When uncertainty roils markets, as is the case right now, it is natural for investors to get knocked off balance, a when off-balance, to make investment decisions that they often regret later. It is during those times that it helps to have a core set of beliefs about markets, and an investment philosophy that reflects those beliefs. You may not be able to mend the damage to your portfolio, but it will help you find balance again and make sense of the noise around you. As an investor, my investment philosophy has been a work-in-progress, but I have had an interest in how the investors around me develop their philosophies, and why differences persist. That interest was precipitated by a seminar class that I organized for NYU Stern MBAs in the late 1990s, where successful investors with very different market perspectives and investing styles presented their points of view, and students struggled to reconcile their different and contradictory points of view. In the aftermath of the class, I started working on a book and a class on investment philosophies, where the end game was not to find the "best" philosophy, but to provide a framework for investors to find the philosophy that best fits them. The first edition of the book came out almost two decades ago, followed by a second edition in 2012. In conjunction with the second edition of the book, I created a free online version of the class on my webpage in the same year, and NYU created a certificate class about six years for the class. While my core thinking on investment philosophies has nto changed, markets and the economy have, and both the book and the class have been in need of an update. I spent the last few months working on that update, and the third edition should be available at book stores in the coming week, and in conjunction, I have an updated (free) online version of the class on my webpage and on YouTube
The Origins
In the late 1990s, I was approached by the Stern School of Business with a request to serve as the organizer for a class on investing, where MBA students would spend a session a week, for a semester, hearing from successful investors of all stripes, and discuss what they learned from that talk in a second session each week. Over the course of the semester, the class had fourteen speakers, and because of our New York location, it drew from a range of investing types. Thus, students heard from a well-known value investor one week, the manager of one of the best-regarded growth mutual funds the next, a high-profile technical analyst in the third, and so on. The speakers approached investing in very different ways and had different perspectives on financial markets and how to exploit market mistakes, but they all had been successful as investors.
As I led the discussion of each speaker's market views and investment practices each week, I noticed students in my class developing whiplash, as they instinctively try to incorporate the views and practices of each speaker into their thinking. As the weeks went on, that became a problem, since other than investment success, the speakers shared little in common, and their views about markets were sometimes contradictory. By the end of the class, there was a fairly large subset of the students who ended up more confused by what they had heard during the semester, rather than enlightened. As I reviewed the class, before handing it off to someone else, I took an inventory of what I had seen not just in the class, but in investing in general, and came to the following general judgments about investing:
- There are very few active investors, who win consistently over time: Active investing is one of the most difficult games to win at, and one reason is that you match the average investor, effortlessly and almost costlessly, by investing in index funds. Active investing has the unenviable task of trying to be better than average, and by enough to cover the costs (research, data, personnel, transactions) associated with being active. Just as illustration of how much of a mountain this is to climb, take a look at the percentage of active institutional investors who beat their respective indices over the last decade:
While there some active money managers who "beat the market" over a year, two years or even five, very few are able to hold on to these excess returns as you lengthen their active investing stint. Like gamblers in a casino, who strike it lucky early, but stay gambing too long, they often leave with none of their gains, or worse. Before I get a blowback, I am fully aware that that there are investing legends (Warren Buffett, Jim Simon and George Soros, to name just three), but the very fact that we can name them suggests that they are the exceptions, not the rule. - Even with those successful few, it is very difficult to separate luck from skill: Much as investment books and classes claim otherwise, investing results are affected by so many forces that are out of your control that disentangling how much of your final returns can be attributed to skill and how much to luck is very difficult to do.
- These successful investors have widely different pathways to delivering success: If you were to make a list of the investors who have had the most success in markets in the last century, I would wager that you would be looking at a very diverse group, not just in terms of how they succeeded, but also in terms of personality. The three investors I named as legends - Buffett, Simon and Soros - obviously had very different views on markets, and how to exploit market mistakes, but even with investors who are often viewed as being from the same grouping, differences remain. Buffett may have learned his early lessons from Ben Graham, but the Graham and Buffett approaches to value investing are varied, with the former more focused on screening for cheap stocks and the latter more interested in finding companies with solid moats and great management.
