The Process of Investment

Now it's time to start developing a framework for investing. I've been meaning to do this for a few months now as I think I've now come far enough to see that there is a real need for a set of boundaries from which to operate within. What I will try to do is write down a set of overall principles and then expand on those principles as I go along. This is a totally iterative process that I intend to develop over time. It may not be right first time around but with numerous iterations I hope to get closer to the goal of something that is both cohesive and structured.

There are five general themes that I hope to expand upon:

1. Goals
2. Investment selection and disposal
3. Risk Management
4. Emotions
5. Academic & real world theories

These five themes provide enough of a breakdown for an end to end process of managing a well rounded portfolio designed to achieve its investment goals. This is not an over reaching, step by step set of hard rules, rather it is based on a set of principles that can be adapted to each individual situation spanning market caps and asset classes.

Like most plans, the best place to start is by defining the goals which being worked towards and at what point these goals are being successfully met. Capital appreciation, income, preservation of principle. Whatever it is, by setting an overall target the development of the plan is obviously far easier. This is probably not far off comon sense. I personally look first for preservation of principle over the long run with capital appreciation and income in between. Because of this, I'll write with these goals in mind.

Investment is a funny game because it plays with your emotions more than I could have ever imagined. It always feels like everyone has an opinion that they are happy to give and the market is apparently "always right". Brokers, colleagues, analysts, the press. It's always easy to let these external influences shape your investment thesis for better or for worse making true investment difficult in all but the best cases.

Having experienced the academic side of investing, it's striking how large the difference between academic investing and real world investing really is. In fact, I can see that the practicalities of academic studies are limited at best if they are not used to simply gain some sort of general insight into the workings of the world. There is a reason why Post Earnings Announcement Drift and the Price to Book value anomalies exist. Would you really want to invest in a company purely because it has beaten consensus forecasts or would you really want invest your pension fund into a basket of low Price to book value stocks despite the stocks having a low ROIC or being less than financially sound? In many cases this is not practical. However, these anomalies do provided an excellent place to start thinking about where to start looking for potential investment candidates.

Obviously, we also have the actual investment selection. This can only really be done in the light of the a holistic process the takes into account end to end thought and care. This is where a careful analysis of each investment case is done with the overall portfolio goals in mind. Here, we need to distinguish between investment and speculation along with what the investment gives you that you don't already have.

Often the focus is purely on what to buy rather than what (and when) to sell. I'm not a big fan of buying and selling for the sake of it as I often think the only ones to win out of this strategy are the brokers. However, at what point have we introduced too much risk into the portfolio through not selling out when the market cap has advanced too far. It could be argues that holding onto an over valued stock is the same as buying an overvalued stock.

Finally, tying all of this together is the risk management process which I believe should be at the center of the whole portfolio. Are we looking to preserve capital, build capital, or a combination of both? How is this going to be done and with what type of assets? How diversified will we be and what do we need to achieve our returns? These are all basic questions that need a set of principles from which we can work within. Once this part of the management process starts to break down then not only will the portfolio start to take on unwanted risk but the portfolio will start to resemble a set of random bets on success.

Of the five areas of this methodology, no one area can be used without the others. Understanding these five areas should create a holistic process for investment and investment management. At the end of the day, this process aims to create a way to allow for investment that is "business like" in order to achieve its goals.