Where do you start if you want to create a truly long-term portfolio? If you don't have the patience to hold a stock or fund for three to five years please turn away now. Those of you still here, you have the upper hand.
Patience is the golden rule of investing. If you can master longer-term thinking then you gain a number of advantages and avoid a number of pitfalls. Time horizon is the crux of the difference between long-term fundamental investors and financial speculators. It relies on determination of future value, not just future price, and on analysis of business models and process, not sentiment or short-term distractions.
So, why is it important?
Everyone (and that includes you and me) is hard wired to make bad decisions. These common mistakes are called behavioural biases and in no other field do they present themselves more frequently than investing.
It is not essential that investors study all of these biases but, in the same way that a few simple principles help sportsmen improve their swing, it is essential that you know what you might be doing wrong, and how to correct it.
So, what are the common mistakes and how does long-termism help?
The first point to make is that everyone believes they are better than average. Once a common pitfall is explained, the majority of investors believe awareness leads to sufficient prevention. It does not.
Take for example a fact of which I am certain - most investors are no better than average at predicting the future, and most admit as much. A logical conclusion is that most investors should never predict the future. It's futile. Yet almost everyone, to a greater or lesser degree continues to attempt the impossible. This is, quite plainly, referred to as "overconfidence bias".
Making investment decisions which play out over many years without making predictions about the future may sound like a contradiction, but it is far from it. Wise investors accept that they can't see the future and restrict themselves to doing things that are within their power. Principally this includes:
- Analysis of business and industries (or funds and fund managers)
- Avoiding emotional biases
- Behaving countercyclically
Paradoxically, thinking long term means predicting less about the future and focusing on where we are. This way we gain insights about what, in a highly unpredictable world, really matters.
The first implication of long-term investments is that we should buy better businesses, which we believe will survive and thrive into the future. Analysis should focus on whether a company operates in an industry in which I would like to run a business.
Excessively precise estimations of the future ignore the huge role that randomness plays. Critically the fact that the future is highly random means what matters most is having the right initial conditions to succeed. As a result, analysis should focus on process, and people.
A second implication of long-term thinking is that if we are agreed that few of us can predict the future with any accuracy then the greatest risk to investors is not what lies ahead, it's what lies within.
Portfolios often become thematic or style-biased in the hope that this high conviction differentiation will lead to long-term out performance. The result is essentially a concentration of risk; a dangerous build-up of latent downside potential should those high conviction ideas turn sour.
This is true also for portfolios which only invest in one "type" of company such as consumer staples. This not only leaves them susceptible to sharp draw-downs, but it also seriously impacts future expected returns as your opportunity set is dramatically reduced.
At Latitude, for example, our process is explicitly designed to construct a portfolio which is style-agnostic and not exposed too heavily to any one theme or macro outcome. We focus on companies' business models, what it takes to succeed in the long-term, and the current and likely future outlook for the industry in which they operate.
The result? A portfolio that is better balanced to deal with any random and uncertain future, and better positioned to avoid falling foul of over trading or excessive reliance on forecasts.
We have all heard the phrase to "think like a business owner" when choosing stocks, and this sage advice applies just as much to overall portfolio construction. Constructing an investment portfolio is like building a business, it takes time, patience and disciplined application of a sound process.
Consider your portfolio as a conglomerate business - like Warren Buffett's Berkshire Hathaway (BRK.A). It's helpful to have multiple sources of return, and we suggest a few key areas of focus below:
- some high cash flow mature businesses (dividend focus, staples etc)
- some high growth disruptive businesses (technology, possibly biotech etc)
- some cyclical businesses (ensure you purchase countercyclically, perhaps oil and gas and mining; we have US banks)
- some defensive businesses (because you always need some portion to do well through a recession, and you will not successfully time the recession)
Moreover, it's ill-advised solely to focus on stocks. Well-timed investments in bonds, index-linked bonds, gold and currencies can hugely improve the risk and return profile of your portfolio, often allowing you more flexibility to hold stock positions for longer than otherwise may have been the case.
Finally, don't be afraid to hold cash when opportunities do not present themselves, allowing yourself to act countercyclically when there is panic in the market and stocks are trading at discounted prices.
So, the ideal portfolio is one which balances its sources of return across stocks with different business models, uses funds and stocks to achieve investment aims.
In conclusion, investors often need to take a deep breath and step away from the bustle of the market in order to make sensible decisions about their future.
We have narrowed down some simple tips that any investor needs in their pursuit of investment success, whether you invest yourself or prefer to choose other fund managers to do it for you. All of them stem from the key principle of taking a long-term view, so if you keep one thing in mind, let it be that and the others should follow.
Stop focusing on forecasting the future or timing the market and focus on achieving a well-balanced long-term portfolio. Having a set of principles which help avoid common behavioural pitfalls helps you achieve this goal.
Simply focusing on these points will dramatically improve your chances of success. If you decided to choose other funds to invest your savings for you, then use these principles as a yardstick against which all good managers investing on your behalf should conform.
Never focus on outcomes alone, because long-term performance, without a consistent and sound process, is genuinely not a guide to future returns.
Freddie Lait is founder and CIO of Latitude Investment Management and Investment Manager of The Latitude Horizon Fund.
This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.