The Disciplined Investor (Part 2)
When I turned 18, my parents deposited $1,500 into an investment account and connected me with their broker. They wanted me to learn about investing. The broker laid out two options:
- A low-risk mutual fund that would make me a modest return each year.
- A high-risk junior gold mining company that had a few promising projects that could net me a significant return.
Blinded by the prospect of doubling my capital, I invested $ 1,500 in the junior mining company. Within six months, I lost the entire investment.
Lesson learned.
Speculative investing is dangerous.
A year later, I started working for a large telecommunications company. On my first day of orientation, my manager walked me through the paperwork. There was a section titled Employee RRSP Program. I could automatically deduct up to 6% of my paycheck, which would be used to purchase the company's stock. For every four shares I purchased, the company would purchase one share on my behalf. All shares would be placed in a tax-deferred retirement savings plan account. I maxed out at 6% and forgot about it.
These were standard employee benefits, but to a 19-year-old, it may as well have been written in another language. It should be noted that the company also had a deferred benefit pension plan, and as I worked up the corporate ladder over the next 15 years, I had the opportunity to receive stock options.
Before I knew it, I was sitting on a small fortune.
Another lesson learned.
Take advantage of your company's RRSP matching and stock option programs and max them out.
Over time, I developed an interest in stock trading. I was a technology enthusiast at the time and read extensively about new emerging tech. This passion led me to invest in some tech stocks early on. I bought and held these stocks over many years, minimizing annual volatility. Over time, I noticed that my technology stock picks outperformed my pension.
This was the first time I questioned allowing someone else to manage my money. Why couldn't I manage my own investment portfolio?
This question burrowed in the back of my mind until it resurfaced when I took a role at another organization. As I worked through the exit process, I had to decide what to do with my RRSP, pension, and stock options. More importantly, I had to decide whether to self-direct my investments or pay someone else to manage them.
I chose to cash out everything and self-direct my investments. In essence, I was betting on myself. I thought I could manage my investments intelligently without paying exorbitant management fees.
I needed an investment strategy.
I started reading John Bogle's bestselling classic, Common Sense on Mutual Funds. It's a love story about index funds and the importance of long-term investing. This was going to be the foundation of my new strategy. Create a diversified portfolio of exchange-traded funds (ETFs) that I would rebalance annually. I wrote about it here: The Disciplined Investor (Part 1).
Years passed, and I was content with using a passive strategy. It was low-maintenance and had predictable, modest returns. I just needed to pick the right ETFs (and a few stocks for fun) and rebalance them once per year. Borrowing a phrase from my daughter, it was "easy peasy lemon squeezy. "
But I yearned for more. Surely, I could do better. I set out to learn from the greats like Graham, Buffet, Munger, and Lynch. I read Kahneman and Taleb to help me better understand risk. One book in particular, Investing Unplugged written by Alpesh Patel, really struck a chord and changed my mindset.
Market success has next to nothing to do with the stocks you pick. It has everything to do with money management - how much you stand to lose, when you increase your winning positions and exit your losing ones. Research proves it, and professional traders confirm it.
These three sentences had a profound impact on how I approached investing and money management. Before encountering this concept, my investment strategy was anchored around diversified index funds that reduced volatility. However, this approach resulted in limited gains.
Graham advises that "successful investing is about managing risk, not avoiding it." By systematically limiting the amount of capital I risked in each trade, I could create a concentrated, diversified portfolio of stocks that yielded higher gains. To achieve this, I adopted the 2% money management rule, never risking more than 2% of my capital on any single trade. I then apply a trailing stop-loss order of 25%. If you're interested in a more detailed explanation, you can find it here.
Lesson learned.
Learn from the top 1% and apply the principles that work for them. Develop a system that manages and controls risk.
It's more important to protect your capital than pick the next big home run. By using the 2% strategy with automated stop-loss parameters, you protect your equity. Losses are inevitable. The best investors limit their losses because, mathematically, the amount you have to gain will be larger than the amount you lost. If the stock price drops by 10%, you must gain 11% to recover. If the stock price drops by 40%, you must gain 67% to recover.
Create a system that protects you from losses.
To summarize what I've learned on my financial journey so far:
- Speculative investing is dangerous and rarely works.
- Maximize company matching policies.
- Utilize tax-deferred accounts.
- Money management is more important than the stocks and ETFs you pick.
- Develop a system to right-size your positions and protect you from losses.
More to come...