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The most important skills in investing

I would like to discuss one common mis-perception today. It appears to me that many people believe that to generate wealth in financial markets one has to have superb stock picking skills. In other words, a person should be able to identify superb businesses priced attractively. This means that he / she has to find such companies early before the price is too high, understand the business model and make sure that it is sustainable and replicable on larger scale.

Most people just do not have time to do all this and either outsource their financial decisions to professionals or prefer more conservative investments. I think both options are not necessarily better - not every professional can deliver higher investment returns than an overall stock market that is available to almost everyone through an ETF. Investments that we think are conservative could simply mean that their price is less volatile (you do not see fluctuations of the price for your flat every second or minute and you do not buy it thinking of selling next week or month). Bank deposits or bonds keep you assured that you will get your money back (in most cases) with some interest income on top, but if you try to measure the purchasing power of your capital afterwards it is quite likely that you are worse off (property prices could have gone higher, higher education requires 20% more now and so on).

Just because financial world looks complex and intense does not mean people should avoid it.

Stocks have historically provided the best investment returns and over time protected and enhanced purchasing power of capital. Anyone who does not need money within 1-2 years should consider owning stocks.

But stock selection contributes just a third to the overall wealth that is generated in the stock market. It is thus important to focus one the other two thirds.

I think that decisions on How much to invest? and When to sell? are responsible for generating two-thirds of wealth (and probably more).

To illustrate, let’s use the 2008 global financial crisis as an example. US stock market went down by about 40% in that year and continued to fall in the first quarter of 2009. If you followed the general principles that stocks are the best investment tool based on long-term stock market returns of about 10%, such crisis would have been a buying opportunity for you. Even if you already owned stocks before, you should have added to your positions to increase the weight of stocks in your overall capital allocation and maybe even added a little more than that (by tapping into your bank’s savings account, bonds, deferring purchases of big items etc).

In 2009, S&P 500 already generated 27% return (from 31 December 2008) and 67% from 6 March lows. If you viewed your stock portfolio as an alternative to savings and planned to keep it over the long-term, you would not be taking immediate profits. In 5 years (by end of 2013), you would have more than doubled your original investment (+129%). And if you still had patience and continued to follow the key principles, by 2018 your portfolio would be up 50% since 2013 and up 2.4x (+344%) from 1 January 2009. By end of 2020, your gains would have accumulated to 524% (up 4.2x).

The main decision during all that time should have been sticking to the discipline of long-term investing and ignoring the news and forecasts about what the market would do next. Throughout that period, you would have received hundreds of comments on what Fed could do next with interest rates, what Trump could do to the economy, how US-China trade war could impact global growth, how likely a military conflict between US and Iran was likely (or Iran and Israel, or North Korea and South Korea, or Russia and Ukraine). You could have also spent a lot of time thinking what Shale revolution means to the global oil & gas prices and whether OPEC+ group of oil producers could restore market discipline.

And I have not even mentioned COVID-19 yet.

This is not to say that all these things are irrelevant for stock returns. Actually, they are - but only in the short-term. Market sentiment can change when positive news (successful vaccine results) or negative (economic slowdown) and as a result stocks prices change. They can also be impacted by changes in profits that take place due to those events.

But over the long-term, the role of these factors get diminished to practically zero. Moreover, there is little an average person can do about the short-term news flow. Professionals will be faster to react, they have better access to wider sources of information and bigger analytical capabilities. But even that may not be enough as more sophisticated investors become - the more efficient the market becomes with fewer opportunities available.

I would like to return to my original example for a second. One message is that just entering the market after stocks have gone through a correction was good enough for long-term wealth creation. The second message is that holding to your investments and not trying to fix profits quickly and ignoring short-term news was also a very important factor. You would be much better off than your neighbour who would have successfully picked most beaten down stocks that recovered the most following 2008 crisis (e.g. materials that went up 49% in 2009 or IT - up 62%) and stayed with his portfolio for just a year or two. By end of 2010, after 2 years of buying two best performing sectors at the beginning of 2009, your neighbour would have generated 80% returns.

