The Investing Equation

Earlier this year I was speaking to a friend about investing and felt like I was standing in front of a metaphorical firehose of investing noise.

“Henry, have you read about Bitcoin? I made 30% last year on it!”

“I made a bet on a gold miner, they have access to three mines but the price keeps going down – I don’t understand why but the market is sure to be wrong”

“Have you heard about Games Workshop? They’ve had a great run and if they get into America people are saying the shares could double again!”

“What do you think about inflation? Buy gold? Short bonds?”

“When do you think housing is going to crash? What should I do about it? I was thinking of getting into but-to-let this year but I’m not sure if the prices are going to collapse”

Once I got them to pause for breath, I asked them how their portfolio had performed in 2021.

“Not great last year – I was down 10% – BUT this year is sure to be different!”

“If you made 30% on bitcoin last year, and Games Workshop is going to double your money, plus you have a gold miner with three productive mines, how did you lose money last year?”

“Well, erm, that 30% was only a small position because I lost 50% of the money I had in it the year before. Games Workshop is also having a bit of a dip; it’s only temporary!”

“And the gold miner?”

“Erm, well, erm, the gold price has been a bit volatile and erm, well, their production figures have been falling…”

If you’ve ever had a conversation like this, then you’ve not really been talking to an investor as much as someone that likes to burn their money. They don’t understand the investing equation.

The investing equation is a simple one. You start off with a number – it doesn’t matter whether it’s £1 or £100,000,000 – and your job is to end up with a bigger number than you started with. I’m not saying it’s easy to get there but step one must surely be agreeing not to run around like a headless chicken randomly making bets and making your number smaller and smaller every day.

I am, by nature, quite a positive person. I enjoy meeting people and I’m generally quite optimistic. When it comes to investing, however, I am one of the most sceptical people you will ever meet. I‘ve lost count of the number of times I’ve spoken to ‘investors’ who think they’re the next Warren Buffett and have an in-depth understanding of the hundreds of variables that affect a company’s future. They have misunderstood the investing equation – it isn’t about sounding clever, being optimistic or trying to convince yourself you’re infallible. It is simply about making a profit.

  • Attending online webinars with a company’s management team is not the ‘inside track’ to assessing their competency.
  • Knowing a company’s 30-day moving average is not some secret indicator to buy or sell.
  • A chart on social media will not make you a millionaire.

Being sceptical is what keeps me out of pump and dump schemes and ‘get rich quick’ bubbles which suck in retail investors and then mug them for their capital without pausing for breath.

No brand is unassailable, no product is unbeatable, no management team is perfect and no investment is a ‘no brainer’. As soon as someone tells you otherwise, you know you’re looking at someone that doesn’t want to do the work. They want to believe that they can make money easily, with no thought, no effort, and with nothing more than an opinion. Let me be honest with you – an unwillingness to do the work will always result in you burning your capital and melting your portfolio. So pay attention to the investing equation and do the work.

An unwillingness to manage risk will always end badly.

Risk comes in lots of shapes and sizes but if you don’t think you’re exposed to risk then you’re begging to have your capital taken off you by the market. If your portfolio has a bad year, I will happily wager that it’s because you have an inability to manage risk. Learning to manage risk is not the most difficult part of investing; far from it. But if you don’t want to do it, then accept that you are going to have huge volatility and lose huge chunks of your portfolio at random times.

The conscientious, hard-working investor will always outperform the lazy, ‘get rich quick’ investor. If you have a strong work ethic, are open to learning and want to take a disciplined approach to investing, then you will always outperform an idle genius over time.

A huge part of risk management is having a reliable, repeatable process in place to help you identify different trading conditions and be able to respond effectively to them. Knowledge is really the ultimate form of risk management because you know what to do when things go wrong. By developing a reliable process you can make more accurate decisions, better understand the likely outcomes of those decisions, and understand what to do if those outcomes are different.

The investing equation requires you to do the work.

Having a winning outcome from the investing equation requires four things;

  1. Capital
  2. Education and Understanding
  3. Idea Generation
  4. Portfolio Management Strategy

Starting with no money is a waste of time. You need some capital to get started.

Education is a harder one – reading a book and talking to investors will get you so far but you must really understand what you’re learning and not simply memorise it. I know more than one investor who can quote all the ‘standard’ sayings about investing;

“Only invest in companies you understand”

“Only invest in high quality companies”

“Be patient with your investments”

“Have a strategy”

“Invest with a margin of safety”

Despite trotting these out they then go on to chop and change their portfolio daily, buying a huge range of companies that they don’t understand, which are of variable quality, and trade these with a fervour approaching mania resulting in capital destruction. When challenged, they can instantly trot out their ‘education’ but they fail to apply it; they have memorised without learning.

My point here is not that the five ideas above are key to investing successfully, simply that some investors think that they are. There are a great many ways to be successful with investing; you owe it to yourself to do the work to understand the different approaches to investing and really master the ones you like.

Idea generation is another area that a successful investor needs to apply their skill. What companies will you invest in and why? When do you buy them and why? What will make a good investment? Most investors have ideas – they don’t struggle to come up with a list of companies that they want to invest in but it’s in the application of those ideas that they really struggle i.e how they turn those ideas into a profitable investment.

A successful investor needs a model for idea generation – how to come up with ideas, then screen out the profitable ones, and then apply them and capture the profit. That model needs to be repeatable; it needs to be followed again and again to continue generating profitable ideas.

Finally, you have portfolio management strategy – the thing I write about most on this blog. How do I size positions? When do I sell them? How many positions do I have and in what sectors? How much do I diversify? Do I use automated trading tools like stop losses?

An interesting observation is that most unsuccessful investors I meet are the most sceptical about this approach to investing. They believe investing is all about luck, not skill. They believe that having an opinion is as valuable as having knowledge – and worse, they can’t differentiate between the two.

Poorly thought-out decisions in life can be irreversible. Losses in a portfolio can be just as irreversible. Ignoring risk will not result in things ‘working out’, it will result in you losing capital. Pretending that not knowing means something isn’t true will end the same way.

By comparison, some of the most successful investors I know are always seeking to learn – and I mean really learn – about new ideas. They’re always willing to question their own beliefs and are able to take criticism and questions about their strategy in a positive way. They accept mistakes, are adaptable to different conditions, and most importantly of all, they have understood the investing equation.