I’ve come to believe the most important investment decision you can make is deciding upon an investment philosophy. I call it a philosophy but it could also be called an investment style, an investing strategy or even and investment system. All of these terms are rather hard to define. Some have clear meanings. Let’s elaborate on investment philosophy.
As usual I searched for these terms on Google. Again the most promising links were from Wikipedia. I found an article on investment management that I thought was a particularity good place to start. My hunch is that the average investor’s concept of investment philosophy relates to mutual funds.
Many Americans have experience with mutual funds through their 401(k) program. When you start at a new company typically you are asked if you want to enroll in the 401(K) program. If you do, you usually have to make some decisions on where your money will be invested. Typically the employee has a choice of several mutual funds and company stock.
Companies typically try to provide a blend of mutual funds that cover many investment styles. For instance you may have large cap, medium cap, small cap, international stock funds and possibly some bond funds. Recently there has been a trend towards target date investing where one mutual fund is explicitly set up for people retiring within a certain five year period. These funds automatically shift asset allocations from more risky to less risky investments as you approach retirement. All of these fund types have a certain investment style or investment philosophy if you will.
So a mutual fund is known for its investment style. Typically mutual funds will try to stay in a certain category like small cap (small, riskier companies with growth potential). In the Wikepedia article referenced above, the management team of a fund is defined by the “3-P's (Philosophy, Process and People).” We care about philosophy and process right now.
"Philosophy" refers to the over-arching beliefs of the investment organization. For example: (i) Does the manager buy growth or value shares (and why)? (ii) Does he believe in market timing (and on what evidence)? (iii) Does he rely on external research or does he employ a team of researchers? It is helpful if any and all of such fundamental beliefs are supported by proof-statements.
"Process" refers to the way in which the overall philosophy is implemented. For example: Which universe of assets is explored before particular assets are chosen as suitable investments? (ii) How does the manager decide what to buy and when? (iii) How does the manager decide what to sell and when? (iv) Who takes the decisions and are they taken by committee? (v) What controls are in place to ensure that a rogue fund (one very different from others and from what is intended) cannot arise?
Investment Philosophy is the “why” behind each investment you make. Your philosophy guides you and helps you make decisions. Should you invest in an index fund that tracks the S&P 500 or should you buy gold? Do you prefer certificates of deposit (CD’s) or do you like currency speculation? These are the kinds of questions you must understand and answer before you make any investment decisions.
When I got out of college, I thought I had investing figured out. Everything goes up. After all that’s what every talking head on TV said. Fast forward a few years and nothing was safe, the whole market tanked. I realized I didn’t really know anything. However, it took me a few years to get back into investing, as I wanted to pay off all my debt first. As it turns out that this is part of my investment philosophy.
In the next few articles, I’m going to explore my investment philosophy. This is as much for my benefit as for yours. I need to get it written down and formalized before I make any changes in my current portfolio.
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Comments
2 Comments so far
My investment philosophy is pretty simple. I find asset classes that provide a diversification benefit when held in a portfolio, e.g., US (large, small, value, REIT), foreign (large, small, value, emerging markets), and bonds, etc, and then determine a percentage of each asset class that I want to hold in my portfolio according to my individual risk tolerance. I then fill my portfolio with low-cost index funds that track these asset classes, and rebalance yearly to my selected percetnages.
In the end, my portfolio is similar to the life-cycle funds you discussed above, but it allows me to be a bit more agressive with my small, foreign, and value tilting.
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