Healthy Investment Process
Rubbing two sticks together intensely to
cause a fire will not work if you will burn out first...but a small continuous dripping of water can bore a hole
through a boulder. Patience and light continuous efforts prevail.
If you know yourself and know your enemy, you
will always win. If you know yourself and don't know your enemy, you will win half the time and lose half the time.
If you know neither yourself nor your enemy, you will always lose. - The Art of War
I recall my first investments class when the
professor explained that the purpose of investing is not to make a killing in the markets. If you try that approach
you are much more likely to be killed. Instead, the idea is to develop an investment process that is likely to
produce slightly higher returns than average over a long period of time. While small incremental improvements may
seem unimportant, over a long period of time they compound (earning extra returns on the extra returns you already
made) and can present a substantial increase in wealth. Patience and making a light, consistent effort for long
periods are the hallmarks of skillful investing.
Self reflection is also critical. Markets are
competitive so you need to figure out where you will find your edge vs... your competitors and focus there. If your
ability to make a particular type of forecast is good, you will probably do better than average over long periods,
or vice versa. So there are two things you need to consider: do you believe the investment selection process is
likely to produce above average returns, and how good are you at making such assessments. Only if both are positive
will you get the desired result.
This approach needs to take into
consideration the fundamental value of the asset (e.g. stock or bond) to be purchased. For stocks you might expect
a series of dividend payments which grows over time in relation to earnings. For bonds it may be a regular interest
payment followed by repayment at maturity. You will want to do some sort of analysis of the entity issuing the
stock or bond to see how likely they will be to make good on these payments. If the likelihood is high and the
payments are attractive relative to your alternatives, there is a reason for you to buy the security. If it
persists there is also a reason for someone else to want to buy it from you later at a higher
Looking for a process to improve returns
incrementally may not require enormous amounts of work. For example, market indices are driven to invest by rules
and do not discriminate regarding whether an investment is priced well or poorly on a value basis. If your
objective is above average returns, the half of the market that performs below the average constitutes a mistake by
definition. So avoiding all mistakes is almost impossible. Being afraid of making a mistake may push you to put all
your money under a mattress, which guarantees a large mistake (as you are certain to lose purchasing power due to
inflation). Of course this point does not mean stocks are better investments than cash, only that the process of
avoiding mistakes out of fear actually brings on mistakes.
However, since the indices do not
discriminate on the basis of value, then it may be relatively easy to avoid the really big mistakes. That company
that just announced it has been sued for accounting fraud and lost, with its stock in a free fall (Note that if you
do not know what the value is of the stock, you have no skillful reason to buy it). Simply avoiding these can have
a significant effect on your long run returns. Some of the less obvious problems where a company is “cheap for a
reason,” might turn out well if the price overly discounted the nature of the problem. Here we do not need to be so
afraid of making mistakes. But for serious problems, we should avoid them or at least weed them out of our
portfolio quickly. This process is healthier and more likely to be effective. If we have the proper attitude, we
will not hesitate to admit mistakes and take losses, so we can invest the proceeds in something more likely to go
up instead of down.
Again, we also need to consider our own
abilities to make these judgments. For example, if I am a musician by trade and know nothing about investing in
stocks, I may be best to leave these decisions to those with proper training and experience. But knowing something
about what constitutes a sound investment process, I will be better armed to select fund managers
An alternative approach might be considered
under the umbrella of technical analysis. Here some charting expert looks only at past historical price patterns of
the stock or bond in question. However, they do not pay any attention whatsoever to the underlying instrument, only
how its price has moved in the past. Based upon these charts they try to forecast how the price will move in the
future. Some speculate that people are unwilling to take losses, so when a lot of buying or selling takes place at
a particular price that price level might have an effect once it is reached again. For example, if people buy a lot
of stock at 100 and the price drops to 50 for 2 years, when it suddenly shoots up to 100 again there will be many
people who bought it at 100 that will line up to sell it. This process brings out supply and forces the price down,
so they might recommend selling it at that level to buy it back cheaper afterwards.
While this might sound reasonable at first,
since they do not even look at the value of the underlying asset, we can see where this is either gambling or
unskillful investing. Their "edge" is to bet that a price will move for reasons unrelated to the actual value of
the investment. People buy investments to make a return, not because of a fundamental desire to follow a chart
pattern. Say they were looking at the price pattern of a tobacco company and tobacco was just outlawed, forcing the
companies into immediate bankruptcy. Or suppose everyone decides they need to get 100 plus inflation for the period
and 105 is the price that brings out all the selling. Since technical analysis offers no fundamental rationale
related to the reason people invest, there is no reason to expect that it would produce above average returns over
the long run.
If you've made it this far, please email us feedback - tell us what you think and if
there is any way to be more helpful.
Legal - The purpose of this site and all services offered are educational in
nature and not to provide any investment advice, planning or recommendations of any securities. The purpose is to
educate you to make your own financial decisions, or prepare you to evaluate your financial advisors with
confidence so you can gain trust in the services they provide.