Do you need an investment philosophy?

/ / Portfolio Construction

Recently, I was invited to participate in a panel discussion on the ‘Art & Science of Stockpicking’. I was fascinated by the topic because I had studied both art and science (actually literature and biology) at undergraduate level and then had chosen finance as a career. I had researched investing somewhat (remember this was 25 years ago, before the age of internet, so research required time and a real network) and had concluded it sounded as something in between the process-driven approach of science and creative thinking approach of the arts. I am happy to say I found not only arts and science (well, actually process, not real science at all) but also psychology, history and philosophy in investing.

What is an investment philosophy?

Philosophy is ‘the study of the fundamental nature of knowledge, reality, and existence, especially when considered as an academic discipline.’ It is also ‘a theory or attitude that acts as a guiding principle for behaviour.’

An investment philosophy is a coherent way of thinking about how markets work – why they might get over or undervalued from time to time – and hence, how one might be able to outperform (or not) over time. It’s a set of core beliefs on how humans behave – how they learn or fail to learn, how they oscillate between greed and fear, how they tend to move in crowds. Once I have formed my view on human behaviour, I have to introspect on my own temperament and form a view on whether and how I can take advantage of other people’s behaviours.

As you can imagine, forming an investment philosophy requires time. It’s not a matter of observing charts over 30 years and concluding that one should buy at PE of 15 and selling at 25. If it were that easy, everyone would be doing it. It requires a deeper understanding of human behaviour – why do investors buy rather than sell when markets have already run up, why do they panic, why do they not buy in times of doom and gloom when prices are cheap.

Howard Marks, in his book ‘The Most Important Thing’ writes that ‘no one arrives on the doorstep of an investment career with his or her philosophy fully formed. A philosophy has to be the sum of many ideas accumulated over a long period of time from a variety of sources. One cannot develop an effective philosophy without having been exposed to life’s lessons.’

Once you have settled on an investment philosophy, you can develop an investment strategy, which is a way of putting your investment philosophy into practice. Strategies may require tweaking from time to time. Indeed you may need to develop completely new strategies if old ones stop working. But people rarely ever change investment philosophies.

Examples of investment philosophy statements

An investment philosophy should be able to be summarised in a sentence or two. Indeed, some prominent investors are able to summarise their within 10 words. Jason Zweig, a columnist at the Wall Street Journal, compiled a few on his blog at http://jasonzweig.com/can-you-sum-up-your-investing-philosophy-in-10-words/

The pioneering investor Benjamin Graham summarised in his in just three words. In Chapter 20 of his book ‘The Intelligent Investor’, he writes ‘In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, ‘This too will pass.” Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.’

Why you need an investment philosophy…

Having an investment philosophy is like having values. Once you settle on a set of values, you can live your life by those values. You won’t need to think from first principles every time you face a new situation. You won’t need to waste your time with people or ideas that don’t fit your values because you know that those will only take you away from your goal. Life is too short…time is too precious to waste on things that don’t matter to you.

Once you develop your own investment philosophy, you can cut out all the noise from your investment process and focus on the things that matter. You don’t have to watch the news, meet salespeople, or stress about market fluctuations if your investment philosophy recognizes these as noise or meaningless inputs. You don’t have to chop and change your investment strategy or tactics and incur transaction costs. You will just sleep better.

…so do all your service providers

All investors need an investment philosophy. Investment professionals – even more so. Your investment adviser, your portfolio manager, your mutual fund manager – all investment professionals should have a well-articulated investment philosophy because they have held themselves out to be experts.

Indeed, a good way to evaluate investment professionals is to ask them for their investment philosophy and how it translates into their investment strategy. Ask them what how they arrived at their investment philosophy, when it has not worked, whether it’s changed over time.

I believe that mutual fund managers should be state their investment philosophy and strategy in their offer documents and websites so potential investors can evaluate them and decide whether it fits theirs. The problem is that too often what shows up in these places is so sanitized, partly for legal reasons, that it’s meaningless. I am exploring cost-effective ways in which we can bring out the investment philosophy through interviews.

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