Warren Buffett writes that it only takes two things invest successfully – having a sound plan and sticking to it – and that of those two, it's the "sticking to it" part that investors struggle with the most. These themes were tackled in two recent columns in the Globe and Mail Report on Business:
The first column offered advice from Benjamin Graham, the father of value investing and considered the single most influential investor of the past hundred years.
1. Bring discipline and process to investing
Warren Buffett has said about his professor "Ben Graham taught us to look at stocks as businesses, use the marketâ€™s fluctuations to your advantage and seek a margin of safety. A hundred years from now, these will still be the cornerstones of investing."
2. Seeking a margin of safety, something that Graham believed was the most important principle of investing.
The margin of safety is the gap between what you can buy a stock for and what Graham called its intrinsic or true underlying value. What the margin of safety does is give you a buffer should the company run into unanticipated problems or the market as a whole go into a decline.
3. Elements of sound investments
In Graham's view, the bigger the gap between a companyâ€™s stock price and its intrinsic value, the safer an investment and the greater the likely return.
Graham advocated seeking out companies with strong balance sheets, conservative financing, solid profit margins and strong cash flow; he was an especially strong proponent of companies that paid dividends that regularly rose.
The second column focused on the obstacles to investment success, based on insights from the field of behavioural finance:
When it comes to long term investing success, the biggest problem stems from investors overconfidence in their investing knowledge and ability.
Many do-it-yourself investors believe that by nimbly jumping in and out of stocks, they can beat the market. Research into the records of heavy traders at a discount brokerage firm discovered was that there's an inverse correlation between the amount of trading and investor returns – the more trading you do, the lower your chances of success. And even if investors do show a paper profit, often commission costs turns that into a loss.
The researchers' conclusion: "Excessive trading is dangerous to your wealth."
A second trap is "herding", also known as the "lemming effect".
It's hard to stand on the sidelines while everyone around us is making money – or conversely to be in the market losing money while people we talk to are safely on the sidelines.
Anchoring makes us fixate on the price we paid, regardless of whether that price is still relevant We have a tendency to latch on to what we paid or what something was worth at its peak, even after the world has changed; some investors held Nortel all the way down, waiting for it to get back to $60 or $80.
Another issue is regret. Research shows that investors experience more pain when they lose money than satisfaction when they make it; that's one of the drivers of risk aversion. That's why people hang on to investments that are underwater, avoiding the pain of selling them and then when they do finally sell, they often do it all at once to get it over with.
5. "We have seen the enemy and he is us"
In a Jump Start interview earlier this spring, I talked about investors' emotional responses to market movements and the resulting tendency to buy at the top and sell at the bottom – and referred to Walt Kelly's famous line from his cartoon strip Pogo: "We have seen the enemy and he is us."
This line is equally true when it comes to behavioural finance traps. The good news is that awareness is the first step to change – and growing understanding of the behaviours that undermine investment success means advisors are better positioned to help clients avoid them going forward.