- Imitating successful investors does not seem to provide much payoff: The practices of successful investors have been probed and investigated by other investors and journalists, and some of them have dozens of books that claim to tell you the secret of their success. Warren Buffett is perhaps the winner in this race, with not only a multitude of books that track his investing life but also his annual letters to Berkshire shareholders which laid out his investing perspective in detail. That said, the investors who tried to follow in his footsteps, often imitating every aspect of his approach, have, for the most part, not been able to match his success.
My takeaways from these assessments are two fold. The first is that there can be no one dominant investment philosophy that is the best for all investors, and any claims to the contrary, whether it be for value investing or market timing or trading, are disingenuous. The second is that there is a right investment philosophy for each individual that reflects that individual's views and beliefs about markets and characteristics as a person.
The Core Idea
The recognition that each investor needs an investment philosophy that is tailor-made to his or her beliefs and personality became the starting point for my creating a class, and writing a book, about the topic. Before I describe what I try to do in the book, I should start with a definition of what I mean by an investment philosophy, and perhaps the best way to do that is by describing what it is not. First, an investment philosophy is much richer and more complete than an investment strategy, with the latter often coming out of the former. Thus, applying a screen to find stocks that trade at low multiples of earnings (low PE ratios or low multiple of EBITDA) is an investment strategy, but the investment philosophy that gives rise to that strategy is one that is built on markets under pricing companies with low growth or boring businesses, perhaps because investors are dazzled by growth and drawn to the excitement of newer businesses. Second, an investment philosophy is not an investment slogan. "Buy low, sell high" is an investment slogan, and a meaningless one at that, since that is the end game of almost every investment philosophy.
If you have been investing for a while, and have never stopped and asked yourself what your investment philosophy is, it is understandable. In fact, you may wonder why you should constrain yourself to an investment philosophy instead of looking for bargains wherever you can find them. The problem with not having a core philosophy is that is exposes you, as an investor, to a whole host of consequences, most of which are negative:
- Chasing winners: If you don't have an investment philosophy, it is almost a given that you will find yourself drawn to whatever strategies worked best in the recent past. Your portfolio will suffer from whiplash as you chase last year's winners, whether that be the Mag Seven or technology stocks or small cap stocks, and while your turnover and transactions costs rise, you will have little to show in terms of returns.
- Scam target: Greed is universal, and that leads us to look for ways to make lots of money with very little risk. Without an investment philosophy constraining you, you will be an easy mark for investment scams, drawn in with promises of upside with little or no downside.
- Empty investing cupboards: If you do find an investment strategy that works at delivering returns, it is worth remembering that the clock is ticking, and that imitation and market corrections will cause that strategy to stop working, sooner rather than later. If that is all you brought to the market, your investing cupboard will be empty and you will find yourself running to stay in place. The advantage of having a coherent, well thought through investment philosophy is that you can go back to it and mine it for other strategies that may exploit the same market mistakes. Thus, if your investment philosophy is that markets undervalue boring, low-growth companies, and low PE ratios are no longer doing the trick (of finding cheap stocks), you may look for other screens (low volatility) that find you boring companies that are mispriced.
Simply put, every investor needs an investment philosophy to guide him or her in the difficult task of trying to delivering success.
Rather than create a laundry list of philosophies, I will use the investment process as the vehicle to describe how and where the different investment philosophies emerge from, as well as diverge:
Using this process, the choices in investment philosophies emerge:
1. Active investing versus Passive indexing: If, as we noted in the last section, doing nothing can deliver returns approximating the average, and nine out of ten investors who try to beat the average fail, there is no shame in adopting a passive indexing philosophy, where your allocation across asset classes is determined by your risk aversion and need for liquidity, and index funds fill out the rest of the dance card. It is human nature, though, to seek to be better than average, and it is perhaps that desire that drives many into active investing choices, and there are multiple pathways that they can adopt.
