking, etc.) and geography (US, EU, Emerging, etc.).

When you normally buy a share, this is called “going long” the company in question. Here you buy a stock with the expectation that you can sell at a higher price in the future. The future price, plus any dividends, is your potential profit. Your ultimate risk is that you lose the amount you have invested if the company goes bankrupt.

Another option is to “go short” a specific stock. Here, your bank/trading platform arranges for you to borrow a share from another shareholder to sell it immediately. If the share price subsequently falls, you can then buy the share in the market and return it to the shareholder you borrowed it from. Here, your winnings are the difference between the two. This way, you also have the opportunity to invest in companies that you believe are overvalued.

However, the risk is not the same as walking long. When you go short, you can basically suffer an infinitely large loss. Yes, you read that right. In principle, there is no upper limit to how much you can lose. The reason is simply that an ‘expensive’ stock can become much more expensive and there is no ceiling on how much a share price can rise. In this case, you would have to buy the share at a higher price to return the borrowed share. For the same reason, private investors should never short the market or individual companies.

Even the famous economist John Maynard Keynes once said after losing money by going short: “The market can remain irrational longer than you can remain solvent“.

A word of advice: Another way to increase your returns is by borrowing to invest. So-called leverage. The benefit is that the return on your invested funds can be increased. You can compare it to putting 10% down on your house and borrowing the 90%. For example, if you invest DKK 100,000 and borrow another DKK 50,000 with an annual return of 5%, your annual return will increase from DKK 5,000 to DKK 7,500.

Most banks and trading platforms offer their customers such loans against collateral in their portfolio. The risk is that if your portfolio falls, the bank or trading platform may force you to sell your shares to cover their loan (a so-called margin call). Especially when the price of your shares is low and you’re likely to make a significant loss. A recent example was during COVID-19, when the entire market dropped around 35%.


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Disclaimer

The above has been prepared by Børsgade ApS for information purposes only and cannot be regarded as a solicitation or recommendation to buy or sell any security. Nor can the information etc. be regarded as recommendations or advice of a legal, accounting or tax nature. Børsgade cannot be held liable for losses caused by customers’/users’ actions – or lack thereof – based on the information in the above. We have made every effort to ensure that the information in the above is complete and accurate, but cannot guarantee this and accept no liability for errors or omissions.

Readers are advised that investing may involve a risk of loss that cannot be determined in advance, and that past performance and price development cannot be used as a reliable indicator of future performance and price development. For further information please contact info@borsgade.dk

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