Invest Like A Professional

Topic Covers |  Active Trading, Asset Allocation, Bear Market, Day Trading, Financial Theory, Hedge Funds, Investing Basics, Personal Finance, Portfolio Management, Retirement, Risk Tolerance, Stocks, Warren Buffett

For those investors who have been lucky enough to have survived one or more major market downturns, some lessons have been learned. For example, there always seem to be some firms that not only survive those downturns, but profit handsomely from them. So why do certain investment companies do better than others and survive market waves? They have a long-term investment philosophy that they stick to; they have a strong investment strategy that they formalize within their products and understand that while taking some risk is part of the game, a steady, disciplined approach ensures long-term success. Once the key tools of successful investment firms are understood, they can easily be adopted by individual investors to become successful. By adopting some of their strategies, you can invest like the pros

Strength in Strategy

A strong investment philosophy should be outlined before any investment strategies are considered. An investment philosophy is the basis for investment policies and procedures and, ultimately, long-term plans. In a nutshell, an investment philosophy is a set of core beliefs from which all investment strategies are developed. In order for an investment philosophy to be sound, it must be based on reasonable expectations and assumptions of how historical information can serve as a tool for proper investment guidance.

 For example, the investment philosophy, "to beat the market every year," while a positive expectation, is too vague and does not incorporate sound principles. It's also important for a sound investment philosophy to define investment time horizons, asset classes in which to invest and guidance on how to respond to market volatility while adhering to your investment principles. A sound long-term investment philosophy also keeps successful firms on track with those guidelines, rather than chasing trends and temptations. Since each investment philosophy is developed to suit the investment firm, or perhaps the individual investor, there are no standard plans to write one.
If you are developing an investment philosophy for the first time, and you want to invest like a pro, it's important that you consider covering the following topics to make sure the philosophy is robust:

Define Your Core Beliefs

The most basic and fundamental beliefs are outlined regarding the reason and purpose of investment decisions.

Time Horizons

While investors should always plan on long-term horizons, a good philosophy should outline your unique time frame to set expectations.

Risk

Clearly define how you accept and measure risk. Contrary to investing in a savings account, the fundamental rule of investing is the risk/reward concept by increasing your expected returns with increased risk.

Asset Allocation and Diversification

Clearly define your core beliefs on asset allocation and diversification, whether they are active or passive, tactical or strategic, tightly focused or broadly diversified. This portion of your philosophy will be the driving force in developing your investment strategies and build a foundation to which to return when your strategies need redefining or tweaking.

The Secret of Success

Successful firms also implement product funds that reflect their investment philosophies and strategies. Since the philosophy drives the development of the strategies, core style investment strategies, for example, are usually the most common in most successful product lines and should also be part of an individual plan. Core holdings or strategies have multiple interpretations, but generally, core equity and bond strategies tend to be large cap, blue chip and investment grade types of funds that reflect the overall market.

 Successful firms also limit their abilities to take large sector bets in their core products. While this can limit the potential upside when making the right sector bet, directional bets, practiced by hedge funds, add significant volatility to a fund that is judged by not only its performance but its relative and absolute volatility.

When defining an investment strategy, it is very important to follow a strict discipline. For example, when defining a core strategy, restricting the temptation to follow or chase trends keeps the strategy grounded. This is not to say that one can't have additional momentum strategies with different goals, as these can be incorporated into the overall investment plan.

Outlining a Strategy

When outlining a sound investment strategy, the following issues, which are similar to those of creating a philosophy, should be considered:

Time Horizon

A common mistake for most individual investors is that their time horizon ends when they retire. In reality, it can go well beyond retirement, and even life, if you have been saving for the next generation. Investment strategies must focus on the long-term horizon of your investment career, as well as the time for specific investments.

Asset Allocation

This is when you clearly define what your target allocation will be. If this is a tactical strategy, ranges of allocations should be defined, if strategic in nature. On the other hand, hard lines need to be drawn with specific plans to rebalance when markets have moved in either direction. Successful investment firms follow strict guidelines when rebalancing, especially in strategic plans. Individuals, on the other hand, often make the mistake of straying from their strategies when markets move in sharp directions.

Risk Vs. Return

At this point you should clearly define your risk tolerance. This is one of the most important aspects of an investment strategy, since risk and return have a close relationship over long periods of time. Whether you measure it relative to a benchmark or a absolute portfolio standard deviation, just remember to stick to your predetermined limits.

Putting the Pieces Together

It's important to remember that investment strategies define specific pieces of an overall plan. Successful investors cannot beat the market 100% of the time, but they can evaluate their investment decisions based on their fit to the original investment strategy.

After you have survived a few market cycles, you can potentially start to see patterns of hot or popular investment companies gathering unprecedented gains. This was a phenomenon during the Internet technology investing boom. Shares of technology companies rose to rock star levels, and investors - institutional and personal - lined up at their gates to pile on funds. Unfortunately for some of those companies, success was short-lived, since these extraordinary gains were unjustified. Many investors deviated from their initial investment strategies in the hopes of chasing greater returns. Individuals can model themselves after successful investment companies by not trying to hit home runs, instead focusing on base hits.

That means trying to beat the market by long shots is not only difficult to do consistently, it leads to a level of volatility that does not sit well with investors over the long term. Individual investors often make mistakes such as shooting for the stars and using too much leverage when markets are moving up, and tend to shy away from markets as they are falling. Removing the human biases by sticking to a set approach and focusing on short-term victories is a great way to fashion your investment strategy like the pros.

