This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 10 October 2015.

When you think back to your years at school, for some people it’s a fond memory of days gone by; for others it’s more of a nightmare that they’re glad they never have to repeat. One school ritual which people either loved or loathed, was the regular PE session. Usually the teacher would select two captains, who would then take turns picking members for their team, whether it be soccer, rugby, netball or any team sport. It was truly a brutal process, for there was no hiding the implications of being picked in the last few rounds. As subtle as a slap in the face, the message was clear: you’re really hopeless at soccer/rugby/netball/whatever. You could sense the desperation in the remaining kids as the captains called out the better, faster, stronger players. You could also sense the hesitation and reluctance in the captains as the numbers were whittled down and they tried to judge who was least-worst between those who remained. It was schoolyard honesty at its most cruel – almost Lord of the Flies–like in its heartlessness, though of course without the chanting or the eventual homicide.

In some ways, building an investment portfolio is not too different from the team selection job faced by the (usually) reluctant captains. The key difference however, and this is the approach we adopt in regards to portfolio construction, is that what you leave out of your portfolio is generally more important than what you decide to include within your portfolio. This may sound like splitting hairs, but the essence of the argument is that avoiding loser investments is more important than selecting the winners. There are two reasons why this is important: firstly, always picking winners is a difficult task. It’s generally easier to identify those investments you should avoid (the losers), than it is to discover some unearthed gem of company whose share price goes from $10 to $100 in a week. There are however, all manner of warning signs which an astute investor should be able to detect in the next Enron or Lehman Brothers. The second and probably more important reason, is that the damage from one dud investment can easily far outweigh the gains from the rest of your portfolio. It can take a long time and quite a few winners to recover from losing 5% of your investment capital outright. So next time you’re thinking of an investment, think Lord of the Flies, and ask yourself, do you really want that ‘loser’ on your team?