Before Investing in Stocks, Find Out Who You Are

 

There Is No Perfect Investment Strategy. Find the One That Fits You

Recently, a young man who is starting a family and beginning to build his wealth asked me about the best way, and the secrets, to succeed in the stock market.

My answer was probably not what he expected. I did not tell him which stocks to buy, which sector will be the next winner, or how to find the next tenbagger. Instead, I talked to him about something much more basic.

Before deciding how to invest, you need to know where you invest, who you are, and what your personal circumstances are.

1. Choose Your Jurisdiction Carefully

This is an issue that, in my opinion, does not get enough attention.

No matter how good an investor you are, the jurisdiction where you live and invest can have a huge impact on your ability to build wealth.

The first issue is taxation of your investment gains and, even more importantly, your ability to compound them.

Investing from the United States is not the same as investing from Spain, just to give one example. Some countries provide much better vehicles for accumulating capital over long periods of time. In the United States, for instance, certain accounts such as 401(k) plans allow capital to compound on a tax deferred basis for many years. In other countries, the possibilities are much more limited.

This matters enormously because compounding works best when you can keep as much of your profits as possible invested and working for you. Two investors can achieve exactly the same investment performance before taxes and end up with very different amounts of wealth simply because one operates in a more favorable tax environment.

But there is a second issue that comes after you have successfully accumulated that wealth.

Some jurisdictions may tax not only the money you make, but also the wealth you have managed to build. Spain, for example, has wealth taxation, whereas the United States has no federal wealth tax.

This creates an additional obstacle to compounding. First, you have to earn the money. Then you have to preserve and reinvest as much of those profits as possible. And once you have successfully accumulated substantial wealth, a wealth tax can take a portion of that accumulated capital year after year.

So jurisdiction matters twice: while you are building your wealth and after you have built it.

For a young person who is starting to create capital, choosing the right jurisdiction may therefore be one of the most important financial decisions he will ever make.

2. Before Choosing a System, Find Out Who You Are

The second piece of advice I gave him was probably the most important: before you start speculating in the stock market, take an inventory of your own values and personality.

Are you, by nature, a long term person, or are you someone who needs relatively quick results?

The answer will greatly influence the holding period of your stocks and, therefore, the type of strategy you will be comfortable following.

But there is another question that may be even more important.

Do you have faith in other people’s opinions? And perhaps even worse, do you have faith in your own opinions? Do you believe you know enough to predict what is going to happen in the future?

Your answer should also determine your approach to the markets.

In my particular case, I am completely agnostic when it comes to the opinions of any human being. I don’t care how intelligent that person is or how impressive his credentials are.

Nobody knows anything.

This is precisely why technical and quantitative analysis fit my personality much better. I prefer decisions to be based on prices, indicators, fundamentals treated quantitatively, and statistical relationships processed by a computer, while minimizing human opinion as much as possible.

3. How Much Time Are You Willing to Devote?

The third factor is much more practical: how much time do you have?

If you have a job, a family, and a life to live, and you don’t want to spend your entire day glued to a screen, I would not recommend stock picking unless you subscribe to a service that you have good reason to believe really works, or invest through an investment fund with a solid stock picking approach.

Managing a portfolio of individual stocks is very different from buying one or two ETFs.

Stock picking is not about having one good idea. And having even one genuinely good idea is difficult enough.

You need many good ideas.

Furthermore, you need many good ideas about when to buy, and then comes the most difficult part: deciding when to sell. Buying is something even a fool can do. The difficult part is knowing when the right time has come to kiss your stocks goodbye.

In my opinion, you should have at least 20 stocks to achieve reasonable diversification, so that no individual position represents much more than 5% of the portfolio. That way, if something goes terribly wrong with one company, that stock does not kill your portfolio.

And those 20 stocks have to be found, analyzed, monitored and, when the time comes, sold and replaced.

All this requires time and a process.

For somebody who does not have that time, or simply does not want to systematically devote it to managing a stock portfolio, it probably makes much more sense to use ETFs and keep things simple with vehicles such as SPY, QQQ, and similar broad market ETFs.

4. What Works for Me Does Not Necessarily Work for You

After explaining all this, I summarized my own values for him. Not because I believe they are the “right” values, but precisely to illustrate that the investment system should fit the person, not the person the system.

My first characteristic is the one I have already mentioned: I am an agnostic. I don’t believe that anybody, no matter how smart they appear or how impressive their credentials, can consistently predict the future.

My second characteristic is that I am short term oriented.

I know it, and I accept it.

I probably would not be very good at creating a company based on a 20 year business plan. To me, tomorrow almost does not exist because things change too quickly. Quite often, by the time the ink has dried on an excellent business plan, the environment has already changed and some of the assumptions upon which that plan was built are no longer valid.

This makes me short term oriented by nature.

I am not a day trader. In fact, I don’t even consider myself a trader. But when it comes to stocks, any investment whose time horizon goes much beyond one year starts making me uncomfortable. Real estate is different. But with stocks, more than one year feels like a very long time to me.

5. I Trust Statistics More Than Opinions

My third characteristic follows directly from the first one.

Since I don’t place much faith in the predictive ability of human opinions, I place much more faith in data.

Prices, technical analysis, sentiment indicators, fundamentals used quantitatively, and any other information that can be processed statistically and by computer are much more convincing to me than the opinion of any individual, no matter how intelligent that person may appear.

Not because a computer knows the future. It doesn’t.

But because it allows us to identify and exploit statistical relationships while minimizing the intrusion of our emotions, opinions, and biases into the process.

6. My Personal Circumstances Allow Me to Pick Stocks

Finally, there are my personal circumstances.

For many years, I have devoted myself full time to the markets. Therefore, I have enough time not only to invest through ETFs but also to maintain a diversified portfolio of individual stocks.

I can devote time to programming, understanding risk, finding good stocks, buying them, monitoring them, and selling them when appropriate.

But this works under my personal circumstances.

Another person may share exactly the same beliefs I have about markets and yet have a job that takes up ten hours a day, a family to take care of, and no desire whatsoever to spend the evening analyzing stocks.

For that person, my approach would probably not be appropriate.

There Are Many Ways to Succeed, and Many Ways to Fail

This was ultimately my answer to the young man.

There is no single way to succeed in the stock market. There are many.

And there are also many ways to fail.

The key is not to find the perfect system. The key is simply to find one of the systems that works and, just as importantly, one that fits your personality, values, beliefs, and personal circumstances.

Even an excellent investment system can become a bad system if the person who is supposed to execute it cannot live with it.

So, before asking yourself what you should buy, perhaps you should ask a much more important question:

Who am I as an investor?

Sincerely,

Manuel Blay

Editor of thedowtheory.com