Investing rule No. 1: Do your own work

Here’s a good rule for investors to follow in any situation: do your own work.

Writing for The Wall Street Journal on Friday, Jason Zweig chronicled some of the problems seen this year at funds that seek to mimic the performance of the market’s most prominent stock pickers.

For a while, this was a great strategy.

Zweig cites research from Evercore ISI that indicates the top 10 holdings among highly focused funds — think Bill Ackman’s Pershing Square, for example, which is long just eight stocks and publicly short only one — outperformed the S&P 500 by a healthy 10.4% a year over the last four.

But now the tide has turned with these funds losing amid not only a late-summer market decline, but huge drops in what became some of these funds’ most overweight holdings. The most public of these heavily-owned-by-concentrated-hedge-funds disasters was Valeant Pharmaceuticals, which lost about 20% in the third quarter and about another 50% in October.

The issues at Valeant have been well-documented and it remains to be seen how that position plays out, but while hedge funds were loading up on the stock and analysts were praising its strategy, there were major investors pounding the table calling Valeant’s strategy, at the very least, problematic.

But if you’re following the big guys, your strategy is built around not worrying what other people say, but merely following what the folks you’re replicating do.

As one fund manager told Zweig, “I have some of the most brilliant people in the world doing my security selection,” which is both true and not.

For one thing, the backbone of any investing process should involve a healthy dose of self-doubt and reconsidering. Is there something I’m getting? Is there something I hadn’t considered about this company before?

Things can and do and will go wrong with companies and investments. As these things first break down you may not know why or how things went they way they did, but a sound, self-critical process will at least give you a chance of figuring it out at some point. If you’ve simply followed other investors into a trade, you don’t have a reliable process for self-discovering those mistakes.

But then there are the practical barriers of actually replicating a big-name investor’s strategy.

Sure, someone like Bill Ackman or Dan Loeb or Warren Buffett is a person you can learn a lot from as an investor. But just because these folks are required by the SEC to make a portion of their portfolios public doesn’t mean 1) you have the full picture and 2) you can replicate their success by following these disclosures.

Zweig references funds in his piece that have $US400 million, $US143 million, and $US176 million under management.

Ackman’s Pershing Square fund, for example, has about $US20 billion.

And so while size is of course not a pre-requisite to investment success — in fact it can often be a detriment — when constructing any portfolio part of the consideration must be capital preservation.

So if you’re aiming to replicate the strategy of some big-money, widely-followed hedge funds with 1/100th the capital, certain market downturns can have an outsized negative effect the folks you’re tracking might not necessarily be dealing with.

And if you’re then selling a certain position as a result, all of a sudden you’re not replicating anybody’s strategy but merely saving your own arse.

Though of course all this can be avoided by simply heeding the advice of one of our favourite Twitter follows, Modest Proposal, who said simply: “Do your own damn work.”

Read Zweig’s full post at WSJ.com »

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