Buy and hold's Ten Commandments

PORTFOLIO POINT: Whether you believe 2012 will be a bear market, a trader’s market, or a bull market there are 10 rules you need to follow if you wish to hold the right stocks.

Since its inception Eureka Report has had a policy of presenting the widest variety of views on the equities market, even if some of those views contradict each other. This year has been no exception with Alan Kohler and Gerard Minack seeing a bear market ahead, and Laurence Freedman and Rudi Filapek-Vandyck* anticipating a bull market.

I'm somewhere in the middle, being relatively optimistic about the United States and Europe (click here), relatively pessimistic about China and emerging markets (click here), and relatively certain that the year will be volatile either way.

As such, last week I presented 10 rules to succeeding in what I see as being a “trader's market” (see The Ten Commandments of trading) with opposing economic and technical indicators underscoring increased volatility, rather than cancelling each other out.

Yet while my reading of the ASX200 VIX (implied volatility) index points to a period of increased uncertainty, I acknowledge that others may see the tea-leaves differently, especially with the US S&P500 VIX volatility index trending much lower. And although this doesn't seem to be supported by alternative measures of market fear, such as the Fisher-Gartman index, which gives a greater weighting to the presently-bearish commodity markets, or the significant divergence between VIX and the US bond market, I also acknowledge that trading might just not be everyone's cup of tea.

Luckily, however, for those who wish to stay in the market despite what both the World Bank and the IMF forecast to be a particularly risky year, there are rules that can applied no matter what you personally foresee. In all market conditions, these are my Ten Commandments for buy-and-hold investing:

1. Thou shalt understand thy stocks

Warren Buffet's aphorism that you should only hold a stock if you'd be prepared to own the entire company has a second meaning, which I believe to be equally if not more important: you should only hold a stock if you understand the company. By following this rule you'll never be able to blame your broker or taxi driver for a bad investment decision, but you'll have a better, more secure portfolio as a result. Further, you'll learn a lot more about investing and stock picking if you approach the market with your eyes open, not closed.

Before investing, understand what the company does and the dynamics are of the industry in which it operates. Do a SWOT analysis: what are its strengths, weaknesses, opportunities and threats? What are the forces at work in the company's macroeconomic environment? Why is it better than its peers? Are you investing in it for reasons of growth, value or income? Who are the management and where are they based? Is the company ethical, sustainable and legally compliant? What is the company's return on equity? Its ratio of profit to revenue? Its ratio of assets to liabilities? Who are the major shareholders and why do they hold it? Has the company been in the news lately and if so, why?

Investing isn't just a process of choosing a stock code and clicking a button on your computer. It takes hard work and if you screen a dozen companies for investment you’ll be lucky to find one that stands out as a solid investment. Not only should you be able to answer all these questions to your satisfaction, imagine you're presenting an investment case to a particularly cynical person you know. If you don’t think they’d be totally convinced, don't invest.

2. Thou shalt know when to buy and sell

This commandment certainly relates to trading, but that doesn't mean it's not relevant to more traditional investing approaches. You don't necessarily need to time the market, but you do need to have strict limits on the prices at which you'll buy and sell. And while most buy-and-hold investors believe the hold means indefinitely, it doesn't.

If you bought a stock at $5 and you still hold it at $50, well done, but you need to ask yourself whether it still deserves a place in your portfolio at those levels. Not only will it be unlikely, statistically speaking, to repeat the same price performance, but it will now have – all things being equal – a value weighting in your portfolio 10 times greater than it originally was – raising the question as to whether you hold too much.

If you find it hard to discipline yourself to sell a stock to which you feel emotionally connected, consider using an automated sell-order based on a target price as you would use an automated stop-loss order based on a level below the buy price. And again, if you don't know at what price to sell, refer to the First Commandment above. Should you own a stock if you don’t actually know what it’s worth?

As for cutting your losses, generally that's a bit easier as most people will want to avoid turning a small loss into a big one, but others will invariably want to chase the falls and double-up; a process that is usually more about pride than about coolly playing a market correction. With stop-loss limits, it can be expected that a stock will fluctuate below the purchase price from time to time; and in volatile markets prices will sometimes fluctuate significantly without any fundamental changes to underlying prospects. A stop-loss at 20% below purchase price should thus reflect a happy medium that takes account of market gyrations, yet still protects you if something is seriously amiss with your investments.

3. Thou shalt maintain an active interest in thy stocks

If you owned an investment property you'd want to know if your tenants are trashing it. If you own a stock you should be just as diligent. Maintaining an active interest in your investments means more than monitoring the trading price and dividends, however, but knowing what's actually going on within the company and, beyond that, the company's industry and operating environment. Hiding your share certificates in the bottom drawer may be tempting if you're anxious and don't want to be spooked by market “noise”, but then perhaps you shouldn't be an active investor. Better to get a financial planner and leave it to them.

In monitoring your shares, you can make this easier for yourself by setting-up automatic news feeds on your stocks through your broker or a free online service such as Business Spectator. Whenever there's an alert, an announcement or a news item you'll receive it in your inbox. If you prefer to not have your inbox flooded, however, a good rule of thumb is to check on your investments once a week. And to avoid the temptation of procrastination, set aside a particular time and place when and where you'll do this. Depending on the size of your portfolio and the nature of your holdings this can take a few minutes or a few hours.

