The School of Athens by Raffaello Sanzio da Urbino sourced from Wikipedia
Despite the opulent or debauched images one might have about the investment industry (depending on one’s perspective), the fact is that investing is a highly intellectual pursuit. I don’t mean this in the colloquial sense where one ruminates on meaningless abstract ideas purely for contemplation’s sake. Rather, it is an immensely cognitive and productive activity. Successful investing doesn’t require exceptional physical conditioning, brawn, salesmanship, “people skills”, mathematical aptitude, or a high IQ. It entails (I think) developing some kind of mental model for how the world works. Not only must this model display some degree of accuracy (i.e. be a good one), but one must maintain conviction in his/her model and have the integrity to stick to it through thick and thin. Said differently, one needs a well-defined investment philosophy.
Investing is nothing more than the act of speculating on the future using money. Whether one be concerned with the demand outlook for a commodity, the amount of cash flow a business might generate over a number of years, the default probability of a nation, or even the volatility of a particular market, an investor (or trader, the difference being time horizon, in my opinion) must make a projection about future events. It is these predictions that ultimately drive investment decisions to either buy or sell, and dictate the quantities in which those actions are taken.
This decision making process is likely an automatic one for most. But being automatic doesn’t necessarily mean it’s any good. How can we judge if we’re making effective investment decisions; if our process is sound; if we’re skilled or merely lucky? Sure, return metrics and Sharpe ratios can give some indication. But there can be long lead times between when positions are entered into and exited, and a multitude of factors can affect an investment’s price such that these measures might not necessarily tell the whole story.
Some time ago, I came across the following passage which forever changed the way in which I view the world:
“As a human being, you have no choice about the fact that you need a philosophy. Your only choice is whether you define your philosophy by a conscious, rational, disciplined process of thought and scrupulously logical deliberation — or let your subconscious accumulate a junk heap of unwarranted conclusions, false generalizations, undefined contradictions, undigested slogans, unidentified wishes, doubts and fears, thrown together by chance, but integrated by your subconscious into a kind of mongrel philosophy and fused into a single, solid weight: self-doubt, like a ball and chain in the place where your mind’s wings should have grown.”
— Ayn Rand, Philosophy: Who Needs It
Regardless of what you think of the author (she can be a polarizing figure), there is a profound truth in that statement. We humans are conceptual beings and thus most of our actions are driven by the abstractions we hold in our heads. Even the simple question of what to eat for lunch requires conceptualization. Our choice may not only be determined by taste alone (a percept), but can also be influenced by its cost, health, and what one might be in the mood for. To be sure we’re fully capable of handling such decisions; we’ve already formed views of our personal financial position, longevity goals, and (likely) dinner plans.
Humans have the unique ability to think in long-term time scales which is what allows us to invest (among other things). Our views of the world and how we fit into it cannot always be directly perceived. Some must be abstracted using logic, such as whether living in a free society is desirable. Some require projection – I know I will be tired tomorrow if I don’t get at least 6 hours of sleep. All require having a mental model for the world. Philosophy can provide us with a framework for constructing one.
Don’t get me wrong, I’m not suggesting that we drop what we’re doing, pick up a copy of Aristotle’s Nicomachean Ethics, and earn PhDs in philosophy. Proficiency in this subject likely has little relation to investment success (though I wouldn’t be surprised to find some). However, developing a clear investment philosophy is likely helpful in generating investment returns. But don’t take this claim from me; Mr. Ray Dalio – arguably one of the most successful investors and entrepreneurs of our time – wrote an entire book and created a video mini-series dedicated to this topic (both found here).
A well-defined philosophy should at minimum address three questions: where am I; how do I know it, and; what should I do? The third question, which is our ultimate concern, is determined by the answers to the first two. A well-defined investment philosophy should do the same. Thus, “where am I” can be transcribed into what markets (geographies) and asset classes (stocks, bonds, derivatives, currencies, etc.) will I trade in? “How do I know it” can be rephrased as what investment approach (fundamental, quantitative, technical, or some specific blend) and style (value investing, trend following, growth oriented, momentum, stat arb, macro, Elliot wave, distressed, capital allocator, absolute return, relative value, long/short, etc.) will I employ, and over what targeted time horizon (hours, days, months, years)? These specifications (by no means am I suggesting this to be an exhaustive list) can be used to build an investment framework. One’s investment framework – or investment philosophy – can then act as a guide to answer “what should I do”, applied to one’s portfolio – the payoff.
