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Rule 3: It helps to buy stocks with the kinds of stories of
anticipated growth on which investors can build castles
in the air.
I stressed in chapter 2 the importance of
psychological elements in stock-price determination.
Individual and institutional investors are not computers that
calculate warranted price-earnings multiples and then print
out buy and sell decisions. They are emotional human beings
—driven by greed, gambling instinct, hope, and fear in their
stock-market decisions. This is why successful investing
demands both intellectual and psychological acuteness. Of
course, the market is not totally subjective either; if a positive
growth rate appears to be established, the stock is almost
certain to develop some type of following. But stocks are like
people—some have more attractive personalities than others,
and the improvement in a stock’s multiple may be smaller if
its story never catches on. The key to success is being where
other investors will be, several months before they get there.
So ask yourself whether the story about your stock is one
that is likely to catch the fancy of the crowd. Can the story
generate contagious dreams? Is it a story on which investors
can build castles in the air—but castles in the air that really
rest on a firm foundation?
Rule 4: Trade as little as possible.
I agree with the Wall
Street maxim “Ride the winners and sell the losers,” but not
because I believe in technical analysis. Frequent switching
accomplishes nothing but subsidizing your broker and
increasing your tax burden when you do realize gains. I do not
say, “Never sell a stock on which you have a gain.” The
circumstances that led you to buy the stock may change, and,
especially when it gets to be tulip time in the market, many
of your successful growth stocks may become overweighted
in your portfolio, as they did during the Internet bubble of
1999–2000. But it is very difficult to recognize the proper
time to sell, and heavy tax costs may be involved. My own
philosophy leads me to minimize trading as much as possible.
I am merciless with the losers, however. With few exceptions,
I sell before the end of each calendar year any stocks on
which I have a loss. The reason for this timing is that losses
are deductible (up to certain amounts) for tax purposes, or
can offset gains you may already have taken. Thus, taking
losses can lower your tax bill. I might hold a losing position if
the growth I expect begins to materialize and I am convinced
that my stock will eventually work out. But I do not
recommend too much patience in losing situations, especially
when prompt action can produce immediate tax benefits.
The efficient-market theory warns that following even
sensible rules such as these is unlikely to lead to superior
performance. Nonprofessional investors labor under many
handicaps. Earnings reports cannot always be trusted. And
once a story is out in the regular press, it’s likely that the
market has already taken account of the information. Picking
individual stocks is like breeding thoroughbred porcupines.
You study and study and make up your mind, and then
proceed very carefully. In the final analysis, much as I hope
that investors have achieved successful records following my
good advice, I am well aware that the winners in the stock-
picking game may have benefited mainly from Lady Luck.
For all its hazards, picking individual stocks is a
fascinating game. My rules do, I believe, tilt the odds in your
favor while protecting you from the excessive risk involved in
high-multiple stocks. But if you choose this course,
remember that a large number of other investors—including
the pros—are trying to play the same game. And the odds of
anyone’s consistently beating the market are pretty slim.
Nevertheless, for many of us, trying to outguess the market is
a game that is much too much fun to give up. Even if you
were convinced you would not do any better than average,
I’m sure that most of you with speculative temperaments
would still want to keep on playing the game of selecting
individual stocks with at least some portion of the money
you invest. My rules permit you to do so in a way that
significantly limits your exposure to risk.
If you do want to pick stocks yourself, I strongly suggest
a mixed strategy: Index the core of your portfolio, and try the
stock-picking game for the money you can afford to put at
somewhat greater risk. If the main part of your retirement
funds is broadly indexed and your stocks are diversified with
bonds and real estate, you can safely take a flyer on some
individual stocks, knowing that your basic nest egg is
reasonably secure.
Even if you use index funds for all your investments, you
might choose to alter the weights of various portfolio
components in an attempt to enhance returns. One
adjustment that I make in my own indexed portfolio is to
overweight China relative to its weight in the world index
benchmark. I do so because I believe that China gets too low a
weight relative to its economic importance. Certain
peculiarities about China’s stock markets lead to China’s
being underweighted both in emerging-market index funds and
in total world indexes.
Most indexes are “float” weighted. If some of a
company’s shares do not trade freely, they are not counted in
the company’s weight in the index. Float weighting means
that China gets underweighted for two reasons. First, none of
the shares traded in the local Chinese stock markets in
Shanghai and Shenzhen get counted, because these shares are
available only to Chinese citizens (with minor exceptions).
Only the freely tradable shares of Chinese companies listed in
Hong Kong or New York are counted in the index. A second
reason China gets underweighted is that the Chinese
government owns a huge portion of the shares of many
companies, and those shares are not counted in the float. As a
result, China gets only about 2 percent of the weight in the
world indexes, whereas, adjusted for purchasing-power
parity, China’s GDP is about 13 percent of the world’s GDP
and is growing rapidly.
Hence, I believe that investors need to put more China into
their portfolios than is available in general world or emerging-
market index funds. I am, however, true to my indexing
beliefs and think the best way to do it is to buy a broad-based
index fund of Chinese companies. Three of them that trade on
the New York Stock Exchange are YAO (an index fund
representing all Chinese companies available to international
investors), HAO (a small-capitalization index fund that
contains more entrepreneurial companies and ones with less
government ownership), and TAO (a Chinese real estate
fund).
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