4. Thou shalt not buy an expensive stock

This commandment is, of course, difficult to judge except in hindsight, but as a general rule you should never own anything that trades at a price that is more than 30 times next year's earnings, no matter how good the prospects or how fast it's growing. For companies that are still unprofitable – junior mining explorers, biotech research firms, venture capital-style investments – obviously this rule doesn't count, but there are other ways to measure value, such as price to cash flow or price to book value and these should be applied just as assiduously.

5. Thou shalt not buy a cheap stock

It's every investor's goal to buy shares at a discount to value – that's the way money is made – but there's a difference between this and buying a cheap stock. Just as anything that trades on a multiple of more than 30 times earnings is too expensive, anything that trades under a 5 times multiple is probably too cheap. Stocks don't do this unless the underlying company is in trouble and, as such, a multiple below 5 is a warning sign. Unless you're a professional, really lucky or a corporate raider looking to buy the entire business and turn it around, understanding the difference between a mispriced stock and a bad stock is not something that most investors can easily do. Let someone else play that game and stick to the middle ground.

6. Thou shalt not invest for tax

The Australian government happily rewards investors through dividend franking credits so that investors don't need to repay the 30% corporate tax rate already applied on the underlying company's earnings. Similarly, with capital gains tax exemptions and through a range of vehicles such as superannuation and pooled-development funds there are other ways to save tax when investing. But while all this is good and useful, investors should never, ever base their investment decisions on tax alone. In fact, investors should never have tax as a major reason for investment.

Everyone pays taxes (or should) and in a complex society it's a fact of life. While many individuals might dream of living on a libertarian island with no government, no rules and no welfare, such a place would in reality be pretty horrible (and dangerous). So when it's time to pay income or capital gains taxes, just be glad that you have income and capital gains in the first place and live in a country where these gains won’t be stolen from you.

Nobody who has rationally set aside money for taxes has been sent broke because of them, whereas plenty of people have been sent broke by investing in tax-efficient forestry programs, motion picture schemes, negatively geared strata property investments and offshore scams. As many traders say, don't fear the tax-man, fear the loss-man.

7. Thou shalt diversify

One stock does not a portfolio make, nor does two, or three. Unless you're supremely confident, supremely experienced or supremely good, investing in just a handful of companies leaves you too exposed to idiosyncratic risks, no matter how much research you may have done beforehand. Just as you would diversify your total portfolio among asset classes, equities just being one of them, you should diversify your equities portfolio by stocks that reflect a risk-adjusted variety of industries, capitalisations, geographic markets, stages of maturity and business model.

A well-diversified portfolio does not mean a portfolio of 16 different junior gold explorers, nor does it mean a portfolio of four different major banks. And if you can afford the time to research and the extra brokerage that comes with it, consider investing outside the Australian sharemarket for additional diversification. Right now, the European, Japanese and US markets especially host some incredibly strong companies priced at low (but not too low) multiples in currencies that are very affordable in Australian terms. The ASX, despite being the home of some great businesses, only accounts for 2% of global market capitalisation. Investing in only Australian companies leaves you concentrated on effectively just 2% of the world.

8. Thou shalt not diversify too much

Yet just as there are reasons to diversify, there are reasons not to diversify too much. As with the First and Third Commandments, understanding your investments on an ongoing basis is essential, but there are limits to how much research and monitoring anyone can do. For retail investors, a ballpark maximum is 20 companies, with the ideal much lower at between six and a dozen. If you find yourself holding $500 in a multitude of stocks chances are you need to consolidate.

9. Thou shalt not be too concentrated in shares

This is more a commandment for portfolio construction (click here for my recent article on the subject), but it's worth mentioning again as to many investors a portfolio often means shares plus family home plus savings account. There's a world of bonds, term deposits, managed funds, ETFs, commodity notes, real assets and foreign exchange accounts out there and in any given year one or some of them will outperform equities. Personally speaking, the equities market is my favourite asset class as it enjoys some of the most accessible and comprehensive research, it's relatively easy to enter and it doesn't require million-dollar orders; but it's certainly not the only asset class, nor is it considered a “safe” asset class compared with fixed-interest securities.

10. Respecteth the market, for it is thy maker

It's fun to be a contrarian investor, and many contrarians make a lot of money with strong convictions, patient resolve and bold calls. Yet sometimes being a contrarian isn’t much fun, especially in a bull market. Similarly, if the market is doing something that doesn’t fit into your view of things, ask yourself whether your view is right in the first place. Sometimes, the herd can be delusional and crowds can be mad, but ultimately price is set by the market, not you, and you have to buy and sell into it.

Depending on how long your timeframe is, the trend is your friend. And indeed no matter what your timeframe, you will never pick every market peak and every market trough with unerring accuracy (if you could you wouldn't bother reading Eureka Report). You may chose not to follow the market with every investment choice, but you ignore it at your peril.

Follow Michael Feller on Twitter @MFellerEureka

* Rudi Filapek-Vandyk has since contacted, disagreeing that he is forecasting the advent of a new bull market. He wishes to clarify that while he sees an up-year in 2012, based on the statistics, a strong argument can be made that average annual returns in the years ahead will be lower than those we’ve seen since the eighties.