It's one of the hazards of the job - as soon as someone learns you're an investment advisor, the first question is usually, "Should I sell my stock in company XYZ?"
However, the response, "Why did you buy it?" often stumps people. Beyond vague hopes that the stock's value will increase, goals are often hard to come by. All investors want their portfolio's value to rise, but to make it go up, a strong plan of action is necessary.
By explicitly writing down an investing thesis - specific goals for each investment in a portfolio - anyone can become better prepared to make decisions, re-allocate funds and analyze their performance over time. By beginning with the end in mind, we are always thinking about our long-term goals before each new investment is made, including our potential exit strategy. Read on to learn how to set goals for your portfolio.
Why Should I Write It Down?
Are you doing what the big boys do? Most buy-side money management firms won't lift a financial finger until a solid thesis is in place for every security purchased, waiting weeks or months before finally vetting the merits of a particular investment. Investors can use many of the same strategies as the big shops, such as organizing research tasks and pre-scheduling follow-up reviews on stock holdings. This is particularly helpful if they've put their hopes and assumptions about the investment in writing beforehand.
Behavioral finance introduces us to the heuristics concept. This means that investors often use approximations and generalizations when investing, rather than pure facts and objective analysis. The human aspect of investing will always be present, but by recording your thesis before making a purchase, you will be less likely to invest on a whim and more likely to take that extra look at the financial statements.
Hindsight bias comes into play when we fool ourselves into thinking we're smarter than we actually are. It's all too easy to view a beautifully vertical stock chart one morning and think to yourself, "I remember last year I looked at this stock, and I knew this was coming." Thus begins a small but frustrating cycle of "kicking yourself" and wishing you had acted on your idea. By writing down your ideas, especially the actionable ones, you can record this history, providing yourself with a better opportunity to act on it.
Loss aversion is another principle from behavioral finance that is quick to rear its ugly head. Most investors feel the pain of a loss more than the joy of a gain and, therefore, may be inclined to hold onto losing stock positions in the hope of making their money back. This scenario is a lot less likely to play out if the investor writes down an exit strategy before purchasing the stock.
Keep It Simple
Goals can be very simple, and a thesis for a specific stock is often just a compilation of goals related to industry performance, the company's size and the future growth of earnings and revenue. The key is for the investor to believe in the practice enough to sell or reduce the stock if the stated thesis proves too slow in playing out - or is just plain wrong.
Some broad categories that are goal-worthy include:
Growth vs. Value - This is a sometimes overused prescription for investing, but the core distinction between a stock that has a premium valuation and a cheap one is easy to comprehend. A broad market multiple as a benchmark is a good starting point.
When considering a growth stock, a simple and trackable goal is for the company to remain a growth stock. A company with a price-earnings ratio (P/E) in the mid-20s will need to grow earnings at a fast pace to retain the premium multiple. Meanwhile, a value stock with a P/E in the low teens may only need to grow earnings modestly and sport a healthy dividend to retain its current multiple.
Company Size - Small-cap stocks are often sought for their capital appreciation potential, while large-cap names are generally favored for their stable earnings and yield potential. Small-cap companies are not widely followed by analysts; a thesis could include the hope for increased attention as the company grows its earnings and market capitalization.
Buyout Targets - It is generally not wise to invest in a company just because it's a perceived takeover or leveraged buyout target. However, if a company is a good takeover candidate, it usually has fundamental metrics that make it a good stock on its own merits. Use these to complete a thesis for the investment, as M&A activity is often based on macro forces like prevailing interest rates and growth in gross domestic product (GDP), which are independent of the company itself.
Time Frames and Upkeep
How long do I want to hold this investment?
This is a vital question, and will go a long way in determining how often to research the company and how lofty the goals or targets should be. If you bought a stock intending to leave it to the grandkids, consider limiting yourself to reading the annual reports. If your initial thesis for the company is a long-term, must-have holding, it's better to not be swayed by short-term market noise. Trust your long-term view, as long as the evidence supports it.
For all time frames in between, quarterly earnings reports are the most comprehensive information source you're likely to find from the company. These quarterly reports are a great time to revisit the thesis for each company. If a holding is more of a trade, then you'll want to be sure to tap into a daily news source for your investment.
How will I judge the effectiveness of my holding, and whether my assumptions are right or wrong?
It is often more helpful to have targets based on earnings, margins or industry growth, as opposed to specific price targets. Valuations (and therefore price) can and will change over time, and not just in relation to the broad market. Individual companies hit their strides at different times, and nobody knows for sure how a specific market will mature. Investor sentiment will often rally behind a stock well in advance of actual earnings growth, and too much focus on the stock price can detract from the broad view of your investment thesis.
If a stated goal or thesis looks to be incorrect, you should have a consistent and swift plan to sell the stock, or at least reassess your thesis - in writing. This not only puts the decision impetus back on you, but also creates a written record, which is extremely helpful for taking a practical look at your performance over time. Many people find patterns in their mistakes, such as a consistent overestimation of industry growth, or too short a time frame. This feedback is vital for making more accurate assumptions in the future.
Know When to Concede
Many investors look to a basket of stocks, such as an exchange-traded fund (ETF), to fill certain parts of the portfolio, especially for hard-to-research industries like biotechnology or mining. When going this route, make sure the thesis involves a full knowledge of fees and the individual holdings within the fund. Upkeep is pretty simple and should consist of periodic checks of a relevant benchmark like a similar ETF or mutual fund.
What Your Thesis Should Include
Here is an example of how your thesis could look for fictional company XYZ Industries:
Example - Investing Thesis for XYZ Industries
May 31, 2013 - XYZ Industries is currently No.2 in market share in its core business of selling designer widgets. Market share is currently at 27%, and it has improved that from 23% a year ago. An industry trade group predicts that the total market for widgets will grow by 10% during 2013 and 2014.
- 35% market share within two years
- Total widget growth to remain at least 8%
- Maintain current P/E of 21 by growing earnings by at least 20% annually
- Maintain or grow operating margins from the current 22% level
- Keep a healthy balance sheet; keep debt/equity below 40%
Exit Strategy - Sell position if XYZ loses market share during a full 12-month period, or if industry growth turns negative for more than two quarters.
Writing down a thesis for every investment may seem almost too simple to be effective, but lessons from behavioral finance tell us that bias and fear of loss often cloud our views, even for the most disciplined investors. By being explicit with your goals, you are creating a record of your thoughts and convictions, which can teach you many things if you are willing to learn from decisions that didn't turn out as planned.