Investment Rules for All Seasons.


During the Tech frenzy of late nineties four portfolios under my administration suffered significant losses. It was particularly disappointing because they had consistently done better than indices for previous twenty years. To determine what went wrong I analyzed every transaction for previous five years and formulated some rules to be followed scrupulously. Admittedly, they did not protect the portfolios from recent meltdown but the losses were not as severe as the indices.

Rule 1. Do not put most of your eggs in one basket.

An oft repeated mistake is to over weight stocks that look good on analysis, even to the extent of a quarter to a third of the portfolio. The damage suffered by such portfolio when the stock collapses due to unforeseen events offsets the gains when such stocks do well. Therefore, a cap on investment, say 10% of total portfolio value in any one stock, is desirable no matter how good it looks. If the price goes up sell some to stay within the cap, but if it drops, do not add to it beyond the cap set by cost, not current market value.

Rule 2. Do not have too many baskets.

Without regular pruning a portfolio can accumulate so many shares that some stocks constitute less than 1% of the portfolio. There is a limit to the number of stocks an investor reasonably track. The desirable number depends on the available time and the aptitude. I set the number at 30, about half of what it was in 1999, and sold off the rest. Some of the discarded stocks went up later but overall it did not make a significant difference either way. From time to time new stock(s) need to be added and some old one(s) retired but there should be no addition without deletion.

Rule 3. Do not have too few eggs in a basket.

If a stock drops to a very small percentage of the portfolio, either because it has lost value or others have gained, it is not worth the trouble to persevere with it. If the cost is below the cap the prospects should be evaluated and further purchase considered; otherwise it should be sold and the proceeds used to build some other position. This brings me to the favourite topic in some circles: cost averaging. In general, it does not work out for one of the two reasons: either the circumstances have changed or the original evaluation was not as comprehensive as it should have been. In any event, cost averaging is not to be contemplated if it will take the total cost above the cap.

Rule 4. Do not buy just because “it is going up.”

Do your analysis before buying regardless of what is going on in the market. What goes up often comes down. Jump in price in itself is not a good reason to jump in. If it is a good company there is time for a thorough analysis. If there are good reasons for the rise in price in terms of improved prospects some relative deadwood may be replaced with it. Otherwise why take the risk?

Converse is true as well. Do not sell because the price has a sudden drop. Evaluate the possible reasons and their impact on company’s prospects before taking action. Often the drop is more than events warrant and there is a modest recovery in the following days. The analysis should indicate the appropriate point to get off if it is desirable to do so.

Rule 5. Balance the portfolio with goals and risk tolerance in mind.

The goal of every investor is to maximize the portfolio. But it must be balanced against risk. My question for impatient investors is “If you are in a rush to double your money, are you prepared to lose it too?”

Rule 6. Balance the portfolio for types of stocks.

There are three types of investments:
1. Conservative; large companies that pay a reasonable dividend, 3% or higher. These also include preferred shares and corporate and government bonds.
2. Speculative; small and medium size companies focus on growth and any gains are through enhancement in share price.
3. Real Estate Investment Trusts (REIT) and other Investment Trust units; distribute a large proportion of the income to unit holders.

Conservative investments perform the best over long haul, speculative type in ‘growth’ periods and Investment Units in rough times. In general, Investment Units do better than preferred shares and bonds, but they are riskier. When the interest rates drop corporations redeem old bonds and preferred and replace them by cheaper new ones. Thus there is usually little capital gain in these investments. Investment Units can not be redeemed and there is no limit to potential capital gains. However, when the business turns bad, Trusts cut the payout and unit price suffers.

Allocation among these types depends on goals and risk to be assumed. In normal times the portfolio of an average investor can be divided roughly equally among them. For those approaching retirement speculation is to be avoided. In uncertain times like now Investments units tend to perform better, particularly when the income is counted in.

Other elements to factor in the allocation of dollars are the type of business e.g. manufacturing, resource development or service, and country where a business is located. There are times when a particular segment is emphasized and other times when it is avoided; there is no general rule. As for geography, unless the investor has means to investigate businesses located abroad, leave alone tax and business environment there, it is safer to focus on Canadian companies.

Last word in investment in troubled times: return on investment is important but not as important as the return of investment.

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