The customer is usually wrong

I have searched in vain among the many 'How to Invest' books for any that discuss how to be a good client. My experiences during quarter of a century on the sell-side of the securities industry show this makes a great difference to being a good investor, because investors are by definition buyers of financial services.

Investment is a cyclical business. Understanding how best to exploit cyclicality and managing the associated risk is probably the most important secret of investment success. This has relevant consequences both for my career and my clients' financial health.

As far as my career was concerned, it required the development of skill in repeatedly reinventing oneself after each cyclical downswing. It was often necessary to find a new investment frontier where demand could grow and supply was limited so as to generate a rise in the value of my services.

It seems one gets the clients one deserves. As a frontiersman, I was seldom employed at doing anything prestigious (at least initially) and so I had little success in attracting important clients, but much better success in attracting adventurous ones. This in turn means I was lucky to count among my clients many highly successful investors.

MARKET TIMING

One important lesson was taught to me by Jock Thompson, a colleague in the first stockbroking firm to hire me, where we both worked in stats, which is now known as wealth management.

That was in the stagflation era of the early 1970s. When I asked him why the stock market moved up and down in apparently regular four-year cycles, he replied that many investors may have been around for 20 years, but most of them had only relearned the same four-year lesson five times. Decades later these cycles may be less regular, but they persist.

Losers go through the same depressing routine time and time again. First, they fail to spot new trends because their minds are elsewhere. Then, if lucky enough to come across any early adopters, they fail to copy them because they would rather place their trust in others than do the hard work of research themselves.

As rational beings, their decisions are made on the balance of the evidence before them. Since evidence freely available is already discounted in share prices, they inevitably do the wrong thing at the wrong time.

Having made an initial investment error, losers then compound it by drawing the wrong conclusion to never play that investment game again. Hence, those who bought technology in 2000 vowed never to buy shares again, so switched into structured products in 2002, just when they were guaranteed to miss the next bull market. At the top of that bull market, they were diversifying into commodities, on the same phoney argument about diversification that led predecessors into emerging markets in 1997, Japan in 1990 and smaller companies in 1983 - each at the peak of its cycle.

On the other hand, winners learned from their mistakes and entered the next cycle wiser. This takes little wisdom, as it merely requires buying sometime in the bottom half and selling sometime in the top half of each cycle. This sounds easy, but it in turn requires acceptance that risk exists, needs to be managed and cannot be wished away. So buying near the bottom of a bear market incurs the risk that prices might fall further before rising. This is a risk that is inevitably better advertised at the bottom, when small, than at the top, when great.

BLAME

A couple of career moves later, when Britain's hard left Government was bent on driving out capitalists, in my youthful ambition of still becoming one I emigrated to Germany where I had my next useful experience in identifying successful private clients. Armed with my Series Seven Certificate as a registered representative (aka licence to steal), I entered a retail market, whose national characteristics made participants particularly unsuited to equity investment.

Typically, Germans went for one extreme or the other. They either chose bonds for safety or short-term highly leveraged trading on margin, options or futures, in order to make their money work as hard as they did. It was a rare German who appreciated the advantages of a well-diversified portfolio of common stocks bought for the long term, but those few stand out because of their rarity.

For one new client I bought a handful of stocks, most of which performed either well or acceptably, but one of which turned out to be a serious error of judgement on my part. Fearing to call him to face his wrath, I did nothing, as is typical of many investment advisers. Fortunately, he called me to ask if I had any ideas for switching because this one did not seem to be working out. Relieved not to be blamed, I gave him an alternative, which worked out much better.

Many years later, despite several more career changes, I still look after his funds. Every so often I make further errors of judgement when markets take an unexpected hit. I send out hand-holding letters about recovery potential. Ideally we invest whatever small amount of cash is available. He gets on with the rest of his life as his portfolio benefits from benign neglect and then participates fully in the next bull market. Over the years, there have been many such clients.

The second lesson, therefore, concerns blame. Losers seek to blame someone else, irrespective of who was responsible. Typically, they decided to invest at the top, only sending funds then, even if recommendations were made on the way up. Then they blame the adviser on the way down, exploiting the myth that the customer is always right, when in investment decisions, he is usually wrong. On the other hand, winners absolve those who tried but failed, with the result that their advisers are willing to continue trying to do their best, rather than taking the salesman's easy route of satisfying the client's stated needs.

DISCIPLINE

Another client in Germany illustrates a third lesson - a disciplined investment process. Working together with this client, a professor of economics, his portfolio ran to 40 stocks, which was an unusually large number. This avoided the risk of falling in love with his shares and meant that he could invest in companies of which he had never heard, because no single one of them represented a significant part of his portfolio.

On average, once a quarter we would discuss investment themes. Each time he went away to develop a shortlist of suitable candidates based on his subscription to value line, a stockpicking service that researches 1,800 companies regularly, which I then subjected to further analysis. He invested in those, finding the capital by selling any existing holding that value line rated as underperform or sell - no questions asked.

After his death, his wife continued the same strategy, even though she had no investment expertise. In due course she became a wealthy widow.

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