Want to Invest Like a Pro?

Want to learn how to invest like a professional investor?

Maybe a good plan, maybe not. But our friends at Investopedia discuss how to “Invest Like a Pro”.

Article highlights and my comments below:

Strategy Before Investing

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.

Per Investopedia, the keys to developing a strong investment philosophy are in defining your: core investment beliefs; investment time horizon; risk tolerance; target asset allocation; diversification.

Basically what we talked about in developing your Investment Policy Statement.

You start out by creating a comprehensive Investor Profile. It takes into account your current financial situation, investment objectives and constraints, time horizon, and personal risk tolerance. The result should be used to drive your investment strategy. And by investment strategy, we are talking your target asset allocation, including diversification and asset classes.

I firmly believe that if you take the time to lay a proper foundation it will improve your actual investment decisions and long-term performance. Sadly, too many individuals ignore this part of the investing process.

Secrets of Success

Match Investments to Investor Profile

Successful firms also implement product funds that reflect their investment philosophies and strategies.

Develop an investment plan that meets your individual situation. Then invest in appropriate products that will best meet your goals.

If you are retired, highly risk-averse, and need investment income to meet your monthly cash flow requirements, then lower risk assets that provide a consistent cash flow are best. But if you are 25, with a 40 year investment window, and do not require investment income to live, then perhaps you are best suited for more volatile investments with higher potential returns.

Match your investments to your personal situation and profile.

As your circumstances change (family, approaching retirement, career success, etc.), you should adjust your profile. As a result, your investment strategy, target asset allocation, and individual investment choices will also evolve over time.

Avoid Sector Bets

Successful firms also limit their abilities to take large sector bets in their core products.

Not sure I necessarily agree with this one, or at least with Investopedia’s phrasing. I think what Investopedia means is that one should not deviate from the core approach to make significant bets in any specific sectors or sub-asset classes.

For example, you have a well-diversified equity portfolio, but the financial pundits all say that tech stocks are the place to be during the upcoming year. So you ditch your utilities, commodities, retail, etc., and load up on tech equities. This is what Investopedia seems to be referring to.

The issue here is essentially market timing. And can you, or even the professional investors, correctly time market (and sub-market) movements? History shows that very few professionals get it right.

How often to economists get it correct? I could post examples like this every week if I wanted. Or what about the best investment analysts out there. Why do the “best” seem to change every year? How many professional investors were screaming when Apple dumped Steve Jobs back in the 1980s? Or why do mutual funds typically lag their pre-determined benchmarks if fund asset managers can time short-term market movements and trends?

The classic passive versus active management debate. It is difficult to beat the market, do not try.

If you are jumping in and out of sectors, you will incur higher transaction costs, as well as lose potential capital by timing poorly. You are investing for the long run. Select a strategy that meets your unique situation and follow it. Do not get caught up in the short term noise and stay the course.

Fully agree. Well, with short term sector bets or chasing trends. However, I do make longer term sector plays. Does that make me a bad guy? A fool? Possibly.

Well, Avoid Short Term Sector Bets

I am more a macro investor, so that is what I do myself to a large extent. I study trends and recommend investments that fit those trends. But I am more interested in medium to longer term trends. I do not think it possible (at least for me) to time short term volatility and I utilize probabilities more than gut feel.

If you ask me what Apple will do over the next 6 months, I can analyze the data and provide a reasoned opinion, but my confidence level will be low. There are too many non-systematic risks in play with individual companies to assess performance. Consider UBS. How many people out there knew a rogue trader in London was going to create so much aggravation for the company? Not me.

This is why we use diversification. To minimize non-systematic risks in our portfolios.

It is also why I recommend passive investing, utilizing a diverse portfolio of low cost index funds.

Looking at systematic risk, how many investors anticipated the September 11, 2001 attacks? Huge short term impact on the financial markets. The S&P 500 fell 11.6% between September 10 and September 21. Yet a month later it was back to pre-attack levels.

So short term volatility and market timing is hard to accurately assess. Or so I believe.

But I do think that smaller, professional investors can take advantage of inefficient markets and longer term trends.

Consider interest rates in Canada or the U.S. Currently, they are extremely low on a historic basis. In a low, medium, and high probability analysis, the odds of interest rates falling are negligible. We can debate forever as to whether they will remain stable or increase over the next 3, 6, 9, 12, or 24 months. But I am pretty confident they will rise over the medium term, if not the short.

Without getting into the correlation between interest rates and fixed income prices, suffice to say when rates fall, bond prices generally rise. When rates rise, bond prices fall. And the impact is greater the longer the bond’s duration (term to maturity, in layman’s terms). If I think rates will fall, I want to own 30 year bonds. If I think rates will rise, I want to hold 1 year bonds. As I calculate a higher probability of rising rates going forward, I believe that investors should shorten their fixed income portfolio durations.

But that is me. I listened to the two top guys at Vanguard last week make a slightly different argument (when they put up a video for the talk, I will post it). They said that perhaps low rates will stay in place for a longer period. By reducing durations, you are giving up yield (generally speaking, longer maturities equals higher yield) needlessly if rates do not increase. And they made some excellent points in support of their position.

If Vanguard is correct and I am not, then I am costing myself income by placing a sector bet on short-term duration bonds. We shall see over time. But I do think for an amateur investors – the doctor, teacher, fireman, etc., who does not spend 10 hours a day studying the markets – stick to a general strategy and that will serve you well over time.

Stay Consistent and Disciplined

When defining an investment strategy, it is very important to follow a strict discipline.

The chasing trends part we covered above. But I highlight the discipline part also in respect of consistency over time.

Use a dollar cost average approach to gradually build your holdings. When markets are down, you will be buying at a discount. When markets are too high, you will buy less and avoid overpaying. You likely cannot time market or individual investment highs and lows. So buy a fixed dollar amount each week, month, or quarter. That will smooth your purchase prices over time and better serve you.

Stay disciplined in your investment style. If you cannot time market volatility, should you even try?

A Final Thought

It is said that a picture is worth a thousand words.

Here is a good example of market volatility and whether one can time markets.

How many investors were able to time the market lows in early 2009? Versus the number that bought in mid-2008? But if you consistently invested $1000 monthly over that period, you may have done all right.

SP500

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