But if he sold his positions after the rally and stayed in cash looking for new bargains for the next 3 years - by end of 2013, he would have still had a gain of 80% (or a little more if he earned any interest). Meanwhile, your returns from a broader market (S&P 500) would have accumulated to 129% (up 2.3x). And I hope in a stress-free way and very cost efficient. Imagine how much time you could have saved to do other things if you just did not follow daily market news (not to mention analysis of individual securities, industries and countries).

Achieving more by doing less sounds very counterintuitive. From early years we have learnt that success comes from effort. More activity means better results. Hence, it is hard to imagine someone getting rich by not paying attention to stock market and doing better than a neighbour diligently analysis market moves and even successfully picking two best performing sectors.

Last message on this example is about size. I cannot stress enough that getting the ‘right’ exposure to the market is much more important for long-term wealth creation than picking the best performing stocks. Just think about this: if you managed to identify Amazon as the ultimate disruptor and long-term winner in 2009 and invested just 1% of your net worth because of all the risks at that time and because you could not be 100% sure that Amazon would succeed 10 years later, you would have gained an astonishing 6,652% (67.5 times).

But because you only put 1% of your net worth into that phenomenal stock, your overall net worth would not change that phenomenally - by just 66.5% (assuming you kept the remainder of your portfolio in cash). On the other hand, if you were humble and did not try picking the best stock - just buying a broad S&P 500 index, but you put 30% of your net worth because you were less worried having a more diversified portfolio, you would have gained 5.2x on your investment and your overall net worth would be 2.3x more than in 2009 (assuming 70% of your remaining net worth remained in cash generating zero returns).

By doing less research (or simply having lower IQ to identify one of the best investments) after 11 years your net worth would have been 61% more than that of a smarter person who only invested 1% in his / her best idea!

This is why I am convinced that stock selection contributes just about a third to the overall results. The other two thirds of wealth creation are attributed to Hold long you stick to your investments and How much you invest.

Last year (2020) provides the same example (in hindsight, at least). You could have spent long hours and sleepless nights looking for best ideas but if you only put a small portion of your net worth into the stock market (because COVID-19 is just too big of a factor to ignore it) - your net results would not be better compared to a person who put more of his/her net worth into the broader stock market (and continued to stick to the investment until now, rather than taking profit on the year-end rally post the ‘vaccine news’).

A couple of words on how to define the appropriate amount of capital / share of net worth that should be invested in stocks. I think the simples answer is that any amount that you can sleep well at night with. And not just every day, but also on days when markets decline 5% and more (market could be down 50% from high to low within 365 days). It is very much a matter of character and psychology.

In more practical terms, I would say that any amount of money that you do not need for the next 10 years should be allocated to stocks.

I think the examples above partially explain why Warren Buffett likes to say “If you have a 150 IQ, sell 30 points to someone else. Investing is not a game where the guy with 150 IQ beats the guy with 120 IQ”. It also explains why Peter Lynch said the following: “If you're in the market, you have to know there's going to be declines. ... If you're not ready for that, you shouldn't be in the stock market. I mean stomach is the key organ here. It's not the brain”.

Finally, as a little word of caution, I would like to note that simply extrapolating last year results (or even results of last 10 years) is dangerous. I don’t know how the next 10 years would look like. It may well be that we will go through a similar period to 1920s with roaring economy as governments support transition to green energy with many new jobs created and successful new technologies launched. But I think there are more chances that next 10 years will be associated with less exciting results especially for the US stock market.

US stocks benefited from falling rates, falling tax rates, growing globalisation and are now trading above 20x PE (vs 15x average multiple). I think chances are lower that rates could continue to decline, taxes will keep falling and valuation multiples continue to expand for the next 10 years.

This is by no means a market prediction. But just more a word of caution not to expect 15-20% annual gains for the next 10 years.

In summary, having the right temperament to add to your stock portfolio during downturn and hold it long enough as well as buying a meaningful amount is at least twice as important as identifying the best performing stocks. To achieve this, you need to focus less on daily fluctuations of the market and numerous commentaries on what the market will do next.