We think there is a fundamental decision an investor faces when they think about how to approach the capital allocation. The decision is between how active should I be in the decision making process – should I decide in detail, regularly, where to invest, or should a delegate that decision to something or someone else.
This decision is often couched in terms of active vs passive investing. We explore that topic here but given we are wholeheartedly active investors, we apply this to active decision making.
The Systems Guy – many investors use checklists and systems to decide how to invest. Stockopedia has a fantastic selection of ready-made systems and checklists based on some of the greatest investors of the last century. But how strictly should we stick to them? There are pros and cons to sticking to a checklist or system, which we explore below.
- System success – when picking a system we are looking for one that has made good returns before, so when we apply it we are confident we are only at risk of errors of application, not underlying system errors.
- Lowering errors – systems and checklist can cut out silly errors that we may be liable to make because of our psychological biases. For example, by choosing a system that only allows for profitable companies, we avoid ‘Jam Tomorrow’ shares that are selling a story which can often turn into dogs.
- FOMO – systems will be their very nature rule out the possibility of making some investments. Sometimes we might see the investment thesis, but it may not fit our system so we leave it. We then watch it run up over 18 months and kick ourselves, feeling a great deal of pain as others make gains and we don’t.
- Boredom – systems can make investing boring for some of us who like the intellectual elasticity and challenge of putting together a novel investment thesis. Having some flexibility might be a requirement to keep us from making spur of the moment decisions.
- Market changes – many systems are successful but necessarily, only in the past, and on some occasions, only for a short period. We might try to apply the Graham Cigar Butt approach now and find that it does not give us good returns over our investment horizon, or indeed at any point between now and the next 50 years.
The Eccentric Genius – many investors, explicitly or otherwise, shun checklists and systems, instead applying a loose screen and combing through them for something that looks and feels right. This is based in either intuition or an ‘unwritten’ checklist which we might apply implicitly. Like an artist, this method might realise fantastic results but its also difficult from the outside to understand why or how it works. It might even by difficult from the inside to try and explain why one set of decisions worked out and others didn’t! Lets run through the pros and cons
- If it isn’t broke don’t fix it! – if this model works for you, should you change it? It would seem pretty apparent to everyone that if its working for you, enjoy it and don’t change it! However, its important to remember investing is probabilistic, so it may not be down to innate genius
- Freedom and fun – having great flexibility is intellectually fun and can make investing a fun challenge.
- Understanding errors – without a checklist or a system, it can be difficult to understand when things do go wrong, why they went wrong.
- Psychological biases – without a structure we can fall foul of psychological biases without knowing it. As we know, we are not always rational, but having a rules-based system can help us realise when we are being dragged off course.
In some of us is often a belief that we are the next Buffet – and that can lead us to favour the Eccentric Genius model, which naturally assumes we are endowed with an above average intelligence and market insight. However, unfortunately that is not always the case! Therefore, we would normally encourage investors to try and move towards the application of a checklist when making their investments – even if only to track a few key metrics whilst applying the genius model.
That said, we think that finding a balance between the two is important – a wholly systems model is unlikely to work 100% of the time. Furthermore, you need to be cognisant of your own psychological biases and approaches – if you like flexibility and have an eye for narratives that the market likes, you will need more flexibility that those who are more confident investing in a system.
We at Journal.investments have made a journal that allows you to keep track of a variety of metrics that are popular in many checklists. This will allow you to input and, with hindsight, understand what was actually a red-flag and not the signal for the next 10-bagger, and vice versa.