4 Ways To Become A Better Self-Directed Investor

by: Alan Brochstein, CFA

This is the time of year where many of us have already started to give up on our New Year's resolutions. Here's one that I haven't yet delivered in 2013 but I intend to keep with the Seeking Alpha community: Share more long-term oriented insight.

I was recently inspired by Chuck Carnvevale's discussion of the Shiller 10PE as the type of article that SA members will be continuing to read in the years to come. So much of what is on the website (including many of my own contributions) has the shelf-life of a Mayfly. So, my resolution is to try to step back from all the minute-by-minute or day-by-day action and share a little more perspective on occasion.

Over the last year or so, I shared two articles that I now consider the first two among my "Keep it Short and Simple" series, which is a win-win for everyone hopefully. For me, these are easy to write and don't require too much time, for they are the result of decades of observations. For you, they are easy to read and hopefully instructive too. The two I shared included a discussion of the flaws in PEG Analysis, which continues to get a significant number of readers every day, and five tips for becoming a better stock-picker.

So, in my first KISS attempt for 2013, I want to share some advice on how to be a better self-directed investor. I believe that there are many people out there who entrust professionals to handle their investments when they could likely do a better job on their own. With that said, it's not easy. It takes a lot of work as well as discipline and the ability to fight off your worst enemy, which is yourself! Here are four suggestions for those who are trying and not yet succeeding:

  1. Define Your Goals
  2. Avoid Excessive Risk
  3. Stay Out of the Closet
  4. Don't FOTM at the Bottom


If you are going to invest on your own, understand what you are trying to accomplish. For most people, it's simply doing better than one could do by entrusting someone else. It might also be to have fun (without paying too much for the entertainment!). Doing better comes from two sources: Making better investments and minimizing costs. It's the former that is really hard and the latter which is pretty easy, so keep that in mind. A DIY investor's goals may be simply to match the S&P 500 (or some appropriate benchmark), and he or she will most likely come a lot closer by using a large ETF that is benchmarked to his or her index because of the lower costs involved. Whether your goal is to beat some benchmark, create a certain income stream or avoid certain "drawdowns" no matter what the environment may turn out to be, then you are one step ahead of everyone else who is driving without some sort of map. If you know what you are trying to accomplish, then every decision you make can be grounded in satisfying those goals.


If only it were as easy as what Will Rogers suggested:

Don't gamble! Take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it.

I think that the worst investing mistake we all make is taking on too much risk. The flip-side is that the more time we spend understanding risk and learning to minimize it, the better our investment returns will be. Some make out-sized investments, reflecting their confidence in a positive outcome. Maybe we do it on margin too, which exponentially raises the risk. Others buy stocks at just the wrong time, perhaps chasing rockets or trying to bottom-fish a falling knife. Some of us fail to properly contemplate things like excessive debt levels or weak cash flows. My list isn't comprehensive, but hopefully it serves as a starting point. Remember, this simple math: If you lose 50% of your money, you have to make 100% on the balance to get back to even. And don't think stop-losses are some sort of nirvana. If one puts a stop-loss of 8% on everything, one can very quickly lose a lot more than 8%. Here is the math: $1000 * 92% (which is what you have left over after a 8% stop-loss) * 92% (which is what you have left over after the second one), etc. leads to a 29% loss after four consecutive mistakes.


In the previous section, I basically said "don't put all your eggs in one basket." Well, the pendulum can swing the other way too. One of the worst things an investor can do is to dilute their portfolio by holding too many securities. First, how many great ideas can one have? The goal is to hold as few as securities as possible while maintaining diversification. I have spent a lot of time thinking about this and concluded 20 stocks in an equity portfolio is probably enough, but I would suggest a realistic range is 15-30. Many large mutual fund companies will own 50-100, but that's because they are forced to do so because of their size. An advantage to limiting your portfolios is that you will be a better manager with more focus. Think about schools, for instance. Would you want your kid to be in a class with 39 other kids and a single teacher? It's the same issue with stocks in my view. When a professional investor takes on too many securities, he or she becomes what is known as a "closet indexer." Why spend all the time and effort to invest only to match your benchmark. If that is what you are trying to do, it will be a lot cheaper and a better use of your time to just buy the ETF!


What the heck is "FOTM" and what does it have to do with investing? FOTM stands for "flavor of the month," and it's a mistake that plagues many investors, whether DIY or professional. When it comes to investing, there are many strategies. At the extremes are momentum and mean-reversion. Momentum investors like things that are going up, and they jump on expecting them to continue. Mean-reversion investors look for things that are going down and jump on, expecting them to move back to average. Neither strategy is likely a guarantee for success, and the more thoughtful ones employ elements of both. In any event, performance-chasing (momentum) leaves you ultimately with a bunch of dotcoms in 2000 or Japanese stocks in 1989 or maybe too many MLPs in 2014 (a guess). This ties back to the first point, which is to know your own goals. If you do, you won't be tempted to give up and just chase what's working. Unfortunately, this type of mentality usually kicks in at the worst time. Investment managers who focused on "value" stocks looked really stupid in the late 90s. They weren't, but their style was out of favor. You know what was stupid? Many of them closed, right at the worst time! I basically warned against being just a momentum investor, and I should also say don't be just a mean-reverter either, as you would have a nice collection of stocks like Enron and Worldcom if so.

Best of luck to you as you try to become a better investor in 2013!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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