2. Investing versus Trading: The second divide in investing philosophies comes from the difference between value, which is driven by cashflows, growth and risk, and price, determined by demand and supply. Investing requires assessing the value of an asset, buying if the price is lower than that value and selling if it is higher, and waiting for the gap to close. Trading, on the other hand, is about gauging market mood and momentum, buying if you expect those forces to drive the price up and selling otherwise.
Within each of these groupings (investing or trading), there are sub-groupings. Trading can take different tacks, depending on where you think that market mistakes lie. The first, price traders, use the information on prices and trading volume to detect shifts in mood and momentum, with charts and technical indicators as tools, to try and generate profits. The second group, information traders, trades around information releases, such as earnings reports, acquisition announcements or even insider trades, with some trading ahead of the news, some at the time the news is announced and some in the aftermath, all trying to take advantage of what they see as market mistakes in reacting to that information. The third group, arbitrageurs, focused on finding the same or related assets trading on different markets, looking for mispricing across these markets, and locking in that mispricing as excess returns.
Investors, for instance, can be drawn to value or growth, and while that difference is often stated in terms of pricing multiples, with value investors buying low priced stocks (low PE, low price to book etc) and growth investors drawn to higher growth and high priced companies, I prefer to think of the differences in terms of where each group thinks it can find bargains. Using my financial balance sheet construct, where I divide the value of a firm into the value of investments already made (assets-in-place) and investments anticipated in the future (growth assets), value investors view their odds of finding market mistakes to be greater with assets-in-place, whereas growth investors feel that their odds are better in finding misvalued growth assets:
3. Market Timing vs Stock/Asset Picking: In market timing, your focus is less on individual stocks or assets and more on deciding whether a market (equities, bonds, real estate etc.) is under or over priced. Returning to the investment process, your focus is on allocating your portfolio across asset classes, based on your market views, underweighting "expensive" asset classes and overweighting "cheap" ones. In stock/asset picking, you take the market as a given and try to find the best individual investments within each investment class for you - the cheapest stocks, bonds and real estate that you can find. There is an ironic contradiction in making this choice. It is undeniable that a successful market timer will make far more money than a good stock picker, but it is also true that it is much more difficult to be a successful market timer than it is to be a good stock picker. The picture below captures the choices in terms of investment philosophy, framed in terms of where they enter the investment process:
Finding an Investment Philosophy
Looking at the menu of investment philosophies, from passive indexing to arbitrage, my end game in my book and for the class on investment philosophies was not to advance a single philosophy or even compare them, but to provide as unbiased and complete a picture, as I could, of the data backing each philosophy and more importantly, the personal characteristics that you would need to succeed with that philosophy.
Step 1: Views on Market Mistakes and Corrections
The first step in finding your investment philosophy is with a view of where (and why) markets make mistakes, and how they correct them. Even the firmest believer in efficient markets will concede that markets not only make mistakes, but sometimes make big ones, but the divergence between them and active investors lies in the nature of these mistakes. In an efficient market, market mistakes will be random, and since there is no systematic pattern to them, there is no pathway for active investors to find these mistakes, even with access to data and powerful tools. Active investors, in contrast, believe that there are systematic patterns that you can use to find these mistakes, and to exploit them for profits, with traders believing that those patterns are in the pricing and volume data and investors hewing more to fundamentals. That said, active investors can and will disagree about the types of market mistakes, with some buying into the notion that markets learn slowly, whereas others believe that markets overreact, and it is healthy for investors to have these disagreements.
