How Not to Invest

investment strategy

There’s a very powerful, yet simple idea Charlie Munger likes to practice: inversion.

It’s an idea where you flip the problems and reverse engineer an answer. Instead of asking, how I can I pick winners in the market? Munger asks himself, how can I avoid losers?

Practiced inversion goes all the way back to ancient philosophers like Marcus Aurelius, Seneca and Epictetus.

All three would regularly picture the worst case scenario. It would help them overcome fears and make preventative plans for the future.

So maybe rather than asking, how should I invest? You should be asking, how should I not invest?

The most logical investment strategy

Why do you decide to buy a stock?

Do you buy stocks in fast moving, exciting industries? Do you buy them because they have talented and experienced management?

Hopefully you don’t buy stocks simply because the price is rising.

I’m of the opinion that you buy stocks because the underlying business is worth far more than what the stock trades for today.

This means you might look for strong, rising earnings, high returns on equity and of course, a reasonable price.

But let’s use inversion for a moment. Which factors would discourage you from buying a stock?

A declining industry, an outdated business model, far too much debt. There’s probably a whole bunch of reasons.

One of those reasons might also be currency.

Surely you don’t buy businesses based on what the AUD or USD will do in the next 12 months. Yet according to The Australian Financial Review (AFR), that’s exactly what stock pickers are doing.

The ongoing troubles in Turkey have sent the Turkish lira into a nose dive. The currency has lost almost 40% of its value against the US dollar this year.

And now asset allocators are taking advantage of the strong dollar. They’re rotating ‘out of emerging markets (EM) into developed markets (DM) in response to a stronger dollar began in earnest at the end of the second quarter,The AFR said.

I get it. Turkey is a basket case.

But why get out of all emerging markets? The AFR continues:

Subsequently, the market has focused on those with weakest fundamentals, which naturally meant Turkey. It not only had all the economic qualifications for a currency crisis, but in President Recep Tayyip Erdogan, who followed his re-election in June with policies such as putting his son-in-law in charge of the finance ministry, also had a heightened political risk premium.

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Clearly fundies are more worried about short-term performance than long-term returns.

I touched on this point in yesterday’s Money Morning. Here’s a short excerpt:

You’ll hear them (fund managers) talk about next quarter or what they think earnings will be next year.

And that’s completely fine, it’s the game they’re in. They’re not necessarily trying find the next Cochlear or Blackmores.

These funds, and most others, are far more concerned with short-term performance. If returns are great (better than the market) in the next 12 months, they’ll have an easier job of drawing more capital to their fund.

If performance dips, considerably lower than the market, investors might jump out and move somewhere else.

Even if these managers found a stock that could potentially rise 1,000% or more in the next five years but won’t do much over the next 12 months, they’ll likely stay away.

It’s also likely that most allocators aren’t picking individual stocks. They’re holding a pool of stocks, giving them exposure to an emerging market in general.

If you want to generate triple digit returns, this kind of investing isn’t going to get you there.

Why investing long-term is more beneficial

If your aim is to generate very high returns and not to smooth volatility, diversification isn’t going to help you.

Betting on what prices will do in the next quarter also won’t help that much either.

To generate massive returns, you’ve got to take long bets on a very few number of stocks you understand. The idea isn’t to have a portfolio of winners.

The idea is to have a portfolio of stocks with huge potential and the odds in your favour. That way, you only need one or two really big winners to make massive returns.

And I believe there are winners like these scattered all over emerging markets.

In fact, there are many here on the ASX with exposure to emerging markets.

Your friend,

Harje Ronngard,
Editor, Money Morning

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Harje Ronngard

Harje Ronngard

Harje Ronngard is the lead Editor at Money Morning. With an academic background in finance and investments, Harje knows how simple, yet difficult investing can be. He has worked with a range of assets classes, from futures to equities. But he’s found his niche in equity valuation.

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