It's called "Selecting Shares That Perform" and was written by Richard Koch and Leo Gough, one a successful investor and the other a prolific author of financial and investment books.
1. Never 'average down' when the price is falling
They must be joking, right. Never average down; surely that flies in the face of conventional wisdom. Heck, I've averaged down on my investments loads of times, when they've moved against me.
But here's the thing -- although times of general market weakness may be a good time for bargain hunting, maybe there's a rational argument for not averaging down when an individual investment tanks. What we are talking about here are shares that fall despite being part of a rising index or portfolio. After all, we buy shares in companies because our analysis leads us to think that they will go up. If they go down, we were wrong, plain and simple.
Averaging down means we think a share is about to turn around and go up again, right? Well that's a tough call to make and one that's easy to get wrong. If you don't believe me, look at shares such as Royal Bank of Scotland (LSE: RBS), Lloyds Banking (LSE: LLOY) and Taylor Wimpey (LSE: TW), all popular 'value' favourites around 2007. Look at the share prices of these companies now and think of those investors that averaged down into the share-price destruction.
To me, it seems wise either to maintain our original weightings in such bad performing investments, or even to consider using the next rule:
2. Never be afraid to sell at a loss
Instead of averaging down, why not axe a falling share? I mean, it's doing the exact opposite to what it was 'supposed' to do, so why not just cut and run after a predetermined decline? The book I'm reading suggests 7-10%.
I wish I'd done that much more often. Shares such as Trinity Mirror (LSE: TNI), Dixons (LSE: DXNS) and HMV (LSE: HMV) could have been prevented from causing so much private-investor carnage if those punters had simply sold on share-price weakness.
3. Balance patience and prudence
Whether we fall into the 'long-term buy and hold' camp or the 'it's never wrong to take a profit' camp, it's a good idea to seek a balance between the two philosophies.
How patient should we be? If we are holding a share for years, and nothing happens, maybe it would be more prudent to sell and move on to other opportunities. Similarly, if a share rockets very quickly, maybe it's prudent to pocket some of those gains. My own rule-of-thumb is 'the faster the gain, the faster the sale.'
Generally, I think it's wise to be flexible and not become too entrenched in either philosophy.
4. Do not over-diversify your portfolio
Traditionally, a diversified portfolio of shares is seen as a defence against individual company risk, but too many shares in a portfolio can actually increase risk.
With too many shares, it's hard to know the underlying companies that well. There is a risk that the quality of your choices might decline and, with so many holdings, you could end up chucking in a few speculative punts with hardly any thought.
With greater focus on just a few shares, it's more likely that we will be on the ball when it comes to buying and selling. The book suggests that between five and ten shares is adequate for most investors.
5. Do not invest heavily when everyone else is
You've probably heard the adage: "When they are crying, it's time for buying; when they are yelling, it's time for selling." In other words, when everyone has gone share crazy, there's a good chance that markets may be close to a cyclical high -- often a disastrous time to buy most shares.
6. Only invest if you are confident in the company's prospects
The book cautions: "Investing in the stock market is not like picking a winner at Aintree", and we can only be confident in a company's prospects if we have researched and analysed it thoroughly.
If we invest in speculative companies with no profits, but with great 'potential,' it is usually very similar to betting on the horses with an unpredictable outcome. On the other hand, finding attractively valued, profit-making businesses with good growth prospects can help us to achieve results that are more predictable.
To me, these are sensible rules and I'm looking forward particularly to applying the first two more with my own share portfolio.
by Kevin Godbold