By Catherine Shenoy, PhD, MBA

Editor's Note: Catherine Shenoy and Kent McCarthy are co-authors of "Applied Portfolio Management: How University of Kansas Students Generate Alpha to Beat the Street." The following article should be a useful guide to investing not only to young adults but to many adults as well.

What is successful investing? With the Applied Portfolio Management (APM) program at the University of Kansas, Kent McCarthy, the founder of the program, and I have had the opportunity to observe many types of investors and investment thinking.  Just as there are many ways to define success in life, successful investing is also multi-dimensional.

Most mutual fund managers are deemed successful when they outperform their benchmark. It doesn't matter if their benchmark is down 10 percent for the year. If they only lost 5 percent, they've outperformed the benchmarks. Over time most mutual fund managers perform in line with their their benchmarks. Only a few have a long-term record of out-performance.

Another way to define a successful investor is one that doesn't lose money very often. He or she may not beat the index, but capital is preserved. It's very hard to have a long-term record that beats the market in both up years and still makes money in years that the market is down. Lots of people have a great year occasionally. Not very many have consistently good years with some great years thrown in.

Many individual investors have a particularly poor performance record. John C. Bogle, the longtime chairman of the Vanguard Group, testified before Congress about the phenomenon. He outlines what he calls the "timing and selection penalty." Investors end up usually buying after run-ups in stock prices and end up selling on bad news when prices are low. Bogle estimates that the the combined annual effect of these penalties is around 8%. With an annual market return around 10% and inflation about 3%, the real return is negative!

Psychologists have identified this type of behavior by investors, and call it the "recency effect." In the APM class we call this type of thinking "ruler analysis." Generally, when people forecast stock prices, or anything else, it's easiest for them to assume that the past will be like the future. However, in markets, individual stocks, economies, and lots of other areas, cycles and changes in directions are very common. Because so many people like to jump on the bandwagon and invest in stocks with rapidly increasing value, those stocks with recent price increases are more likely to be overvalued.

Another big influence on investment decisions is the financial media. The media, especially since the advent of CNBC, want to create a sense of crisis to keep viewers or readers tuned in to each tiny gyration in the market. How do they pick stories and stocks to follow? They want to follow large companies with a broad base of investors.  "Breaking news" helps them hold on to viewers and create a sense of urgency.

By understanding different market participants' incentives, we try to see when there may be some influence on prices outside of a stock's intrinsic value. In class we try to focus on making our own decisions about stock valuation and not being too influenced by temporary price aberrations caused by one of the market participants or the media.

We define successful investing as long-term return. We don't need to beat any benchmarks. Even in down markets, we'd like to be flat or have a small positive return.  The other component of our success is learning. If we have a good return on an investment, but the students didn't learn anything from holding that position in our portfolio, we weren't successful in our mission to educate student investors. Individual investors may also have non-financial results that are important. The growth of socially responsible investing is an example of a goal that is not purely financial for many investors.

Common Traits of Successful Investors

Extremely successful investors are focused, hardworking, and driven. They are always excited to talk about investments and investing. They are always looking for the next insight and trying to get another piece of the market puzzle to earn an extra point or 10. We've identified some commonalities over the years. We've found that these individuals are honest, they are avid readers, and they are working both on the details and the big picture of an investment idea.

To be honest, you've got to keep score. Know where you are with all of your holdings, not just the good ones. Humans tend to remember things that bring pleasure and forget things that bring regret. It's important to examine both the good and bad outcomes, and determine whether these outcomes were the result of luck or decision making. Sometimes you make the right decision but have a bad outcome. Sometimes you make the wrong decision and get lucky. To become a better decision maker, you have to recognize when luck intervenes.

Being honest is admitting and learning from mistakes. Being honest takes courage. CNBC doesn't invite people to be on their shows to talk about mistakes, but honest investors will learn a lot more from mistakes than from successes. To improve, you've got to figure out what went wrong.

Not everything works, but some things take time to work. Investing is dynamic. The situation changes every day. It's important to reevaluate your ideas frequently. Make adjustments if necessary. Recognize that some ideas require years to play out. The ideas that take a long time to develop should have the kind of payoff that rewards a patient, long-term investor.

Being honest means knowing yourself. Can you ignore the public clamor and bet against the crowd? If not, then it will be very hard for you to be a contrarian. Most students don't yet trust their own judgment and analysis. They figure that an analyst who spends lots and lots of time studying a company will make better investment decisions. In many cases, they are right. Yet there are many times when an analyst gets caught up in previous recommendations. A situation might have changed. The analyst understandably doesn't like to admit he or she is wrong. The investors who relied on the analysis aren't always forgiving sorts, but it is better to admit a mistake and move on.

Read

No investment manager ever has come to class and said he had enough time to read all that he wants. They all want to read more about companies, about the world, and just about everything else. We expect students to read about the macroeconomic environment and to read about the companies we're invested in. We all should read authors and ideas that we agree with and most important we should read authors and ideas we disagree with.

One APM speaker, Frank Whitsell, director of research at Security Benefit, a mutual fund and financial advisory firm based in Topeka, KS , made the analogy that understanding investments is like a building a wedding cake. Experience really matters. In the first layer of the cake you are forming the base, but you don't have much depth. After a year or two of looking at a company or an industry, you start to understand some things that weren't obvious when you started. Now you are putting on another layer on the cake. Reading about events over the years, understanding your reaction and others' reactions to the same events are all important components to building your cake.

Work Hard on the Details and the Big Picture

Successful investors have a guiding philosophy - the big picture. They are usually eager to discuss, share, and talk about their philosophy. So why aren't we all rich successful investors? Because the devil is in the details. Successful investors spend a lot of time with the hard work of implementing their philosophy. We all like the idea of being a successful investor, but we don't all like the idea of the work it takes and the focus on the details. Surface analysis dooms average investors.

A less common but frequent mistake of new and newly energetic investors is being so engrossed in the details that they lose track of the big picture. In late 2000 it was common to hear people talking about what a great deal certain tech stocks were. Yahoo's price/earnings ratio was "only" 81, down from over 2000 in 1999. People who claimed to be value investors were now saying that Yahoo was a great deal at 81. Historically 81 was still in the stratosphere.

Know what type of investing cycle we're in. Part of the keeping an eye on the big picture is recognizing what types of market conditions make it harder for your strategy to produce top results. Value investors didn't give up value investing during the tech bubble, but it was very tough for them to sit and watch the "irrational exuberance" that the momentum investors were enjoying and the big returns they were raking in. Warren Buffett had a bad year during that time, but he didn't abandon his overall philosophy or view of the world.