Eight Principles Of Profitable Self-Directed Investing

Self-directed investing is simple, if not easy; doable, if not intimidating. Uncomplicated, focused research conducted in a thoughtful, disciplined manner can outperform Mr. Market over an extended holding period, more often than not. Here are eight principles of profitable self-directed investing that when consistently implemented can produce market-beating portfolios over an extended period. How many of the following strategies are you currently applying to your 401(k), IRA, or individual brokerage accounts?

Principle One: Investing is 90% Half of This

Paraphrasing baseball legend, Yogi Berra, investing is ninety percent half common sense. As much as the institutional way of stock picking may attempt to convince you otherwise, this is not rocket science, folks. Warren Buffett, arguably the most successful investor of our time, once said:

Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.

How well do you know and understand the company’s products or services of the stocks you own? Could you explain the enterprise’s value proposition to practically anyone?

Never invest in any idea you can’t illustrate with a crayon. – Peter Lynch

Put another way, would you purchase the products or services of the targeted publicly-traded company if you were in the market for them?

Alternatively, imagine a friend was the managing partner of a similar, although privately-held enterprise and invited you to buy-in as a partner. Assuming you had the necessary funds, would you accept his or her offer?

The answers to these hypothetical questions should validate your understanding and confidence in the prospects of the company’s value proposition or competitive advantages toward continued growth and prosperity as reflected in the stock price over time.

Give your portfolio a K.I.S.S., i.e., keep investing super simple. Your portfolio's beneficiaries will thank you. And when the Wall Street fee machine insists that its complex investing paradigms are best, remind yourself that common sense and keeping it simple are the primary tenets of successful, do-it-yourself portfolio management.

Principle Two: Disciplined Investors Rarely Lose Money

They eschew complicated or expensive investment vehicles such as options, futures, arbitrage, currencies (crypto or sovereign), commodities, trend following, short positions, technical analysis, momentum growth, high yield dividend, or any trading schemes in the hopes of fast money gains. He or she happily leaves those speculative ventures to professional traders, market gamblers, and the Ouija Board.

Some market pundits believe they can predict future price movements with abandon. Their proverbial crystal ball — disguised in the sophisticated clothing of technical charts, trends, and assumptions — wreaks havoc on the portfolios of unsuspecting investors.

Disciplined value investors do not pretend to know what any stock’s price will be one, three, or five years from now, never mind next week. Nonetheless, an attractive current stock price is a non-negotiable prerequisite for initiating the productive partial ownership of a quality company.

But how can a self-directed investor protect the principal capital of his or her investment?

One rule virtually guarantees an investor will not lose money on an investment.

          An investor cannot lose money unless he or she sells out the position after it declines below the   cost basis.

The above rule recognizes the ever-present dichotomy of realized and unrealized gains in our portfolios. Dividend payouts notwithstanding, an investor can only lose money on a stock if he or she sells shares for a realized loss as opposed to waiting patiently for a realized gain.

Naturally, the inverse is true, as the capital gains of individually-held stocks are treated as unrealized or paper profits until the investor executes and settles a trade.

Nevertheless, unrealized paper gains are always more fun – and paper losses more palatable – than realized losses.

Successful investors practice discipline in every approach to the investment paradigm, most importantly the protection of principal capital invested.

Disciplined, self-directed investors are prosperous because he or she does not lose money.

Principle Three: The Scarcest Commodity on Wall Street

Patience is perhaps the scarcest commodity on Wall Street. Self-directed value investors get to profit from this anomaly.

Patience is the scarcest — and thus most valuable — commodity on Wall Street.

The pursuit of alpha can equate to a portfolio of dividend-paying common stocks of quality companies outperforming the corresponding benchmark over time, plus exceeding any other expectations disciplined, long-view investors have placed on themselves.

Practicing patience in waiting for our investment theses to play out is paramount to investing success and arguably the most challenging aspect of the investment paradigm.

The big money is not in the buying and selling … but in the waiting. -Charlie Munger, Vice Chairman, Berkshire-Hathaway

Self-directed investors can consistently accomplish alpha by researching fundamentally sound companies that are trading at reasonable valuations and demonstrating the propensity for upside while simultaneously exhibiting downside protection or margin of safety of invested capital.

He or she then patiently wades through market and company gyrations for the thesis on the stock to play out over a long-term holding period.