Step 2: Pick an investment philosophy that reflects market views
Your views on market mistakes and corrections should guide you in your choice of investment philosophies. Thus, if you believe that markets overreact to news, good or bad, you may decide to become a contrarian, either trading (by buying after bad news and selling after good) or by investing (by buying companies with solid fundamentals whose stock prices have dropped by far more than they should have). Conversely, if you believe that it is momentum, not fundamentals, that is the biggest drivers of stock price movements, you may choose to ride that wave, based on charts and technical indicators. Superimposing time horizon onto the types of mistakes that markets make, you can create a matrix of investment philosophies:
Step 3: Check for viable strategies
Investment philosophies are a critical component, but to make money on a philosophy, no matter how well thought through, you need to devise investment strategies that can generate profits for you. In coming up with these strategies, you will confront the two realities that cause many strategies that look good on paper to fail: transactions costs and taxes.
- On the transactions cost front, the brokerage trading cost is just a small part of the overall cost, with two other costs that can often be much larger. The first is the bid-ask spread, small for large, very liquid stocks, but much larger for smaller and less liquid investments. The second is price impact, again non-existent if you are a small investor buying or selling shares in a large market-cap company, but substantial if you are a large investor trading on an obscure stock.
- On the tax front, some strategies will create more tax costs than others, partly because of how investment income is taxed (dividends create immediate tax consequences but capital gains require trading to incur tax liabilities) and partly because of how much trading your strategy will require of you, with higher turnover generally creating more tax liability.
Step 4: Check for personal fit
Investment philosophies, and the strategies that emanate from them, come with different demands in terms of time horizon, with some requiring holding on to investments for many years and others requiring trading in minutes, different risk exposure and divergent tax consequences. Investors who choose to adopt these philosophies have to reflect on whether they are good matches, on the following fronts:
- Capital to invest: If you are just starting on your investment journey, and have only a small amount of capital to invest, your choices in terms of investment strategies narrow. You will definitely not be able to be an activist investor, since you will have no weight (in terms of money invested or shares held) to throw around, and you may lack the wealth to buy illiquid, small companies, if that is where you think market mistakes are most often found, since you will not be able to spread your bets. The good news is that you continue to build up your capital, your investment choices will widen, and you can modify your investment strategies accordingly. At the other end of the spectrum, and this is perhaps more the case if you are managing other people's money, you can have so much capital to invest that some investment strategies become infeasible. For instance, if you are planning on investing in illiquid, small cap stocks, having billions of dollars to invest will increase your transactions costs (by increasing price impact when you trade).
- Time horizon: Many investors, when asked the question about time horizon, claim to have long time horizons, often because they believe that it is the answer that "good" investors give. The truth is that for most investors, time horizon is as much determined by external factors, such as age, health and liquidity needs, as it is by internal motivations. If you have to pay tuition for your children or expect to have substantial hospital bills in the near future, your time horizon just became shorter, and that has to be factored into your choice of investment strategies.
- Risk exposure: As with time horizon, the willingness to take risk is partly a function of your personal makeup and partly determined by your life standing. If you have accumulated wealth and have a job with a stable (or rising) income that more than covers your expenses, you are better positioned to take risks than if you are on the verge of retirement, and are investing money that you will be needing soon to cover your post-retirement cash needs.
- Personal qualities: Your personality and characteristics also come into play in your choice of investment philosophy and strategies. If you are, by nature, impatient, it is unlikely that you will be able to sustain a strategy of buying undervalued companies and waiting for a long time for mistakes to correct. Similarly, if you are easily swayed by peer pressure and what the rest of the world is thinking and doing, it is difficult to be invested in contrarian causes, short-term or long-term. Finally, if your strategy requires special skills to be put into motion, you will have to either have or acquire those skills; a strategy built around finding undervalued companies will require that you know how to value companies and one built around analyzing large and complex datasets looking for mispricing needs statistical and data analysis knowhow.
- Economic setting: Over time, economic settings and structures change, and investment philosophies have to adapt or even be abandoned. For instance, I have argued that technology and disruption have created winner-take-all businesses in the twenty first century, and if you buy into that argument, an investment philosophy (and strategies) built around small cap companies will no longer deliver the payoff it did in the twentieth century.