The Bottom Line

Taking cues from successful professional investors is the easiest way to avoid common errors and keep on a focused track. Outlining a sound investment philosophy sets the stage for professional and individual investors, just like a strong foundation in a home. Building up from that foundation to form investment strategies creates strong directions, setting the paths to follow. Investing like the pros also means avoiding the temptation to drift from your investment philosophy and strategies, and trying to outperform by large margins. While this can be done occasionally, and some firms have done it in the past, it is nearly impossible to beat the markets by large margins consistently. If you can fashion your investment plans and goals like those successful investment companies, you too can invest like the pros.

3 Essential Rules For New Investors

Topic Covers | Asset Allocation, Beginning Investor, Index Funds, Investing Basics, Portfolio Management

 The investing landscape can be extremely volatile and change year after year, but there is a lot to be said for investing in what you really know and understand. Considering the enormous number of products on offer, as well as the nature of the industry, it is not that simple to be simple, but it can certainly be done. First, we will take a look at the potential difficulties of understanding investments, and then we'll look at how new investors can invest safely, suitably and sensibly.

How Much Do We Really Understand?

One could argue that the only asset that is fully understandable is cash in the bank, or some form of fixed deposit. Here, you know exactly how much you will earn and that you will get your capital back. The problem is that you will be lucky to beat inflation, and simply leaving your money in cash is not the answer; it is just not a productive investment.

Moving a bit up the risk ladder, we get to bonds. Given the variety of bonds and bond funds, understanding what you get is also not necessarily that simple. Government bonds are fairly straightforward, but, again, they don't pay much. Municipal bonds pay a little more and are usually tax-exempt, but are not going to satisfy the average investor's retirement needs. So to really earn anything, you need a variety of bonds, both corporate ones and, arguably, foreign. Yet these start to become complex and more risky, depending on various factors relating to the issuing company or country. Likewise, bond funds may depend on a number of managerial and financial issues.

The same applies to stocks, mutual funds and so on. Even real estate funds have proved to be less reliable and straightforward than many people might think. Direct real estate purchases are more understandable in one sense - what you see is what you get. But then again, there can be unknowns relating to the market, taxation, the location, disclosure by the seller and so on.

Similarly, alternative investments, such as hedge funds, can be extremely complex. Infrastructure, too, is without doubt a great idea in principle, but the nitty-gritty of investing in it is not such a sure thing. No matter how sound the principle of a particular investment, there is almost always someone or something out there that can make it go wrong. And as for certificates of deposit (CD), they are probably the hardest type of investment to understand. Given yield curves, expectations and potential early withdraw penalties, they may be the easiest to missell.

Tracker funds, on the other hand, are relatively simple to understand - you are indeed
just "buying the market," but the markets themselves are not so easy to deal with and understand. Furthermore, the tracker market is becoming more sophisticated and complex. This all sounds very daunting. But in fact, one can still invest simply and understandably, at low cost and with a good, diversified portfolio that is likely to perform well over time.

How Can We Invest Sensibly, Suitably and Simply?

The above section certainly implies that we really know very little about a lot of asset classes and investments. Nonetheless, there are many ways of ensuring that you are investing in what you know. One can really invest in a straightforward manner, and understand what one is doing.

Many veteran investors have simple diversified portfolios, and look more at asset allocation.

Spending hours performing regression analysis is not an option for many part-time investors. For example, Steven Goldberg, of Kiplinger, has said in his "Value Added Web Column" that: "Most people wish they didn't have to be investors," and that they "lead busy enough lives without having to worry about stocks, bonds and mutual funds." Goldberg therefore recommends sticking with index funds that simply mirror the market and only attempt to be average. He even argues that one only needs three index funds: one covering the U.S. equity market, another with international equities and the third tracking a bond index.

Trackers are sometimes better than actively managed funds.

 Lower fees, low turnover and a combination of available investor education makes index investing extremely attractive. So, a really straightforward mix of these funds is transparent, cheap and does as good (or better) a job as more complex and expensive vehicles. Despite the above, to be fair, there are a lot of good managed funds out there. With a bit of effort, you can find reliable and understandable equity and bond funds with which you can relax.

A good piece of advice is to search through Investopedia.com's tutorial section, to start with simple investments and then expand and extend as you learn more. Specifically, mutual funds or exchange-traded funds are a good way to get going, and one can then move on to individual stocks, real estate and further down the line, even a sensible amount into resources or hedge funds.

It is interesting to note the book title, "How Buffett Does It: 24 Simple Investing Strategies from the World's Greatest Value Investor" (James Pardoe, McGraw-Hill, 2005), about the world's greatest pro. Buffett himself comments that Wall Street dislikes too much simplicity. The reason is that brokers make money out of complexity. But one does not have to fall for this.


The Bottom Line

The more you learn, the better. But above and beyond this, you can (and probably should) avoid investments that you do not even understand in principle. A small number of index funds seems a very good solution.

Also, go on sound recommendations. If your parents-in-law have been investing for 20 years in some mixed fund which has served them well, there is a good chance that it will continue to do so. On the other hand, if you get a phone call from someone you met in a pub last week who wants to give you a hot tip as a "big favor," be more skeptical. Likewise, there are many independent financial advisors around who get paid only for their time and not on commission.

Their job is to understand what they recommend, without the pressure of having to sell to earn a commission. And make sure you diversify, not only into asset classes, but possibly into different banks and fund providers. Then, if something goes wrong that neither you nor anyone else seemed to understand after all, the losses are not so disastrous. Always bear in mind that too many bits and pieces also create complexity which can lead to errors.