Thirty words to success

Within the confines of the 30 words in question, there is a complete plan for equity investors; almost an assurance of success for those who do no more than follow the advice - both implicit and explicit - contained in that short sentence. The advice, taken from Baruch's memoirs, is: "Even being right three of four times out of 10 should yield someone a good fortune if he has the sense to cut his losses quickly when he is wrong."

Let's dissect this because it packs a lot of information into a short space. The words clearly say something about when to sell, telling the average investor to "cut his losses when he is wrong". But, more than that, they reveal clear advice on how long to hold a stock.

Baruch says that in order to make decent average returns an investor only needs to be right three or four times out of 10. Put it the other way round: he can get up to seven out of 10 calls wrong yet still make acceptable overall returns. That's an encouraging thought. It says that the wonder of the positive-sum game that is the stock market can bring good results even to an investor who gets two-thirds of his initial assessments wrong. The key, however, must be that this investor can quickly separate the sheep from the goats - the winners from the losers - and act accordingly. He runs the winners and gets shot of the losers.

Since it is impossible to know in advance which selections will be the winners, there needs to be a mechanical formula for separating them from the losers. This is vital - the performance of the portfolio will depend on running these comparatively few success stories.

Bearbull knows this better than most. No one would accuse the Bearbull Income Portfolio of being anything other than successful. In its nigh-on 15 years, it has turned £100,000 of capital into £276,000, while simultaneously generating £111,000 of income; over the same period, London's All-Share index generated about £47,000 of capital gains and £35,000 of income. Yet, as the table, The importance of winners, shows, the income fund's success has depended hugely on the gains made from its 'Big Four' marvellous holdings: food processing companies Carr's Milling (CRM) and Dairy Crest (DCG) plus construction firm Henry Boot (BHY) and Bristol Water, which was taken over in 2006.

The table breaks down the income fund's £176,000 gains into a £47,000 uplift that would have arisen simply by tracking the All-Share index plus £118,000 of gains from those Big Four (£75,000 of which have been realised). True, smart readers will spot a bit of mathematical confusion (some of the £118,000 provided by the Big Four must be attributable to tracking the market, too), but we can ignore that for the purposes of this exercise. That leaves just a weedy little £11,000 profits from all the fund's other dealing over the past 15 years. Granted, the performance of many decent investments has been dulled by having all the fund's lossmaking transactions netted off against their profits. But the aim here is to illustrate the importance of running winners.

The importance of winners

Okay, it would be nice if the fund's profits had been spread around a bit more. But let's take the positives from the situation - that whatever Bearbull was doing, it permitted profits to be run from investments that would turn out to be ultra successful and, I repeat, I could not have known in advance which ones those would be.

As to the mechanics of running winners and selling losers, there are many ways of doing it. Finding a formula that works and sticking to it is more important than the formula itself. I simply set 're-set’ and 'sell' levels either side of the price at which I buy (usually plus and minus 20 per cent to begin with). If the share price falls below the stop-loss level, I sell (almost without exception). If it rises above the re-set level, I do what it says and draw new limits. For serial winners whose levels have been re-set several times (currently Carr's Milling, for example), I will start narrowing the limits. That way minimises the chances that profits will slip away. It ain't rocket science, but it is effective.

Think hard about it and you can see that Bernard Baruch's advice has implications for the sort of stocks to buy as well. That, however, is for another time, and after a bit of stock screening.