- Market lessons: Your views on market mistakes come from looking at data and your own experiences in the market, and as a consequence, they should be revisited as markets change. Just in this century, markets have been tested by crises (the financial crisis of 2008, the COVID meltdown in 2020 and the tariff announcements last April, just to name three), and it is becoming increasingly obvious that assets across classes (stocks, real estate etc) and geographies are moving far more in sync with each other than they did in the last century. That reality has to be integrated into your market views and the investment philosophy/strategies that you use.
- Trading microstructure: It is undeniable that access to information and trading on most assets has become easier over the last few decades. That is good, but it does come with a cost. Investment philosophies built around the assumption that most investors, especially retail and individual, would not be able to access data or trade easily, may need tweaking, adapting or even abandonment.
- Personal changes: It won't come as no secret to you, but you will get older, the amount of capital you have to invest will change, your health and family obligations will shift, and you may even become more or less patient or more or less susceptible to peer pressure. Those factors will all feed into your investment philosophy.
The Investing End Game
We all share the same end game in investing, which is to generate the highest returns on the capital we invest, though there are wide variations in how much risk we are willing to take and how long we will wait before cashing out. That is the definition of investment success, but given that there are so many forces that are out of our control, you can do everything right and still fail to meet your objectives, leaving you frustrated and questioning yourself. It is for that reason that a better endgame is to seek out investment serenity, where you end up with an investment path that you are comfortable with, and accept the results that emerge, good or bad.
I have spent this entire post talking about investment philosophies, and in case you have not noticed, I have not shown my hand, on my investment philosophy. I have never believed in hiding behind vague and opaque generalities, and my investment philosophy is built around three principles:
- Intrinsic value matters: I believe that every asset (anything that generates cash flows) has a intrinsic value, and that with imagination and a willingness to make mistakes, you can estimate that intrinsic value for any company, from start-ups to companies on the verge of default. I believe that much of what passes for valuation in practice is pricing, where people using pricing metrics (such as PE ratios or EV to EBITDA multiples) to make pricing judgments, and that a good valuation requires understanding business models, telling stories and converting these stories into valuation inputs and value estimates.
- Markets are for the most part right, but make mistakes during periods of uncertainty and change: I never cease to marvel at markets, where millions of individuals with disparate views and information reach consensus on a price. In an age where we have turned over our choices on what movies to watch to Rotten Tomatoes, and which restaurant to eat at to Yelp!, it is worth remembering that markets were the original fount for crowd wisdom. That said, it is also true that markets have provided us with illustrations of crowd madness, where the collective wisdom is hopelessly wrong, and I believe that this is often the case when investors face significant uncertainty, as is the case when companies transition from one stage of the life cycle to another, entire industry groups are faced with the threat of disruption and markets are put into upheaval by crises.
- Do no harm: While I seek out investments to make that will beat the market, I am cognizant of the reality that I am not entitled to rewards, just because I put in the work, and that luck and chance still can wreak havoc on my best-laid plans. In particular, I have learned, through experience, that my biggest mistakes come from overreach and overactivity, and I have built that learning into my investment philosophy by:
- Spreading my bets: I have written before about the concentration versus diversification argument, and that what you choose to do as an investor will be a reflection of how much confidence you have in your investment choices, or “conviction”, in investing parlance. I must confess that I don’t share the conviction that concentrated investors bring to the game, and not only spread my portfolio over three dozen stocks, but also follow rigid rules on not letting any single investment exceed 15% of my portfolio.
- Acting rarely: I don’t trade often, and when I do, I follow the old adage of measuring twice (or three times) before cutting (trading). It helps that I don’t track the market or my portfolio holdings all day, almost never watch the financial news and am not easily swayed by investment sales pitches.
- Staying away from my weaknesses: I steer away from active market timing and sector bets for a simple reason. I am not good at either, and what I might gain from an occasional win will be wiped out by what I lose in the long term.
- Being aware of my blind spots: I try to be self-aware, though I don’t always succeed. I know that I am thrown off my game plan by taxes (I don’t like playing them, and that sometimes gets in the way of doing what I should be doing) and I sometimes fall in love with company narratives, because I want them to be true.
