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It is springtime. A few cuckoos have announced their arrival. Woodpeckers have been knocking away for weeks, making nest holes in rotting trees to raise their brood.
Spring brings optimism for investors. Newspapers are awash with bright, shiny, new investment ideas with which to line your savings nest. Early birds will be topping up this year’s Isa allowance and selecting investments.
Before adding anything new, though, it is worth scrolling through your portfolio and taking time to review the holdings from previous years which failed to fulfil their promise. They are easy to spot — usually in glaring red, underlining your losses.
There are good reasons why you might prefer to ignore them — benign neglect has its benefits as an investment style. It may be that you harbour a nagging fear that they will shoot up the moment you sell them. Or you could favour the “sunk cost” excuse that they have lost so much that things could hardly get worse. Bitter experience has taught me they can. A share that has halved can easily halve again.
Some investors cannot accept their failures and instead double down on them. This is so common among professional investors that we have a phrase for it: “averaging down” — buying more shares at a lower price and so reducing the average price you have paid for your holding.
This is a dangerous game to play. It might better be described as throwing good money after bad. I average down very rarely — and even then only after I have taken a blank sheet of paper and checked both the investment thesis and the valuation from scratch.
Going through my own investment checklist, I need to be wary of “cognitive dissonances”. The late Daniel Kahneman won a Nobel Prize for his work in this field. Many fund managers found his 2011 book, Thinking, Fast and Slow, catalogued the ways in which we muck up, and others have been added to the list since.
Kahneman tells us emotion and instinct are powerful influences, often playing against more logical instincts. It is perhaps worth noting that the more experienced you become as an investor the more inclined you can be to trust your instincts more and your analysis less. This may not be a good thing.
So, I go back to that blank sheet of paper and take out a pen.
1. What’s the investment thesis?
For each investment I make I try to write down what I expect will drive the share price. I recommend this approach. The thesis should be long-term and reliable, such as ageing Western populations or developments in computing power. I avoid any thesis based on economic forecasts.
Armed with these notes, you can decide later whether the original reason that you made the investment is still valid. At this point you should beware the “self-serving bias”, which compels us to credit all our winners to our own brilliance and losers either to the advice of others or external events.
Hopefully, you will find a few winners that stem more from luck than from judgment — as well as some losers where you feel your original investment case still stands or is maybe even stronger. If you find some mistakes, accept them and move on. Being too hung up on losers in your portfolio can make you over-cautious. All successful investors have losers. They just have more winners overall.
2. What’s changed?
If your original thesis still seems compelling, have other parameters shifted? Has a change in the level of inflation or interest rates altered the valuation landscape? Has the chief executive of the company turned into a megalomaniac with ambitions to expand into areas outside their competence?
Keynes was a successful equity investor, managing the endowment of King’s College, Cambridge, from 1921 to 1946. He did not say: “When the facts change, I change my mind”, but he did warn that obstinately ignoring changed facts and circumstance in the long run leads to “grievous loss”. I think that is more powerful. If circumstances have changed it is time to sell your loser.
If the investment thesis and circumstances have not changed is your loss down to an irrational market? Be honest with yourself! “I know I’m right, so the market is wrong” is a bold claim. All you really know is that you have been wrong — at least so far — which is why the next item on your checklist should be valuation.
3. Would you buy it again today?
This is important in any portfolio review, but I think it should always come after the investment thesis. Try to avoid another bias here — “anchoring”. The price you paid for a share should not influence your decision on what to do next. Consider it an irrelevant number and reappraise everything afresh.
It is tempting to hold on to a loser because the valuation looks low, even if the investment case is bust. A low valuation can attract a takeover bid — albeit one that may not be at a level to recover much of your losses. It can make the “buy” case stronger. But you should ask yourself — did the valuation measure you used turn out to be a poor guide to performance? Did you expect more growth than has been delivered? Will it really be different now?
On valuation, bear in mind that cyclical stocks should be bought when their price-earnings ratios are high: that is, when their earnings are depressed. They should be sold when the ratios are small: that is, when earnings are at their cyclical peak.
4. Could you buy better?
The last question is perhaps the most useful. Your losers may have plummeted as far as they can go, but is there something more productive you could be doing with your money instead of waiting for recovery?
This is especially relevant after market falls. At such times I make a habit of trying to improve the quality of my portfolio, even if this means selling a stock that looks cheaper or which has fallen more than a better-quality stock. Market falls are a rare opportunity to buy the best stocks at a small discount to their normal valuation. These are the holdings that should then sit for years in your portfolio, compounding in value.
5. Don’t beat yourself up.
My final comment is to go easy on yourself. Investment is about taking risks, so you will make mistakes.
Reviewing your losers can help you notice patterns in your own investing style where you can improve. Think of those red lines in your online portfolio as part of your investment education. Once you have reviewed your losers, you can look over your winners and pat yourself on the back.
Simon Edelsten is a former professional fund manager
