Everyone wants to build a solid portfolio that will support them in their retirement, but what does we need to know to do so? Knowing how to interpret financial statements and value companies is obviously important, but successful investors are more than just skilled accountants. The best investors have a set of rules or principles that they adhere to, and that guide them in their decision-making. Having well-defined guidelines will allow us to make the right choices even in cases where the specifics of a situation may be unclear.
Don’t worry about things we can’t predict
It is true that macroeconomic variables like interest rates, commodity prices and geopolitics affect the market in very significant ways. But it is also true that they are extremely difficult to predict, and there is quite a lot of evidence to suggest that even professional forecasters do little better than laypeople who guess randomly. What does this mean for investors?
Firstly, we should not make investments based on what we think may happen. A fall in property values may lead to a drop in the share price of a quality housebuilder, but we should not bank on the decline to continue in the hope of getting a better deal. We should use changes in macro-variables to our advantage, but never depend on them. Secondly, we should make sure that our portfolios are recession-proof by focusing on high-quality income stocks with solid cash flows. We cannot predict a bear market, but we can position ourselves in a way that minimises our losses if one does occur.
Specialise in something
Warren Buffett, considered to be the greatest value investor who ever lived, coined the term ‘circle of competence’ – the idea that you can only have a limited knowledge of anything, including companies. Accordingly, we should focus on a specific sector or industry, and search for bargains among businesses that we understand.
This is simpler than it looks. Investors already likely have a circle of competence. Peter Lynch, another famous value investor, is a great proponent of the idea that even non-professional investors have an ‘edge’ – something that gives them an advantage over the market average. For instance, a doctor may have special insight into biotechnology firms, a mechanic into automobile manufacturers, and so on. Don’t try to learn a little about a lot of companies – focus on learning a lot about a little.
Specialisation can also be extremely useful when looking for bargain companies in inefficient markets. A doctor’s ability to read scientific papers and evaluate medical research would give them a significant leg up when investing in early-stage biotech companies that might not be accessible even to professional money managers. Inefficient markets with high informational barriers and fewer investors will always have more mis-pricing than larger ones.