In theory, investing in the stock market should be easy: buy low and sell high. Doing this without the benefit of hindsight, however, is much easier said than done.
Investment decisions are made in real time, and this process can often be difficult and intimidating for investors.
To generate above-average returns in the long term, investors need to think independently of the market and not be unduly influenced by short-term events, says Greg Hopkins, chief investment officer at PSG Asset Management.
The objective to buy low and sell high is difficult to do in practice when the market is configured to make you do the opposite, he explains.
These factors can create panic setting in or cause irrational behaviour, according to Hopkins:
1. Negative news headlines
These create fear and uncertainty around current events. Examples include declining commodity prices, China’s slowing economy and a sell-off in emerging-market currencies.
2. Short-term focus
Looking at funds that perform poorly on a weekly or daily basis creates a natural reaction by the investor to “avoid the pain” and sell.
3. Loss aversion
If there is a portfolio with 10 funds, seven of which perform well, investors will remain fixated on the three funds that underperform.
To counteract this, Hopkins recommends you as the investor take a long-term approach before you make investment decisions; are prudent about the way assets are deployed; and have an obsessive focus on researching any security you plan to buy and ensure you understand the odds.
Hopkins explains a simple philosophy to get the odds in your favour:
- Determine the “economic moat” or competitive advantage of the business you’re investing in. A business with a competitive advantage over its rivals should generate higher margins.
- Consider the management of the business, their track record, past performance and the levels of transparency, especially regarding ethical issues.
- Consider the margin of safety: make sure there’s a buffer between the price paid for a security and the value generated. Invest in high-value businesses that are selling at below-average prices.
This is an excerpt from an article that originally appeared in the 26 November 2015 edition of finweek. Buy and download the magazine here.