Counter Arguments to 10 tips by Paul Larson to be a successful equity investor

I came across this article – “10 tips to be a successful equity investor ” on Morningstar website. 

The article is about what it takes to be successful equity investor by Paul Larson. Paul is Portfolio Manager at Oppenheimer Funds. Prior to this position, he was the chief equity strategist at Morningstar. During that period, he penned down some thoughts on what it would take to be a successful equity investor & Morningstar build on those.

Following are the tips and my counter arguments to it.

  1. Think Like a Owner: Yes one should think like a owner when invest into a stock. But primary reason for coming to equity market and invest in a stock is one CAN NOT ACT LIKE A OWNER. E.g. Suppose you are owner of a business which deals in to Auto Mobile. Now if you invest in a company which is a Bank, will you be able to think like owner (MD/CEO) of a bank? Or will you have a resources (money, time, people etc) to think like an owner of big oil drilling company. Generally, people invest in equity to participate in the growth of a company in which they can not be a PRACTICAL OWNER. Further, it is humanly not possible for an individual investor to ACT like a owner of a Bank, Automobile, Cement, Telecommunication at same time. Thinking like a owner and acting like a owner is totally different. Owner will stick to a company even if it is sinking. Rational investor will come out of that company and look for another opportunity. If you are investing in a MARKET via Indices, you are taking exposure to thinking of all the owners put together discounted in the prices.
  1. Stay with your circle of competence: Again, investor invest in stocks so they can participate in the growth of a company in which they do not have competences. If i were to invest in businesses in which I have competences i.e. financial and skill competences, I better do that business myself instead of investing in someone else’s business. By investing in MARKET via Indices, you get the exposure to all the competent people who are actually running businesses and also market has recognised their competencies.
  1. Keep an eye on value and price: This is contradicting the first point. If as an investor I think like a owner, will I look at value or price? No, I will just stick to my company. Further, value is subjective. One investor may see a great value in same company which is of zero value to another investor. Market is a wonderful mechanism which discounts all such value opinions and reflects average value in prices.
  1. Don’t ignore margin of safety: As mention in the article, according to Seth Klarman, a margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. This statement says it all. Further, quantifying margin of safety is questionable and subjective. Indices are built in such way that automatically keep such margin of safety of individual stocks by recognising average risk of that company.
  1. Look at moats: Businesses that have strong and sustainable competitive advantages—a wide  economic moat—will increase in value at a greater rate than those that do not. Wide-moat firms are also best suited for survival, possessing the high ground that will flood last, if at all, when a downturn hits. This is again contradicting first point. Will I sell my ownership, just because my company do not have wide moats. Further, companies having wide moats currently may go bust in future. Market by default  not only recognises such moats but also automatically adjust value and price as and when there are changes in such moats.
  1. Look at reputation of management: When you try to evaluate reputation of any management, you try to evaluate information openly available in market. In general, while interactive with management personally, no management personnel will reveal anything which may damage their reputation. Any information good or bad about management will flow to market and get reflected in the prices.
  1. Patience is a virtue in investing: As mentioned in the article, activity for activity’s sake is harmful since frictional trading costs can greatly harm returns. Aim to minimize commissions, brokerage, taxes, and fees. What else can be a better way to do it then Indexing? In long term, many companies will come and go, many managers will become star and eventually go out of market, but market or an index will remain there. Instead of wasting time and cost in researching companies and churn the portfolio, it is prudent to let market do it for you. You just need to have patience and adjust the portfolio according to changes in index. This can be done with any Index Fund or ETF.
  1. Don’t go overboard with diversification: Diversification should be among the asset classes and not within the asset classes. I have seen many equity mutual fund portfolios where investors have over diversify by investing into couple of similar category of fund. When you invest in an Index Fund which gives you exposure to around 80% to 90% of the market, you need not to worry about further diversification within equity as an asset class.
  1. Alway consider opportunity cost: As mentioned in article, investor should not be afraid to sell a good opportunity to take advantage of a great opportunity. One can generate value by selling dollar bills trading for $0.90 to buy other dollar bills trading for $0.60. Now this contradicts all the points mentioned above. If you think like owner will you sell your business just because you find another opportunity? What if you still see a value in a dollar bill trading at $0.90? What if a company has a wide moat even if there is another opportunity? What about patience? Further, why will anyone be willing to sell a dollar bill at $0.60 and buy a dollar bill at $0.90 from you?
  1. Don’t be afraid to go against the crowd: As mentioned in article, John Templeton wisely says, “If you want to have a better performance than the crowd, you must do things differently from the crowd.” Which means, invest at the point of maximum pessimism. If all start following this, there will not be pessimism or optimism in first place assuming all investors are rational. But we are not rational. If we all become rational market will be one directional. There will not be any price discovery. And going against crowd comes with its own risk. If you are ready to take that risk it good. Else it is prudent to listen to the crowd and flow along with the crowd.

To avoid all these it is advisable to take exposure to equities via Index Fund or ETFs and enjoy the risk premium you get by way of returns in long term.

[sgmb id=”1″]