Because disciplined investors remind themselves that patience is the scarcest – and thus most valuable – commodity on Wall Street.

Principle Four: Protecting Your Portfolio from the Wall Street Fee Machine

To be sure, Wall Street institutions will always outperform the Main Street self-directed investor in overall investment-related income due to their knack for punishing clients with enormous churns of fees and commissions.

As contrarians of the Wall Street Way, the mantra of the self-directed investor of Main Street is the absolute return of both capital and dividends with minimal fees and trading commissions.

They never pay more than one percent of invested assets annualized in discount brokerage trading and fund fees, combined. It is just not necessary to pay more. And he or she will likely incur significantly less than one-half of one percent in annualized fees and commissions on their investments.

Considering other, often overlooked costs, such as 401(k), IRA, and 529 plan fees; inflation; income taxes on dividends and capital gains; and the technology used to research and trade those investments, keeping up-front fees and commissions closer to 0.25% becomes paramount to a low-cost portfolio.

Furthermore, disciplined, self-directed investors do not allocate hard earned dollars in any speculative, often high-cost investments such as commodities, high yield or distressed debt, currencies, or abstract derivatives enjoyed by the Type A personality Wall Street traders and speculators.

Also avoided are complicated, risky investment vehicles such as options or short selling. Perhaps we are entertained by observing such exhilarating and speculative activity, but only from the sidelines.

The bottom line in keeping portfolio costs reasonable involves picking cost-effective investment vehicles such as dividend-paying common stocks, low-cost exchange-traded funds; plus FDIC-insured cash instruments to store dry powder from contributions, capital gains, and dividends.

Be cautioned that some funds and brokers are charging inexcusable fees for money markets and sweep funds as well. The Hampton beach house churn comes from virtually all investment categories.

Just like any business, work diligently as an investor to keep your costs as low as possible to make controllable contributions to your portfolio's bottom line.

Principle Five: Own Slices of Companies, Not Just Faceless Stocks

The concept of trading stocks was created to facilitate willing participants taking affordable ownership slices of publicly-traded companies. Of course, that original premise has evolved beyond the fundamentals-based ownership of common shares to a myriad of research methodologies, types of ownership, and trading platforms.

Thoughtful, disciplined, and patient self-directed investors buy the stocks of dividend-paying companies to take advantage of the magic of total return compounding. Ultimately, dividends keep you compensated in the short term as you wait patiently for capital appreciation of the stock over time.

That said, I think the best advice conveyed to investors that lack the rare successful fast money trader’s DNA — myself included — is to stop placing bets on speculative equities and start investing in quality companies. Benjamin Graham, the father of value investing, is the source of that enduring investment wisdom.

Seek high-quality companies with overall attractive long-term prospects. Nonetheless, the potential for the magic of compounding on total returns is more likely when the stock exhibits a wide margin of safety at purchase. To be sure, the enduring quality of the operator remains paramount to the success of the investment over time.

Infamous stock picker, Peter Lynch, author of Beating the Street (New York: Fireside, 1994) provides the best phrasing of this investing phenomenon:

Often, there is no correlation between the success of a company's operations and the success of its stock over a few months or even a few years. In the long term, there is 100% correlation  between the success of a company and the success of its stock. This disparity is the key to making money; it pays to be patient and to own successful companies.

Profitable, self-directed investing targets highly profitable, cash-generating companies that provide margins of safety in a literal sense. Disciplined investors own companies with efficient and transparent management that leverage returns for customers, employees, and shareholders.

Instead of chasing the dragon, they prefer the long-term benefit of partnering with a company that supports its customers with in-demand, useful products or services, rewards its employees with sustainable career opportunities, and compensates its shareholders with positive returns protected by world-class internal financial controls.

Think of yourself as an investor that owns slices of wonderful companies, not just shares of common stock purchased in an instant at your online discount broker.

Principle Six: An Investment Truth Likely to Endure Through All Market Cycles

Warren Buffett famously said, “Price is what you pay, and value is what you get.”

Value matters in all areas of our financial lives, including the stock market. That fact will likely endure through all market cycles for decades to come, if not forever.

Price is what you pay for ownership slices of these wonderful companies. Value is what you get, over time.

