3 good fund manager rules that investors should follow

Many textbooks and articles will tell you how successful fund managers go about analysing companies when they invest. However, what they don’t tend to disclose is that a lot of investment success is also a result of never doing certain things.

Here are the top 3 things that the many top performing fund managers will never do. Whether you are a beginner or expert share investor, you can easily apply the same rules.

1. Never believe “I really can’t sell those shares”

Have you ever invested in shares and then the share price falls significantly because the company announced poor financial performance?

Is your first reaction to say “I really can’t sell those shares” because I would be making a loss?

This is a very common reaction and, in fact, psychologists have a term for this: it is called loss aversion. It simply means most people tend to feel greater emotions from losing money than from making money. This is why many investors tend to hang on to their losing investments in the hope that the share price will appreciate so they don’t have to feel the pain of realising an investment loss.

The best fund managers never do this. Instead, the question they always ask themselves is whether there is a better risk adjusted investment available elsewhere versus their current investment. If the answer is yes (even if the answer is cash), they will sell the existing investment despite crystalising a loss. In fact, some fund managers will even go to the extreme of actively removing historical purchase prices from their internal portfolio tracking data in order to reduce the potential for loss aversion.

It may sound counterintuitive but it works. For example, any investor in the large cap miners (e.g. BHP or Rio Tinto) in the last few years who held on while share prices fell around 50%, would have been much better off having never said “I really can’t sell those shares”. This doesn’t mean you should always sell your loss making shares, but rather you should always ask whether there are better opportunities for investment returns elsewhere for the money invested in those shares.

2. Never fall deeply in love with an investment

It is great investment discipline to keep a close eye on the underlying company performance of the shares you’re invested in. However, there is a difference between closely monitoring company performance and falling in love with your investment.

Let’s use a hypothetical example. An investor invests in Woolworths in 2012. Two years later, the investor has an unrealised capital gain of approximately 35%. A very good result but unfortunately Woolworths’ earnings performance starts faltering soon after. The investor, having made an unrealised gain, is not too concerned having found research reports and articles suggesting it is just a short term issue at Woolworths. Unfortunately, more earnings downgrades come and the CEO resigns.

Having shopped at Woolworths for many years as a customer, the investor continues to believe the business is fundamentally very sound but just needs some new direction. A selection of press reports also suggests Woolworths is potentially a great turnaround investment and the investor takes comfort from this while disregarding any commentary about Woolworth’s longer term issues. Unfortunately, by this time the share price has been falling substantially for 2 years.

It is clear this investor has fallen deeply in love with Woolworths by only reading positive reports confirming their original investment hypothesis. Have you ever done this before?

It is a very common human behavioural trait called confirmation bias.

The best fund managers will actively try to avoid confirmation bias for all their investments. They do this by always looking for the opposing views to their investment thesis to help them better understand the material investment risks that others see. If you do the same, it will no doubt help improve your investment skills as well.

3. Never become trapped by fixed investment styles

Are you a value investor or a growth investor?

These are just two of the many investing styles that investors and textbooks advocate will help with generating strong investment returns. Traditionally, many investors follow one investment style for all their investments with the belief it will generate the best returns over the long term.

However, is it really right to view investments with such a restrictive lens?

Let’s look at perhaps the world’s most famous and successful investor, Warren Buffett. He is known widely as a value investor and tends to be perceived as someone who only invest in companies trading at low valuations. To many investors, he is the embodiment of value investing. However, he once wrote the following specifically about value and growth investing in Berkshire Hathaway’s annual letter to shareholders.

“In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value……a high price-earnings ratio, and a low dividend yield, are in no way inconsistent with a “value” purchase.”

The quote above sums up very well how Warren Buffett and the top fund managers invest. For them, investing is never about simply classifying a share as a value or growth share. It is about whether the current share price is lower or higher than the fund manager’s view of valuation for those shares.

Kent Kwan, co-founder, AtlasTrend

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