Beyond stock picking - a 3D framework for smarter portfolios

We’ve all been there. Picked some great stocks with conviction. Run our winners. Been delighted with the gains. Only to see those gains drain away.  

It hurts, it’s galling, and you are left wondering where you went wrong.

Worse than that, by the time it happens you may have started counting on those gains as part of your future planning. How are you going to pay for that big ticket item - that home purchase, a child's education, or an early retirement?  It’s very real.

In this piece, I’ll introduce the three mistakes we can all make, and the three solutions.

But first, a personal tale…

An early education

For me, my big lesson came in the global financial crisis. I was young enough to be reckless, but old enough to have known better.

I had a silly amount of my capital riding on two big picks. Both were AIM listed stocks. One was called Renesola (SOLA) - a solar energy company that was absolutely smashing it on sales growth. The other was RC Group (RCG) - a biometrics company.  I’m sure some of you remember these stocks.

I’d bought really well. And I’d bought more as they rose. At their peak, I had 50% of my portfolio in RCG, and probably 30% in SOLA. They really were motoring - they had both already tripled. I couldn’t have been more confident.

It was 2007… what could possibly have gone wrong?

The mistakes we all make

There’s an eye-opening academic research paper by Barber and Odean titled “The Behaviour of Individual Investors”. When I first read it I was gobsmacked. It was a mirror of every mistake I’d ever made, and hugely influential in shaping my future mindset.

I’ve thought long and hard about their findings, and grouped them into three themes:

1. We suffer “perverse stock selection”

That quoted phrase is their words. We often pick risky stocks for the wrong reasons.

We often talk about the perils of story stocks at Stockopedia. Stories are how the human mind makes sense of the world, but projecting a hollywood ending onto a share is not rational.

Whether we’re chasing headlines, themes we know a lot about or jumping on a bandwagon so not to miss out. We seem to have a “taste for stocks with lottery-like payoffs”.

But lottery tickets have negative returns!

2. We underdiversify

We buy a share and get to know the theme. The price goes in the right direction, and we buy more. We buy another, benefiting from the same theme.

One highlight from the paper showed that “on average investors hold only four stocks” which tend to be “highly correlated” - i.e. too few stocks in too few sectors.

I ended up in 2007 with a portfolio 80% in Chinese AIM stocks. Hindsight is wonderful isn’t it.

3. We buy and sell recklessly

We’re human. We’re prone to want to do something. This action bias might have helped when we were chased by lions, but in volatile markets it’s an expensive tendency.

It’s so easy to buy and sell these days. A trade is just a thumb press away. But ease of trading does not a disciplined investor make. 20% of investors turn over their portfolio almost three times per year - which is not only hugely costly in terms of transaction and tax costs, but can’t be good for mental health.

Beyond this, we’re terribly prone to hanging onto our losers, and snatching at profits. And even worse, we tend to pull all our capital out of the market at lows, and reinvest at highs.

The 3D framework that solves for these

I’m sure we can all recognise some of these behaviours in our own habits. But as John Templeton once said “If you want to have a better performance than the crowd, you must do something differently from the crowd”.

So in this vein, I propose three dimensions of intelligent investing that can guarantee you invest contrary to the mistakes of most investors.

1. Invest in stocks that have a genuine tailwind of return Drivers.
   • Avoiding pure story stocks is the simple solution to “perverse stock selection”.  Focus on shares that have the same fundamental characteristics of past winners.
   • That means selecting good quality, inexpensive shares with positive trends.
   • These kinds of shares are often ignored by the crowd, even though they consistently outperform the market (on average over the longer term). 
2. Ensure you have enough Diversity in your portfolio construction.
   • In ten years of running the NAPS Portfolio - only 7% of shares owned have ever doubled in a single year.  So we don’t diversify just to reduce risk, we diversify to maximise our chance of owning a big winner.  These are the stocks that can make a real difference to your portfolio.  
   • Own at least 14 stocks to give yourself a better chance of holding a multibagger.
   • Own stocks across at least 5 (out of 10) sectors, and make sure you own both cyclicals and defensives. Think of your portfolio like a football team - you need strikers and defenders. And be careful going all-in on a favourite theme!
   • Be wary of huge positions - you may not be as smart as you think you are.  Start with equal weights.
3. Pre-commit to buy and sell Discipline.
   • Have a plan for every share purchase - a plan actively helps you avoid reactive over-trading and snatching at profits. This includes having a sell plan. Whether that sell plan is based on time (e.g. after a one year holding period - to accrue gains), thresholds (e.g. when value is realised, or the StockRank falls below a certain level), or events (e.g. selling immediately on a profit warning).  This webinar is a comprehensive overview of sell rules.
   • Only hold for the long term the highest quality securities. Be extremely wary of holding just because you’ve grown familiar with the story. The numbers must back it up. As Jim Slater once said - “you want to be first in the line of disappointed enthusiasts”   if something goes wrong.
   • Don’t hang onto your losers - have a bias to selling them (using a stop loss, or after a fixed time), or average down (but only if you have genuine insight - which you probably don’t). Doing nothing creates opportunity cost, and can turn a small loss into a big one.

Creating your own set of rules from these principles is part of the fun of investing.  There are turnkey approaches, but you have to find a set of rules that fits your own personal circumstances (psychology, capital size, tax status and so on). 

Putting the principles to work

I've always been amazed at how extraordinarily powerful the consistent application of simple rules is.   We all like to overcomplicate things, and second guess the markets, and make silly decisions at times.   Investing really is simple, as Warren Buffett says, but it's not easy. 

The NAPS Portfolio is a classic case study of using these 3D principles. It’s an equal weighted 20-stock portfolio of the highest quality, value and momentum stocks, two from each sector, refreshed once per year. 

I share this chart again from the 10 year review just to reinforce a point - the consistent application of the NAPS rules has outperformed every UK equity fund over a decade.  

It's not luck, it's just process.

But I'm a passionate believer that discretionary stock pickers can do even better than the systematic NAPS in their own investing, if they craft their own rules keeping in mind the 3D principles.   

In the coming weeks, I'll be running a few webinars on this theme - so please stay tuned for invites.

Meanwhile, I'll leave you with a great quote from Dr Van K Tharp - the late, esteemed investment author, educator and coach:

If you don't have rules, everything you do is a mistake.