You must develop your own investment style

By Bengt Saelensminde Jan 31, 2011

Over the last couple of months we've been discussing investment mistakes. And one of the biggest mistakes that investors regularly make is to put their faith in old investment maxims.

You know the type - "Buy low, sell High"..."Sell in May, Go Away.."....people love these maxims because they are simple and punchy. They allow us to delude ourselves that we actually have a handle on what is going on in the market.

But these maxims are the antithesis of good investing. The important thing is to develop your own, unique investment style.

Today I'm going to strip apart one of the oldest maxims. And I'm going to use that maxim to explain a little of how I developed my own style of investing.

Never catch a falling knife

I'm sure you've heard this line a thousand times...

The idea is simple. If you attempt to catch a falling stock, you have to be prepared to get your hands bloody. It warns against buying stocks on the way down in the hope of recovery.

Here's the idea in high definition 2-D...

The problem is that this is a gross over-simplification. And as metaphors go, it's a pretty silly one when you think about it...

Stocks don't fall to the floor (zero), if they did, they'd be bust and there'd be no upswing. The truth is you never know when the stock has fallen to its low - as long as there's life in the stock, it can still fall some more.

Here's the FTSE 100 over the last three years. It illustrates the problem perfectly:

I've plotted two curves that potentially fit in with the ‘falling knife' strategy. But only one of them would have proved profitable:

If you followed the principle in April/May 2008 (curve a), you'd have ended up with bloody hands - the market rebounded, but then fell off again for another year.

If you'd followed curve b (April/May 2009), you'd have started buying stocks as the rally got going. And you'd be sitting on some tasty profits today. So...

How do you know when you've hit rock bottom?

The answer to this question is a matter of style. Some people love taking quick, risky bets. They see a dramatic fall in the FTSE over a few days and they pile into the stock at curve a - looking to make a quick return on the recovery.

Others prefer to take big, contrarian bets after a big downtrend. They say to themselves: "everyone is selling out of the FTSE right now, people are despairing - this a perfect time for me to buy". If they are really smart, they'll buy in somewhere towards the bottom of curve b.

Now it's easy to draw lines over an old stock chart and make all sorts of wise-crack conclusions. Hindsight comes with 20:20 vision and is in glorious Technicolor. In reality, nobody knows where to draw the line.

But here's how I approached the problem. Let's home in on the FTSE chart to illustrate.

The box in the chart highlights the period when the FTSE traded under ten times earnings. And thats where I called the bottom. Why?

The FTSE 100 hits the bottom

I take great comfort in price earnings (p/e) ratios. Historically, when the FTSE 100 trades at less than 10 times earnings, it's cheap. That's why I zoomed in on that part of the chart in my example. In 2008/09 the concern was that the economy was heading for meltdown and company earnings would implode. So many investors ignored this simple valuation rule and stayed out of the market.

Last week, I recommended Russia - a market trading on only 8 times earnings. And after having a good think about the reasons why Russia is so cheap, I became convinced that Russia is seriously undervalued.

In fact I think you would have been better off ignoring the price movements altogether. My experience has been that if you are trying to find the trough and waiting for the upswing, you'll rarely get your timing right.

So I prefer to focus on value. To maintain a patient and well-considered outlook at all times. And to continually question the reasons for making my decisions.

Here's the point: you need to work out your own investment style. The more personal your style, the better a chance you have of making the right decisions at the right time.

How do you work that out?

Trust your own approach - and learn from it

We all have a unique approach to picking stocks, or markets. You need to learn what yours is. I suggested last week that you start to make a monthly diary of your thoughts on the market and the reasoning behind your trades. This is all part of getting to ‘know yourself'.

Ask yourself, are you the kind of investor who jumps in on curve a? Or the contrarian who chases the bottom of b?

And you can use whatever techniques you want. It doesn't matter, so long as you are consistent.

Just don't expect the old maxims like the falling knife, or buy low, sell high to provide much practical use. The market is a complex and anarchic system. And you can never hope to get a handle on it by sticking to the old clichés.

In The Right Side, I'll continue to offer you my thoughts on what works for me and I hope it helps you devise your personal approach. But even though I've been trading my own account for over 25 years, the truth is that I'm still ‘learning on the job'.

It's the funny thing about your investing style - it keeps evolving - the key is to make sure we keep moving up the evolutionary ladder.

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