What is an investment philosophy?
An investment philosophy is a coherent way of thinking about markets, how they work (and sometimes do not) and the types of mistakes that you believe consistently underlie investor behavior. an investment philosophy is a set of core beliefs that you can go back to in order to generate new strategies when old ones do not work.
When you’re about to do something small, you need a reason. When you’re about to do something big, you need a plan. When you’re about to do something life changing, you need a philosophy. An investment philosophy is a set of goals and ideas that dictate the “who, what, where, when and why” of your investing habits. It governs your plans and guides your decisions. At its core, an investment philosophy embodies the rhyme and reason for why you’re investing in the first place.
An investment strategy is much narrower. It is a way of putting into practice an investment philosophy.
Ingredients of an Investment Philosophy
Step 1: All investment philosophies begin with a view about how human beings learn (or fail to learn). Underlying every philosophy, therefore is a view of human frailty - that they learn too slowly, learn too fast, tend to crowd behavior etc
Step 2: From step 1, you generate a view about markets behave and perhaps where they fail…. Your views on market efficiency or inefficiency are the foundations for your investment philosophy.
Step 3: This step is tactical. You take your views about how investors behave and markets work (or fail to work) and try to devise strategies that reflect your beliefs.
Why do you need an investment philosophy?
An investment philosophy is simply a guiding belief system as it pertains to your investment decision-making process. Successful, long-term investors recognize the importance of having an investment philosophy to help cut through the noise and keep them laser focused, which is especially important during the tougher times in the market. Your investment philosophy should be the foundation that your investment strategy is built upon. Anything built to last needs to have a solid foundation, since the slightest weakness in your foundation could cause the whole thing to come crumbling down when put under pressure. When things are going well you can get away without having a solid investment philosophy. The market is moving up, your investments are gaining value, and things are great, right? It’s hard to lose money when the markets are grinding higher. A house built on a shoddy foundation isn’t likely to crumble when there isn’t an earthquake. It’s when things aren’t going so well, such as during a recession or bear market, that the strength of an investor’s foundation, or their philosophy, is truly tested. The successful investors have built their investment philosophy knowing exactly what they will do (or better yet not do) when these market earthquakes come, and they have built a solid foundation to withstand these inevitable tremors. As Warren Buffett puts it, “only when the tide goes out do you discover who’s been swimming naked.
If you do not have an investment philosophy, you will find yourself:
- Lacking a rudder or a core set of beliefs, you will be easy prey for charlatans and pretenders, with each one claiming to have found the magic strategy that beats the market.
- Switching from strategy to strategy, you will have to change your portfolio, resulting in high transactions costs and you will pay more in taxes.
- With a strategy that may not be appropriate for you, given your objectives, risk aversion and personal characteristics. In addition to having a portfolio that under performs the market, you are likely to find yourself with an ulcer or worse.
Categorizing Investment Philosophies
Market Timing versus Asset Selection:
With market timing, you bet on the movement of entire markets - financial as well as real assets. With asset selection, you focus on picking good investments within each market.
Activist Investing versus Passive Investing:
With passive investing, you take positions in companies and hope that the market corrects its mistakes. With activist investing, you play a role (or provide the catalyst) in correcting market mistakes.
Time Horizon:
Some philosophies require that you invest for long time periods. Others are based upon short holding periods.
Developing an Investment Philosophy
Step 1: Understand the fundamentals of risk and valuation
Step 2: Develop a point of view about how markets work and where they might break down
Step 3: Find the philosophy that provides the best fit for you, given your
• Risk aversion
• Time Horizon
• Portfolio Size
• Tax Status