After 40 years as an investment banker, an incident on Tuesday brought into focus many of my basic beliefs in what makes for a sound investment strategy.
On Tuesday, the Dow briefly plunged more than 140 points after a tweet from the Associated Press’ Twitter account claimed two explosions had hit the White House and President Obama had been injured. The markets then closed the day up 152 points after the Associated Press said its corporate Twitter account had been hacked and the White House confirmed that no such incident had occurred.
Yes, this shows that selling into a panic is expensive, especially given the tax consequences. But it also brings me to belief No. 1: Most retail investors should determine the percentage of risk represented by assets they want to commit to the stock market, regardless of daily market sentiment. Instead of diving into and out of the market, they should keep their allocations relatively stable.
Your asset allocation should be determined by your time horizon, your liquidity needs and your risk tolerance. The “offensive” side of your portfolio — the equity exposure — should have a long-term time horizon.
In the short term, the market price of a given stock is a popularity contest. In the long term, the market is a weighing machine that reflects the company’s intrinsic value. We have to remember that equities are stakes in businesses, not just pieces of paper to be traded. Over the long term, the value of a stock is the discounted value of all of its future cash flows.
Uncertainty is not the same as risk. If security prices drop to low levels, then investments become less risky.
I purchase stocks whose business prospects will grow over time, focusing on businesses that have a strong and sustainable competitive advantage. These companies are best suited for survival.
In addition, I purchase only companies whose business model I can understand. I also focus on U.S.- and Canadian-based multinationals, because better news coverage of them offers more insight.
I focus on the value of a stock, and not its price. Shares in Google Inc. trading for close to $800 is probably a better value than most penny stocks. To gain a margin of safety, I try to buy companies trading below what I consider to be their fair value.
I also do not “bet the ranch” on one investment. Instead, I weigh my positions to maintain balance: 1 percent positions, 2 percent positions and 3 percent positions. The decline of Apple from $700 to under $400, despite the bullish sentiments by many research analysts, underscores the need for portfolio diversity.
Diversification requires limiting one’s exposure to industries. Because their volatility is low, one can have a greater exposure to utilities and consumer staples. But financial stocks such as banks and insurance companies are particularly risky, because most of them are highly leveraged. Their earnings are dependent upon absolute yield, yield spreads and the amount of leverage used.
When investing short-term cash, I am very conservative. It would be a major mistake to reach for yield.
So, demand significant additional compensation for illiquidity, because it creates high opportunity costs, preventing one from meeting commitments and delaying the chance to exploit other long-term opportunities.
And be wary of financial innovation. New products are almost never tested in stormy weather.
Leverage is dangerous. The capital markets can be extremely fickle. Borrowers should always match their liabilities against the duration of their assets.
The good news is that investing means that you have accumulated a nest egg. Because very few companies now offer defined-benefit pensions, we need to develop our own war chest to supplement Social Security during our retirement years.
We must look to our own fiduciary responsibility. Remember that almost nobody will accept their roles in precipitating a crisis, not leveraged speculators, not regulators, not government officials nor politicians. After all, nobody has gone to jail for precipitating the 2008 financial crisis.
Originally published in the Sarasota Herald-Tribune
