Seldom I see aspiring investors talk about this core topic i.e. Investment Styles, while most of the time I observe that everyone wants to copy someone else’s style or rather blindly do what has already worked for someone else. So I’d like to take you through what I think of as a central theme in investing, which is to have an investment philosophy. Having said that, I have noticed two things: one is there aren’t that many great investors out there, right? I mean you can name them, the list is not huge and the second is if you look across these great investors, they actually are often known by their particular style of investing. Peter Lynch was great at investment, he was a growth investor. Warren Buffett is a great investor, he is a value investor. In fact, there are some investors who know charts and have been able to generate great wealth just on that knowledge.

This leads me to the conclusion that you can be successful with a variety of investment philosophies as long as you’ve chosen a philosophy that fundamentally works and second you’ve chosen a philosophy that best fits your characteristics as an investor. What I mean by that is, the best investment philosophy for you is not the one that works for Warren Buffett or Peter Lynch but the one that works for you. So with that introduction come let us together dive more into this topic.

What do you mean by Investment Style or Philosophy?

An investment style or philosophy is a way of constantly re-engineering your investments and allocation, it’s a way of thinking about the market, it’s a way of thinking what things will work out for you and how will they work out, it’s about which style of investment will be sustainable for long term. It is equally based on both, your knowledge and your characteristics.

Philosophy v/s Strategy

An investment philosophy is not a strategy. When I ask you what can be said as investment philosophy and you tell me to invest in low p/e stocks then I’m going to say “No that’s not an investment philosophy, that’s an investment strategy“. So an investment philosophy is far broader than a strategy. It’s a way of thinking about markets, allocation, risks, and rewards.

Why you need a Investment Philosophy?

The reason is very simple if you do not have an investment philosophy (and lots of investors don’t which includes most portfolio managers), then here’s what I think will happen to you:

First, you’re going to be easy prey for anybody trying to sell you that crystal ball or a magic bullet. Some so called expert will say just do this and you’re going to make a ton of money. If you don’t have an investment philosophy you’re going to get swayed by the next great salesperson who comes by telling you that he has an investment strategy that works.

Second, if you don’t have an investment philosophy you’re going to tend to chase whatever worked last year and try that next year. Then again you’re going to try something else the year after and so on and so forth you will be constantly juggling between strategies. This process will probably be mentally tiring and not to mention will consume your precious time. The more strategies you try, the less there is a chance for any of these strategies to successfully work. You’re going to end up with a ton of transaction costs and perhaps a very happy brokerage account because those are the people who will make money and not you. Finally, if you don’t have an investment philosophy you’re often going to pick some strategy that doesn’t fit you.

I think I have clearly explained why everyone needs an investment philosophy to be a successful investor and so let’s think about different kinds of philosophies. To set the table again I’m going to look at the investment process as I see it. The investment process always starts with the investor so if you’re managing your own money it starts with you. If you’re managing somebody else’s money it starts with that somebody in particular.

What to know?

One should know what one’s risk preferences are. Are you risk-averse? How risk averse are you? What is your time horizon? Are you short-term or long-term? And don’t just blindly say long-term as it might often be out of your control. Also what kind of tax status we have? Do we have to pay a high tax rate or a low tax rate? The answers to these questions might vary from person to person and they will decide how your portfolio will look like.

Easy Part

The key factors that drive the first steps in the process are understanding the tax code and understanding yourself as an investor.

Then starts the portfolio management, and the first step in portfolio management is creating a portfolio based asset allocation. Deciding how you divide your money to put in broad asset classes like stocks, bonds, real assets, etc. To further discuss each of these, between stocks you can have your domestic stocks and foreign stocks. With bonds you can have corporate bonds, you can have treasury bonds, you can have high yield bonds. With real assets you can have real estate, you can have gold, and a variety of other real assets. Generally, the first step in portfolio management is identifying the “Allocation” and it’s going to depend as much upon your risk aversion as it does on your views about the market.

Then comes the part where once you are certain with the allocation. Let’s say you choose 50% of the money to be invested in stocks. You have to choose which stocks you’re going to buy now. Either you could pick your stocks based on charts, or you could pick stocks based on the growth potential or you could pick stocks that pay high dividends or something else. In effect there, what you’re trying to do is bring something to the table that will allow you to pick the best. Similarly, you divide the other half of your money to choose the best bond or best real asset you think can give decent returns. So you’ve allocated your assets and then you pick the right securities within each asset.

Last step is execution. You actually have to go out and buy those assets. No big deal, right? Read further then.

Tricky Part

Well, I did not mean it as tricky, you can say this part needs little extra efforts that not many of us put. Obviously, for this part, I think most of us should get help from a good financial advisor. None the less it everyone should know this part, and I strictly recommend to read on.

Tracking your portfolio is essential, not daily but yes at least half yearly or quarterly. You have to look back at your portfolio and ask yourself did I make a sufficient return? Not just “did I make money?” but “did I make a sufficient return?” given the risk I took. So you have to measure the risk on your portfolio. You have to measure the return on your portfolio. You have to have some kind of benchmark that you decide which you have to beat and more importantly you have to be honest with yourself, “did I actually make money with all of this work I’ve put into this portfolio management process?”

Bird’s eye view

You can categorize investment philosophies very broadly on the following dimensions:

  1. Your investment philosophy can be a market timing philosophy where much of your work is done at the asset allocation stage. Here you basically shuffle the asset allocation based on your analysis of the market. For example, if you think there will be a surge in gold prices and stocks are going to underperform then you shift-increase the asset allocation from stocks to gold, etc etc. As long as you understand the markets very well, you just have to put your money in the right asset class and you’re going to make money.
  2. If you can pick the right stocks or the right bonds or the right real assets it can be activist investing or passive investing. As an activist investor, you actually take a position in an asset or a company and you try to change the value of the company. Most of us don’t have that much power but if you have enough money you might try. Whereas as a passive investor, you invest in the best investments you can and hope and pray that those investments go up as much as you thought they would.
  3. If you have asset selection strategies basically you’re looking at a variety of different philosophies. You could pick stocks based on charts, you can pick stocks based on fundamentals, you can pick stocks based on growth. Whatever you’re doing you’re essentially trying to still pick the best stocks or the bonds that will make the highest returns.
  4. Finally, the execution based philosophies where essentially you try to take advantage of market mistakes. A classic example of this is arbitrage based strategies where essentially you try to find the same asset price differently in two different markets and just buy it in the lower price market, then sell it in the higher price market and claim the difference. Another example would be if you think a company is undervalued in the same market, with all your skills you are able to identify that little early than the market, then investing it that company can get you decent returns in the long term.

To Summarize…

I think the first step is to lay the foundation you need to be able to understand risk and incorporate risk into your decision-making. I’m not talking about this understanding risk and return models in finance you might never use them but you might still be able to understand risk.

Second, you need to understand financial statements you cannot invest in stocks without understanding basic accounting statements. You have to understand the process of trading, what is the cost of trading, what are the frictions, why might your strategy not work in the real world.

Develop a point of view about how markets work and where they might break down markets make mistakes. If you believe markets make mistakes you have to start fleshing out what types of mistakes they make and why they make those mistakes and then find the philosophy that best fits you. That’s the key!

Finally, investment philosophies can be short-term medium-term, and long-term and there’s again no predisposition on my part to say long-term philosophies are better than short-term philosophies if you can find a short-term philosophy that works for you all the more power to you!

Enjoy more such articles on cannysaver.com! Happy investing! Peace!