This is the third in a series of Money and Markets columns where I’ll share with you the five essential building blocks that can help you successfully earn enduring investment gains in your portfolio.
The first building block that you must have to grow your nest egg is a Better Investment Model. As you’ll recall this means kicking the concept of luck to the curb and fine-tuning your process so you can confidently apply it to any future investments you make.
With a time-tested model in hand that you can trust and easily implement, you are well-on-your-way to the second building block: Finding Superior Information amid a slew of TV reports, newspapers, and thousands of Web sites that provide little or no investment value.
With an understanding of the importance of having a Better Investment Model and the knowledge that Superior Information is not necessarily more information, you can now move on to the next building block for investment success …
In investing, your objective is to make profitable moves that compound your money over time. In this process, no one wants to lose their precious investment capital.
Risk, then, can be defined as that which interferes with your intended result. To be a successful investor, you must be constantly aware of risk and avoid taking on too much.
But that’s not as easy as it seems because in life, as well as in investing, risk and uncertainty are inevitable. That’s why you can’t completely eliminate risk from your investment portfolio. However, if you’re careful, you can manage and control it.
And the primary risk management tool in an investor’s toolbox is …
Patience and Selectivity
Successful investors invest with a purpose, keep their positions focused, and avoid trades that don’t offer an attractive risk-versus-potential-reward scenario.
You shouldn’t feel any pressure to invest based on every hot stock tip or market rumor. Instead, you should trust your model for analyzing investments, tune out the “noise” and make decisions based on the best-quality information you can find. And then, act only when you see that the odds and potential pay-off are in your favor.
|Avoid jumping on every tip that comes your way … be selective.|
In fact, successful investors manage their portfolios the same way Ted Williams approached hitting a baseball.
Williams was one of the greatest hitters in baseball history. He combined power (521 lifetime home runs) with patience (more walks than any other player of his era) and control (a .344 lifetime batting average).
He documented his legacy in a thesis on batting called The Science of Hitting.
Williams wrote that he would only swing at pitches when he knew he could usually connect and get a hit a high percentage of the time — places he called his success zones.
If a pitch was on the fringe, he would patiently wait for the next one. He knew that a called strike was better than swinging at a bad pitch, which could result in an out.
The lesson here, then, is that you greatly increase the odds of success with your investing strategy when you are selective and only swing when the odds are squarely on your side! That’s because …
In Investing, There are No Called Strikes
As Warren Buffett reminds us, “The great thing about investing is that there are no called strikes.”
You can stand at the plate and let the pitcher (Wall Street, in this instance) throw pitch after pitch right down the middle, and you don’t have to swing!
If, for example, the pitch Wall Street is throwing is the Facebook IPO at $38 per share and you don’t like the price or know enough to decide whether to make the trade — or if you know the odds aren’t squarely in your favor — you can let it go right by.
There is no umpire to call a strike. In investing, taking a swing is entirely at your discretion. If only it had been so easy for Ted Williams!
For you, there is only one way to strike out, and that’s if you swing and miss. So, there is no reason to swing unless you see the pitch you want.
An Example of Risk Control
As an example of an investment that uses the selectivity to control risk to earn superior investment returns, consider the Harding Loevner Emerging Markets Fund (HLEMX).
HLEMX owns only 76 of the highest quality companies located in the emerging markets. By selectively investing in high-quality businesses with durable long-term growth prospects, HLEMX logged a return of almost 23 percent in 2012, which handily beat its index.
While the fund has underperformed so far in 2013, successful investors keeping the long term in mind focus on the fact that HLEMX has returned more than 16 percent annually over the past ten years, almost double the emerging markets index for the same time period.
The fund’s highly regarded portfolio managers, Rusty Johnson and Simon Hallett, have extensive emerging markets experience and will invest only when they see a pitch they like.
Stay tuned. Next week I’ll show you why it doesn’t pay to swing for the fences or load-up on one big bet.