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Rules of the game

Don’t be too hard on yourself. So your portfolio has lost 14 per cent of its value this year. That’s okay. The FTSE All-Share index, which may well be your benchmark, is down 19 per cent, despite its bounce-back. You’re well ahead of the average.

Second, I need to throw in some caveats. I know nothing about your portfolio, your investment aims or the time horizon over which you’re working. Yet these factors are crucial – they will determine your appetite for the volatility that always accompanies investing in equities. So I am restricted to making general points. Here are four:

●  Stick to the discipline.  Using clear, mechanistic rules about when to buy and sell is more good than bad. Such rules have limitations, but they tend to lead us away from our faulty thinking. This is particularly valuable in avoiding what’s been labelled ‘getevenitis’ – the tendency to hang on to a losing position for too long in the hope of eventually getting even. What’s really happening is that we can’t bear to turn a book-keeping loss, which can be mentally fudged, into a cash loss, which can’t.

Using rules helps investors get through that mental barrier. Jesse Livermore, a great speculator of the US markets in the early decades of the previous century, once remarked: “A loss never bothers me after I take it. I forget about it overnight.” That’s true. Believe me, I’ve done it often enough. Livermore also cautioned: “But being wrong – not taking the loss – is what does damage to the pocketbook and to the soul.”

●  Know the limitations of stop-losses.  Rules are good, but only up to a point. This particularly applies to stop-losses. They work best when they’re used to run a winning holding. The stop-loss moves up in line with the rising security price. That way, you will never sell at the very top, but your exit will be thereabouts.

For holdings where there is no profit to run, stop-losses are less useful. Imagine you buy a stock and its price dips 25 per cent almost immediately. The stop-loss tells you to sell and you do so. That’s good to the extent you’ve followed the Jesse Livermore dictum. But perhaps you have simply crystallised a loss where – with patience – there would have been a good profit. This is where it pays to understand the importance of volatility and valuation.

  Understand volatility and valuation.  Volatility tells us that share prices bounce around lots. It would be unusual for the whole market to be down 25 per cent on the year. For the price of an individual share, however, that’s quite normal over any 12-month period, especially if the company concerned is fast growing and hard to understand.

Maybe that means you simply widen your stop-loss levels, especially in the early stages of holding a stock before there is a profit to run. It also means you should understand that volatility is partly the fault of the valuation process.

Valuation offers the appearance of precision, but it’s an illusion. This is why share prices are so fragile. One blow to the valuation edifice – it does not have to be a hard one – and the whole thing collapses. Yet – and here’s the paradox – if the values that the process produces are useless, the valuation process itself remains vital. Really, we are back to talking about discipline; in this case, the discipline of using formal procedures to think hard about something difficult – how to value a company. That helps give us the confidence to calmly assess those volatile price swings.

●  Know how little you know.  Your letter says “I knew the market would rise sharply” following its fall. But what if the market had not bounced? What if we were seeing a re-run of 1973-74 when UK equities just kept falling and falling? And what about the next three months? Will the market reprise April and May or February and March, or something in between? We can’t know. So, let’s be clear – this was intuitive knowledge you mention, not the factual kind.

No problem with that, but I wonder if your intuitive thoughts would have been so confident if your equity portfolio was your only asset and your sole source of income. The losses you might have been staring at could have destroyed any confidence. And the point here is to talk up the importance of diversification. Put simply, the more that assets are diversified, the less it matters how little we really know.