By Tony Featherstone
A young family member asked me about investing. He wanted to buy junior mining stocks after his friend made $10,000 in quick profits.
“My friend has a fool-proof investment system,” he said. I replied: “Don’t do it. You’ll blow your savings and set yourself back financially for years. Put your money in a low-cost managed fund, educate yourself on shares and follow the market.”
Of course, he did not heed my advice. Does any 20-year-old take conservative, sensible advice on money matters from someone more than twice his age? He invested $8,000 in a mining stock and within a year lost most of his capital.
That $8,000 was saved through a series of part-time jobs and weekend sacrifices. The funds could have bought a cheap used car and his first overseas holiday. Or better still, been the start of a sharemarket portfolio.
My young relative has sworn off the sharemarket. His confidence is busted. It will take years before he regains enough confidence to buy shares, if ever.
A twenty-year-old punting on junior mining stocks seems an extreme example of sharemarket confidence gained and lost. But even seasoned investors lose their confidence when well-researched stock purchases turn sour and destroy capital.
Resilience is an under-appreciated skill. Great investors have it in spades. They recover from setbacks and live to fight another day. They know the two most important words in investing are Capital Preservation.
Regaining confidence, after the market mauls your portfolio and comes back for a second helping, is never easy. But the ability to buy stocks when others lose their confidence and panic can supercharge portfolio returns.
Here are five ways for small investors to regain their sharemarket confidence:
1. Have realistic expectations
Confidence is all relative. Some investors give up the market after their first loss, not realising that even professional investors struggle to beat the index.
Almost 70% of Australian general equity funds underperformed the S&P/ASX 200 index over five years to the end of 2016, Standard & Poor’s found.
Put another way, seven in 10 funds, each run by professionals who invest in the sharemarket as their day job, could not do better than ASX 200 over long periods.
A friend, a successful Melbourne stockbroker, says his goal each year is to pick one unknown small-cap star. Yes, just one. He manages it about two in every five years, but the gains from a stock that increases five or tenfold more than outweigh average returns and small losses in others part of his portfolio.
Have realistic return expectations. Australian shares returned 5.5% annually (before fees) over 10 years to the end of 2015, found the 2016 ASX/Russell Investments Long-Term Investing Report. That’s lower than normal because of a weak 2015, but single-digit returns have been, on average, the norm since the 2009-08 Global Financial Crisis.
These stats are not meant to deter you from share investing. Rather, they provide some context for expected returns. You’re doing well if your portfolio consistently returns more than 10% each year, after fees — and if your stock winners outnumber loses each year by a decent margin.
Think about that next time your confidence is shattered and you give up. Every investor has losing stocks. It’s how you limit losses and recover that matters.
2. Invest in education
It sounds cliched or trite to suggest that “education is the best investment” and a cure-all for struggling investors who lose their confidence. There’s no magic formula in the sharemarket or “how-to” guide that delivers dazzling returns.
I’m always surprised when investors put thousands of dollars into a stock with barely any research into the company or sharemarket generally. Like my young family member, they are easy prey for savvy investors who take their money.
If your sharemarket confidence has evaporated, use the next six months to learn about investing. Buy a good, readable local investment book, such as Roger Montgomery’s Value.Able or Michael Kemp’s UnCommon Sense. Or classics by US investing gurus Peter Lynch, Jeremy Siegel and others.
Enrol in the ASX Public Sharemarket Game. This free, online simulated trading game allows you to buy and sell shares, without money. It’s a great way to test your investment or trading strategy and get some confidence back.
Beware buying expensive courses or software when your investing confidence is low. Some financial products prey on disheartened investors who seek a quick fix to recoup their losses.
3. Learn money-management techniques
In the earlier example, my family member punted his entire portfolio on a single stock. He should have invested in a low-cost active fund or exchange-traded fund that provided diversification.
He had no idea of the stock’s valuation and no stop-loss rule (a pre-determined price point to sell the stock, to limit losses). As so often happens, he rode the stock all the way to the bottom, hoping it would recover.
Limiting your losses is central to successful sharemarket investing. Ever noticed how many fund managers dump a stock as soon as it downgrades its earning guidance? They take a small loss early, to limit larger losses later.
My relative could have invested $2,000 across four stocks (forget about transaction costs, for now). He could have had a 20% stop-loss on each trade. For example, a 10-cent stock is sold if it hits 8 cents, and the stop-loss is lifted as the stock rallies, to protect profits.
Using this basic technique, he would have limited the loss on the bad mining investment to $400 (plus transaction costs), instead of the $8,000.
Some simple rules on portfolio diversification, position sizing (how much you allocate to each stock) and knowing when to sell go a long way to preserving capital. Your investing confidence will stay intact if you limit losses when things go wrong and preserve capital.
4. Consider a funds approach
Too many first-time investors dive straight into stocks and forget about managed funds. In doing so, they risk poor portfolio diversification and take on too much risk.
Choosing an actively managed fund with a sound, long-term record and investment style is a good idea at any time, and especially when your confidence is down. You focus on picking the right manager, not the stocks its portfolio holds.
Listed investment companies, a form of listed funds on ASX, are a good option for new investors with limited funds to invest.
Plenty can go wrong with manager selection: yesterday’s star can be tomorrow’s underperformer. But it’s easier to pick a high-quality manager than to spot an exceptional company trading below its intrinsic or fair value.
It’s also rewarding earning 10% or more from a fund that holds dozens of stocks (thus reducing risk) and where the manager does the hard work.
Focus on choosing the right active and/or passive funds for the core of your portfolio and you’ll soon develop the confidence to buy stocks directly as portfolio satellites.
Having most of your portfolio held through funds allows you to focus on fewer direct stocks where you have a strong view on their prospects.
5. Stick to the best companies
Focus on high-quality companies when your investing confidence is down. Do not chase mid-, small- or microcap stocks, unless there are compelling reasons.
As I outlined previously for The Switzer Super Report, exceptional companies tend to have a high and rising return on equity (ROE), low or no debt, strong surplus cash flow to fund growth internally, and a clear, sustainable competitive advantage.
Better still, look for exceptional companies with reliable, fully franked dividends. Their yield will eventually attract investors if the share price falls too far and investors are confident the dividend will be maintained.
Most of all, think like a company owner, not an asset trader or speculator. Focus on buying strong companies when they trade below their true value, often during market corrections or pullbacks that affect most stocks.
A few good wins from exceptional companies will soon boost your confidence. Your portfolio will benefit from higher returns at lower risk, your wealth will grow and you’ll develop greater clarity on investment decisions.
Remember, confidence works both ways. It’s a killer when you blow your hard-earned savings on a stock. And an investment weapon when you have the confidence to buy great funds or stocks when everyone else is nervous.
By Tony Featherstone