Secrets of Success: Wise rules to follow for healthy returns

Doing some research for an article about the historical performance of one of last century's great investors, I stumbled across one of the lists of investment dos and don'ts from another era that I like to add to my growing collection.

Doing some research for an article about the historical performance of one of last century's great investors, I stumbled across one of the lists of investment dos and don'ts from another era that I like to add to my growing collection.

This one has a splendid pedigree, having first been published as long ago as 1930. It is the work of an American professional investor called Philip Carret, who worked from a dusty office opposite Grand Central Station in New York, and achieved the remarkable distinction of still being in business at the age of 100, as well as being publicly praised for his skill by Warren Buffett.

The list is another of the gems to be found in the updated edition of John Train's book about successful investors that I mentioned a few weeks ago. I have added some comments where appropriate.

* Never hold fewer than 10 different securities covering five different fields of business. This is standard diversification theory. Note that Carret does not say own every sector. As a one-man business, he did not have time to know enough about every type of business, and index funds - which allow the know-nothing investor to own the whole market in a cost-effective way - were still many years in the future.

* At least once in six months reappraise every security held. If you make a serious effort to pick the right securities for a portfolio, it is an insult to your intelligence to follow their progress every day. It is better use of your time to make a few good decisions than a lot of indifferent ones. Having said that, it is clearly sensible to review the progress of your portfolio at regular intervals.

* Keep at least half the total fund in income-producing securities. This is the big difference between investors of the old school and the modern markets. The concept of a portfolio that relies mainly or solely on capital growth and neglects income is a bull market/late 20th century phenomenon. All studies show the bulk of returns from stock market investment come from reinvesting income. A security that does not produce an income at some point is either very risky or not everything it appears to be.

* Consider yield the least important factor in analysing any stock. Buying only the highest yielding shares rarely produces the best results, as they tend to be the dogs of their day. Profitability, the nature of the business and quality of management are all more important factors in buying individual shares.

* Be quick to take losses, reluctant to take profits. I know of no serious investor who does not swear allegiance to this principle, which is as old as investing itself, though it is easier to promulgate than put into practice. Behavioural finance, a science that did not exist in 1930, has subsequently helped us understand why.

* Never put more than 25 per cent of a given fund into securities about which detailed information is not readily and regularly available. This is one principle that is probably now redundant for shares, given the dramatic improvement in disclosure requirements. But it might be usefully extended to other types of investment.

* Avoid inside information as you would the plague. No serious investor is ever going publicly to advocate insider dealing, of course, which is now illegal (though for many years it was not). The point that Carret was making is that even legal inside information is not a surefire way to profits. You have to know what the information means and also understand why someone has chosen to share it with you.

* Seek facts diligently; advice never. Tell this one to the FSA! I imagine the point Carret was making here is that as a serious investor you have to make your own judgements. My recent column about the behaviour of wealthy investors today would seem to reinforce the notion that advice is not as rewarding as it is cracked up to be.

* Ignore mechanical formulas for valuing securities. This is absolutely central to any investment discipline. It is one thing to have a consistent philosophy, but hard-and-fast rules invariably fail in the end because markets conditions and styles change so frequently.

* When stocks are high, money rates rising, and business prosperous, at least half a given fund should be placed in short-term bonds. First, don't be lulled into a false sense of security: good markets are always followed by bad ones, so lighten up your exposure when things are going well. Second, it pays to have liquidity going into a bear market.

* Borrow money sparingly and only when stocks are low, money rates low or falling, and business depressed. Gearing is dangerous so only gear up when markets are bad, debt is cheap and things can only get better, not the other way round. You want to maximise your gains, not your losses.

* Set aside a moderate proportion of the available funds for the purchase of long-term options on the stocks of promising companies whenever available. If you are going to try to add some pep to your portfolio, the surest way is to back good companies with long-term growth prospects and gear up through the use of options.

I was also amused by Carret's comments about what type of people make good investors. "Doctors," he says, "usually make poor investors. A doctor has to be as close as possible to infallible with his patients. He can't be right two thirds of the time. If he were only right that often, he ought to be thrown out of the profession.

"But in investing it's fine to be right two thirds of the time. So when doctors start to invest and discover how things really are, they get nervous."

Whether or not this is a fair reflection on the medical profession, the point is that no matter how long you study financial markets, an element of irrationality will always remain and a perfect strike rate is an impossibility.

jd@intelligent-investor.co.uk

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