Warren Buffet has stated that the price you pay determines your rate of return. Really, however (and which is implied), it’s the price you pay relative to the price at which you will sell. Over the course of an investment there are only three possible relative price movements; they may move higher, move lower, or stay at about the same level. As we all know, asset prices do not remain static. They are in constant motion and for all sorts of reasons. So how does one know when is the right time to buy or sell, and in what quantities; if a profitable trade resulted from skill or luck; if prices reflect future fundamentals or are merely a random walk?
According to the popular adage, the trick to trading is cutting one’s losers short and letting the winners ride. This sounds easy but in reality it’s anything but. For example, suppose you went long shares in stock XYZ at $10. A month later, it moves up to $11. You just bagged yourself a 10% monthly return, not too shabby. But now what? Sell, take your profit and happily move on? This is where having an investment framework comes in handy. It can offer guidance as to what one’s course of action should be. If your thesis was not attained and, say, the price movement was purely market beta (and this wasn’t your aim), then selling would not be a consistent action; your framework would dictate accepting the market’s gift and holding on for more (being a pig in Stanley Druckenmiller’s terms). What if your catalyst occurred but your p&l shows you a loss? Well, perhaps it’s time to cut that trade loose. Trading is hard enough without the emotional component. Having a framework can help temper some of this intensity, possibly providing some clarity and an edge.
I recognize that the above sounds elemental, and in fact it is; that’s what makes it so important. If any of you are like me, you might have unconsciously constructed an investment framework by means of osmosis. And this “mongrel philosophy” may or may not actually mesh well with your personality and interests, and hence be suboptimal.
An explicit investment philosophy can also bring to light some obvious conflicts that may be impeding one’s success. How reasonable an approach is it to combine a deep value mandate with a 6-12 month investment horizon? What about being a swing trader who holds positions for years? These are inconsistent actions and goals; – dreaded contradictions which when brought to the fore can be corrected and stamped out.
I began my professional investing career on the sell-side in equity research. We made financial forecasts and applied a valuation multiple in order to estimate a price target for a particular stock. This point estimate and its relation to the current trading price determined the recommendation we’d issue (i.e. buy, sell, or hold); quite the standard practice. However, this methodology never sat well with me. I found these target prices to be inherently unstable and extremely sensitive to inputs. Anyone who’s constructed a discounted cash flow model can relate. As a result, the expression GIGO loomed too large in my conscious for me to fully buy into this investment process. I became cynical about investing. People were fooling themselves, I thought; they were merely throwing darts against a board. Little did I know how wrong I was. (As a note, I’ve long since moved on from equities.)
It was only recently that I awoke to the vast universe of investing methods and styles. As faithful readers know well, this blog serves as my vehicle by which to explore that world. There are many successful investors out there who have found or developed a style that works for them. Studying others has done more than provide me with alternative approaches to incorporate into my own practice. It also removed the cynicism I was carrying and restored the enjoyment I get from investing. As a result, I’ve become a better investor (though remain far from great).
Thus far I’ve briefly commented on value investing, technical analysis, some timeless tips, and the interplay between value and momentum factors; though note that I did not plan for these to serve as summaries at the time of their writing. My intention is to continue this practice of sharing my thoughts as I dig further into these and other topics as I explore them. I can think of no more profitable pursuit as an investor than optimizing one’s investment approach. There’s an expression that “if you can measure it, you can manage it.” Explicitly defining one’s investment philosophy facilitates the measurement, the management, and ultimately the refinement of one’s investing process.
“As [an investor], you have no choice about the fact that you need [an investment] philosophy. Your only choice is whether you define your [investment] philosophy by a conscious, rational, disciplined process of thought and scrupulously logical deliberation — or let your subconscious accumulate a junk heap of unwarranted conclusions, false generalizations, undefined contradictions, undigested slogans, unidentified wishes, doubts and fears, thrown together by chance, but integrated by your subconscious into a kind of mongrel [investment] philosophy and fused into a single, solid weight: self-doubt, like a ball and chain in the place where your [portfolio’s] wings should have grown.”
(Changes made in bold and are mine.)