The problem

Ever wished you bought Apple long before its big moves?

If yes, don’t worry, we all do.

That is because people’s underlying thinking pattern is to look for the next big thing in the market. Here’s how that plays out. You buy a stock (after little to no research), it doesn’t perform well. You’re disappointed, so you sell it and buy another one (after little to no research). You are not thinking about building a portfolio or applying strategy. So the pattern repeats over and over again.

But you feel like you’ve educated yourself on investing, after all, you read both news and social media. You even follow people who write about earnings estimates - it doesn’t get any more “financey” than that, does it?

Let’s be honest, a lot of media is financial entertainment. It is not helping you to invest properly. Also, the entire deck is stacked against you. You mostly hear about the big name stocks in the media. Those companies are followed by an army of analysts and fund managers. There are no undiscovered gems waiting there. Consequently, your investment results are below average.

Despite all this, you believe that you should pick your own stocks. You are a stockpicker at heart. And all you need is a little strategy to help you out.

Let’s get financey.

Investment philosophy

First thing’s first. You need to develop an investment philosophy. This is a broader system of how to think about the stock market. To create a philosophy you must recognise your beliefs about how the stock market works. Then you must identify the kind of mistakes you think are happening. From that you can create tactics to benefit from them.

Underlying beliefs

The assumption behind most investment strategies is that somewhere investors have made errors which have resulted in mispriced stocks. For example, if you like investing in value stocks, deep down you believe that stocks are priced too low because investors are ignoring some fundamental quality, which will later be recognised. If you like growth stocks, deep down you believe that there is more opportunity in these stocks than is being recognised by the market. These are examples of underlying beliefs which influence your investment decisions. You need to make these beliefs explicit by writing them down.

Tactics

You can have different tactics to deal with the various market inefficiencies that you believe exist. For instance, if you believe that markets have overreacted to big news, you may decide to buy into stocks whose prices have fallen after negative news. Or if you believe that the market as a whole is too pessimistic, you may buy during dips. You might even look for neglected stocks if you believe that a lack of information is depressing their prices. Either way, there is always an assumption that mispricing has occurred because of an inefficiency in the market.

Creating your own philosophy

Good investment decisions require an investment philosophy, which becomes the basis of your investment thinking. The starting point of developing an investment philosophy is getting to know yourself and recognising what your market beliefs are. Once you have done this, you will no longer be on the endless rollercoaster of trying this strategy and that strategy and changing how you invest every day of the week. With an investment philosophy in place, you will have a consistent point of view from which to assess opportunities. If your philosophy is not working, you can change it systematically.

Tips on developing your own investment philosophy:

1. Ask yourself why do you think opportunities are appearing? Which market inefficiency do you believe is occurring? How can you benefit from it?

2. Try to understand your own psyche. What are you looking for when you invest? How do you feel when markets are in turmoil? How are you making decisions at that time?

3. Most importantly, write all this down. You need it on paper so that you can use it as your North Star.

Example:

I believe that companies with consistently strong performance are more resilient, but the market also knows that, so these companies are highly priced.

Based on my belief. I can implement my philosophy using tactics to avoid overpaying. The first step would be to find strong performing companies. The second would be to wait for mispricing opportunities. These could appear if the company has a temporary hiccup, such as missing an earnings number, which temporarily depresses the stock price.

Most importantly, I have a consistent point of view on how to approach stockpicking and tomorrow’s news won’t change that.

Now that you have a philosophy, you can get on with the next part of creating your investment strategy. This means bringing risk management into the strategy.

Risk management

Since the future is uncertain, your number one job in investing is managing risk. Contrary to popular belief, it is not to find the best stock. The two most common risk management techniques used by investment professionals are diversification and position sizing. Let’s look at them in turn.

Diversification

It is said that diversification is the only free lunch in investing. In our specific case, diversification means owning multiple stocks. As a risk management technique, it is your friend because you cannot know ahead of time which companies may surge ahead. Diversification helps you to participate in the success of many companies because you own an assortment of them.

There is a bit more to diversification, such as correlation between asset classes and between different stocks. But in this case, we are going to keep it simple and think of it as owning multiple stocks.

How many stocks do you need to own? The research shows that most diversification benefits are achieved by owning as few as 15 large capitalisation (cap) stocks or 26 small cap stocks. More is also fine.

Position-sizing

Position-sizing is how much of your cash is invested in each stock. If 90% of your money is invested in one stock and 10% is invested in 20 other stocks, you are not diversified. You have concentration risk, which means that you are highly exposed to one stock.

How much of your portfolio should a single stock contribute? Based on the diversification numbers, a large cap stock can be up to 6% of the portfolio and small cap can be up to 3.8%.

Now the question is how to make all this work practically. Enter the core-satellite portfolio.

Core-satellite portfolio

No doubt, twenty six is a lot of stocks. It is hard to know what to buy and it can also be prohibitive if you have a small amount of cash to invest. It is also difficult to research that many companies.

So how do we implement this practically? We do it using a core-satellite portfolio strategy. In this method, the core of your portfolio is created using a broad market index. This is something like the S&P500 or the MSCI World Index. Benefits to index investing include low-costs and built-in high levels of diversification. In addition, you can also save on taxes because you don’t have to buy or sell this portion of the portfolio too often.

The satellite portion of your portfolio are the stocks you actively pick, based on your investment philosophy and tactics. The satellite portion is used to get the extra performance you believe you can achieve. Since you have the core, it doesn’t have to be 26 stocks anymore. You can pick just a few.

The satellite stocks can be outside the index or you can increase the concentration of stocks which are in the index. Just remember to keep position-sizing in mind. If the core index already has 4% exposure to a large-cap stock, you probably don’t want to add another 6% to that in the satellite portfolio. The benefit to the core-satellite portfolio strategy is that it allows you to exercise your investment philosophy while still managing your risks.

Size the core and satellite portions in accordance with your disposition to stockpicking. Generally speaking, if you want less risk, increase the percentage of the portfolio in the core. If you want more risk, increase the percentage of the portfolio in the satellite.

Mental reframing

But wait, how are you going to get rich on the next big thing if you spend only 4% on it? This is the mental reframing you have to do. Pro investing is not looking for the next big thing. Investing is building a portfolio that in totality gives you adequate return over time.

Here’s how Benjamin Graham (Warren Buffett’s mentor) put it:

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

Think about investing from a portfolio perspective. Your aim is to protect your principal amount while achieving an adequate return on it. That is an investment operation.

Wrapping up

If you want better stockpicking results, use an easy-to-implement strategy to improve your odds. Don’t pick on gut feel. Think in portfolio terms. Then identify your investment philosophy and implement it in a core-satellite portfolio.

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