How To Develop Your Investment Philosophy

After giving you a taste of investment philosophy in my previous article, today’s article focuses on the specifics of developing an investment philosophy. At the outset, I would like to declare that an investment philosophy isn’t a strategy and the two should not be mixed by the investor.

An investment strategy has more to do with putting your philosophy into practice. So, if you say that your philosophy is to buy stocks with a low P/E ratio or you are a contrarian (it means you buy when everyone else sells and sell when everyone else is buying), you are essentially confusing an investment strategy with your overall philosophy.

Developing a philosophy: The process
Before I go any deeper into the process, you should first understand the entire investment process. The first step into it is to ask the investors three fundamental questions:
How risk-averse are they?
What’s their time horizon?
And finally, what’s their tax status?

The answers to these questions form the fundamentals to devising an effective investment philosophy, based on the investor’s reality.

The next step is asset allocation. At this stage, the investor has to think about different asset classes, such as stocks, bonds or real assets (for instance, gold), where he wants to invest or the markets (either domestic or international) he is eyeing. Your views on macroeconomic factors like inflation, interest rates and GDP growth are the main factors driving this decision.

Once you have zeroed in on the right mix of asset classes to be included in your portfolio, the next step is to choose the securities within each class that will best fit your strategy. Essentially, you have to ask yourself – which stocks? Which bonds? Which real assets?

And again, the answer to these questions gives way to a bunch of investment philosophies. Your views on markets, how they work and where they make mistakes should drive this decision. You may look at fundamentals, cash flows or use techniques like charting to make the selection. It depends entirely on you and your perception of the market.

The final stage in the investment process is to actually go out there and buy the stock, bonds or real assets you have just shortlisted.

While the decision is fairly simple in case of a stock/bond and cheap as well, buying a real asset like real estate means you have to consider the huge transaction costs as well. Now, there is a bunch of different philosophies that will come up along the way. So let us discus each one of them.

The first is a market-timing philosophy and it occurs at the asset allocation stage. According to this philosophy, if you can forecast which markets are going to go up the most, it doesn’t matter in which specific assets (in that market) you are investing. As long as the entire market is going to go up, you will make money. For instance, if you think that the stock market will see the greatest rise, it doesn’t matter whether you invest in TCS or Reliance; so long as you buy the index portfolio, i.e., Sensex or Nifty (long position), you are home free.

The second is an asset-selection philosophy. This one, as the name suggests, has to do with the choice of specific assets you want to add to your portfolio. Now, how you choose it is totally on you. You could be a value investor and in such a case, your investments will be based on intrinsics. Or you may pick your investments based on momentum, whatever it is. As long as it works for you and you can make money out of it, hold on to it.

Finally, we have execution-based strategies which depend on the mistakes made by the market. A good example is an arbitrage-based strategy wherein the same asset is priced differently in different markets, and you buy in the market where it is cheap and sell where it is dear to earn the spread.

Also, investment philosophies can be classified based on the investor. An investor may follow an active investment philosophy, which essentially means buying an asset and then acting as the force to catalyse the change that will help make money on the investment. However, this type of activist approach can only be undertaken by rich investors who have sufficient clout to move the markets.

You can also develop a philosophy based on time horizon. You could have a long-term, medium-term or short term philosophy, and it essentially depends on how you view the market.

Finally, in developing an investment philosophy, you need to ponder upon the following points:
· There is no investment in this world without risk. Hence, it is extremely important for you to assess and incorporate the same in your analysis of any investment.
· You should know how to read the financial statements. After all, these statements are your gateways to analysing stocks.
· Before you decide to invest, be aware of the costs you will incur as a result of the investment.
· Develop your own opinion on how the markets work, why they go up, and where they make mistakes because you will make money on market mistakes and hence, developing a sense of market’s performance is important.

To conclude, I will end from where I began. You need a philosophy that fits you best and this has to be analysed, keeping in mind how risk averse you are, your time horizon and your tax status.

In my next article, I will begin with one of the most crucial aspects of investment – analysing risks.

About the author: Rohit Singh is the founder of www.investobharat.com, a platform dedicated to bust the jargon and offer unbiased and crowd-sourced investment analysis.