One of the most common investment platitudes you’ll ever hear is that investors should “have a plan (or system) and stick to it.”

This is good advice if your alternative is to invest without any sort of plan. However, unlike the time-tested value investing approach, many of today’s investment plans are not worth sticking with.

Value investing: Look beyond financial indicators

When they first set out to formulate a plan, many investors decide to base investment decisions on a handful of measures. For instance, they may want to see a p/e ratio (the ratio of a stock price to its per-share earnings) below 15.0, say, along with an earnings growth rate of 20% or more annually, and perhaps a 2% dividend yield.

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This approach worked a lot better in the pre-computer age, when investing was more labour-intensive. Few people wanted to dig through old newspapers, annual reports and other material to get at the data. So more gems were left to be found by those willing to do the work.

Today, if you find a stock with this (or any comparable) combination of favourable ratios, it probably comes with some more-or-less hidden drawback not covered by your system. Instead of steering you away from investments that you don’t understand, or that harbour hidden risk, this system will steer you toward them.

Resist the urge to invest based on momentum

Something similar happens with momentum-based investing, which ignores value investing principles because it involves buying stocks that are going up, particularly in response to earnings reports that beat forecasts. These kinds of criteria are easy to track electronically, so momentum favourites tend to get overpriced quickly. When a momentum favourite reports an unexpected earnings downturn or warning, however, it can drop 25% to 50% instantly.

Other kinds of systems or plans aim at avoiding risk by buying put options to give you a way to avoid losses on your holdings, or using stop-loss orders to sell falling stocks before they drop too far. Plans like these are sure-fire ways to generate commission income for your broker. They do cut risk substantially, but they are even more effective in cutting profit.

The best investment plans or systems use a variation of our value investing approach. That is, they revolve around choosing high-quality investments and diversifying your holdings. Our three-pronged value investing program takes that general description a little further. We advise you to invest mainly in well-established companies; focus on companies that are outside the broker/public relations limelight; and spread your money out across the five main economic sectors (Manufacturing & Industry; Resources; Consumer; Finance; Utilities).

You’ll still need to make your own investment decisions. But our three-part value investing framework will temper the effects of your bad decisions and help you cash in on your good ones.

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