News & Views ICT's weekly bulletin

Developing an Investment Philosophy: The Step

Aswath Damodaran. Professor of Finance at the Stern School of Business at New York University & author of several highly-regarded and widely-used academic texts on Valuation, Corporate Finance, and Investment Management.
If every investor needs an investment philosophy, what is the process that you go through to come up with such a philosophy? While portfolio management is about the process, we can lay out the three steps involved in this section.
Step 1: Understand the fundamentals of risk and valuation
Before you embark on the journey of finding an investment philosophy, you need to get your financial toolkit ready. At the minimum, you should understand
- how to measure the risk in an investment and relate it to expected returns.
- how to value an asset, whether it be a bond, stock or a business
- the ingredients of trading costs, and the trade off between the speed of trading and the cost of trading
We would hasten to add that you do not need to be a mathematical wizard to do any of these and it is easy to acquire these basic tools.
Step 2: Develop a point of view about how markets work and where they might break down
Every investment philosophy is grounded in a point of view about human behavior (and irrationality). While personal experience often determines how we view our fellow human beings, we should expand this to consider broader evidence from markets on how investors act before we make our final judgments.
Over the last few decades, it has become easy to test different investment strategies as data becomes more accessible. There now exists a substantial body of research on the investment strategies that have beaten the market over time. For instance, researchers have found convincing evidence that stocks with low price to book value ratios have earned significantly higher returns than stocks of equivalent risk but higher price to book value ratios. It would be foolhardy not to review this evidence in the process of developing your investment philosophy. At the same time, though, you should keep in mind three caveats about this research:
a. Since they are based upon the past, they represent a look in the rearview mirror. Strategies that earned substantial returns in the 1990s may no longer be viable strategies now. In fact, as successful strategies get publicized either directly (in books and articles) or indirectly (by portfolio managers trading on them), you should expect to see them become less effective.
b. Much of the research is based upon constructing hypothetical portfolios, where you buy and sell stocks at historical prices and little or no attention is paid to transactions costs. To the extent that trading can cause prices to move, the actual returns on strategies can be very different from the returns on the hypothetical portfolio.
c. A test of an investment strategy is almost always a joint test of both the strategy and a model for risk. To see why, consider the evidence that stocks with low price to book value ratios earn higher returns than stocks with high price to book value ratios, with similar risk (at least as measured by the models we use). To the extent that we mismeasure risk or ignore a key component of risk, it is entirely possible that the higher returns are just a reward for the greater risk associated with low price to book value stocks.
Since understanding whether a strategy beats the market is such a critical component of investing, we will consider the approaches that are used to test a strategy, some basic rules that need to be followed in doing these tests and common errors that are made (unintentionally or intentionally) when running such tests. As we look at each investment philosophy, we will review the evidence that is available on strategies that emerge from that philosophy.
Step 3: Find the philosophy that provides the best fit for you
Once you understand the basics of investing, form your views on human foibles and behavior and review the evidence accumulated on each of the different investment philosophies, you are ready to make your choice. In our view, there is potential for success with almost every investment philosophy (yes, even charting) but the prerequisites for success can vary. In particular, success may rest on:
a. Your risk aversion: Some strategies are inherently riskier than others. For instance, venture capital or private equity investing, where you invest your funds in small, private businesses that show promise is inherently more risky than buying value stocks – equity in large, stable, publicly traded companies. The returns are also likely to be higher. However, more risk averse investors should avoid the first strategy and focus on the second. Picking an investment philosophy (and strategy) that requires you to take on more risk than you feel comfortable taking can be hazardous to your health and your portfolio.
b. The size of your portfolio: Some strategies require larger portfolios for success whereas others work only on a smaller scale. For instance, it is very difficult to be an activist value investor if you have only $ 100,000 in your portfolio, since firms are unlikely to listen to your complaints. On the other hand, a portfolio manager with $ 100 billion to invest may not be able to adopt a strategy that requires buying small, neglected companies. With such a large portfolio, she would very quickly end up becoming the dominant stockholder in each of the companies and affecting the price every time she trade.
c. Your time horizon: Some investment philosophies are predicated on a long time horizon, whereas others require much shorter time horizons. If you are investing your own funds, your time horizon is determined by your personal characteristics – some of us are more patient than others – and your needs for cash – the greater the need for liquidity, the shorter your time horizon has to be. If you are a professional (an investment adviser or portfolio manager), managing the funds of others, it is your clients time horizon and cash needs that will drive your choice of investment philosophies and strategies.
d. Your tax status: Since such a significant portion of your money ends up going to the tax collectors, they have a strong influence on your investment strategies and perhaps even the investment philosophy you adopt. In some cases, you may have to abandon strategies that you find attractive on a pre-tax basis because of the tax bite that they expose you to.
Thus, the right investment philosophy for you will reflect your particular strengths and weaknesses. It should come as no surprise, then, that investment philosophies that work for some investors do not work for others. Consequently, there can be no one investment philosophy that can be labeled best for all investors. (excerpt from “What is Portfolio Management” – source: Damodaran Online)