I attempt to uncover asymmetric price/value opportunities by conducting due diligence on five fundamental areas without the need for the typical Wall Street prerequisites of an Ivy League MBA, sophisticated financial models, and trading algorithms.

My preferred areas of due diligence are the value proposition of the company's products or services, shareholder returns, management effectiveness, valuation multiples, and downside risk. I then add a pinch of common sense.

I am forever seeking great companies whose common shares are trading at fair prices – then holding the shares for the long-term, if not forever – as the most profitable approach to investing.

Principle Seven: Invest in Current Value, Not Speculative Growth

I often observe that too many investors believe that it is possible to predict trends, catalysts, and macro events with consistency. Their crystal ball is disguised as sophisticated methodology encompassing forward revenues and earnings as well as specific future stock prices. Indeed, history shows that such practices are mostly the fool’s game.

Defensive investors prefer companies that are already growing, not just promising to grow. Howard Marks, author of the groundbreaking book on investment risk, The Most Important Thing (New York: Columbia University Press, 2011) summarizes the distinction between present facts and future speculation with eloquence:

The choice isn’t really between value and growth but between value today and value tomorrow. Growth investing represents a bet on company performance that may or may not materialize in the future, while value investing is based primarily on analysis of a company’s current wealth.

As such, when conducting due diligence for your portfolio, consider evaluating a minimum of three-year trailing growth in revenue, earnings per share, and dividend rates. In each case, look for realized double-digit – or at least favorable – compound annual growth rates [CAGR].

Determining the attractiveness of a stock’s price based on valuation multiples relative to a company’s fundamentals is a primary tenet of the thoughtful, disciplined, and patient investor’s search for stock investing nirvana or alpha.

The potential for increasing annualized compounding from total returns on capital and dividends improves when one purchases stocks with wide margins of safety, i.e., at a price he or she believes is below their estimate of the intrinsic value of the company represented by the underlying stock.

With a nod of gratitude to Marks' timeless wisdom, avoid silly attempts at equity analysis that makes calls such as “XYZ shares undervalued by 27%.” common sense dictates that although a stock appears mispriced in general, an investor should never fall into the self-delusion of being able to predict exact percentages of presumed pricing discrepancies.

If such prognostication were more often right – wrong being the most common outcome – the so-called top 1% of wealth would be more like 50%; until, of course, the zero-sum game of investing reared its ugly head in spite of the magical price predictions.

Nevertheless, in buying value now, an investor is more likely to benefit from growth later.

Principle Eight: Stock Investors' Biggest Fear is Not a Market Crash

A seemingly endless bull market where illusions of fast money proliferate even as bargains become scarce will test a value investor's thoughtfulness, discipline, and patience. Those who compromise and join the herd in scooping up overpriced growth stocks, poor-quality value traps, or tempting fads on the fear of missing out usually regret the purchases when the market ultimately retreats.

Thus, a good question for a self-directed investor to ask at the pinnacle of a bull market is, "What do I dread the most - the fear of missing out or the fear of losing money?"

You can bet on one thing: this time will not be different, and quality bargains will once again abound for the disciplined, patient investor flush with FDIC-insured cash. When will that happen? I have no idea and dismiss any expert predictions on market trends, stock prices, and interest rate movements as no more dependable than the Magic 8 Ball.

I remain steadfast that holding the stocks of quality companies purchased at reasonable prices outperforms the roller coaster movements of the markets over time.

As a bonus, the partial ownership of great companies gives the thoughtful, disciplined, and patient, self-directed investor the sense of directly contributing to socioeconomic opportunities for his or her family, country, and the world.

Main Street Value Investor Podcast

Audio versions of this article are available in the Main Street Value Investor Podcast on Anchor and iTunes.

Copyright 2018 by David J. Waldron. All rights reserved, worldwide.

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Susan Miller 5 years ago Member's comment

This was helpful, where can I read more by you? Do you plan to publish additional articles here?

David J. Waldron 5 years ago Contributor's comment

Thank you, Susan. I am happy that you found the post helpful. This piece originally published on the MSVI blog (see my profile), but I do plan on submitting new material to TalkMarkets from my Finding Value series, in 2019. Happy New Year.

Mike Nolan 5 years ago Member's comment

Gotta love Yogi Berra!

Terrence Howard 5 years ago Member's comment

Solid pointers, thanks.