Developing An Investment Philosophy Part 1 2 comments

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Is there such a thing as the "optimal" investment/trading philosophy? This is the elusive holy grail of all new market players but as they immerse themselves deeper into the market, the greater the realisation that there is no such silver bullet.

The reason why this is so is that the market is made up of human players which means feedback processes are so complex as to be considered random. Trading themes change all the time, from technology (late 2003) to the China story (2004-05) to oil and gas (mid-2005) to property (3Q 2005). If one wants to optimise stock performance, he will have to know what the average market is thinking. Or rather, what the average market thinks the average market is thinking. No equations are adequate to describe this type of interaction. Which means even if one's investment philosophy is very logical and scientific (eg. PE-based (contrarian), fundamentals-based (financials, business trends analysis), dividend-focus (Dogs of the Dow) etc or technical-based (charts, assessment of technical position of market, overbought/oversold indicator), there are stretches when one will underperform the market, due to this network of complex interactions.

What this means is that investment/trading is not a science, but an art. There are no absolutes, only context. One, however, should not throw up his hands and give up on developing a philosophy: I feel a reasonable and logical investment philosophy recognising the foibles of the market, the business trends of various industries, and one's personal character failings, will in the medium to long term yield above average profits. This philosophy doesn't just spring out from books dishing out investment advice, however; it is a function of one's experiences in the market, his experiences with investing in stocks in various industries.

What one gets out of reading books is just the basic philosophy, buy-and-hold or contrarian or momentum or trend-trading or whatever, but ultimately the devil is in the details. For the same reason that virtual/phantom trading (ie. without one's money involved) is a waste of time, the investor can derive a great deal of knowledge and confidence (incidentally, both are equally important) from doing actual trades, whether he loses or gains. The provisos that one augments to his basic investment philosophy are in fact the most important, and these cannot be developed without actual market experience. What do I mean by provisos? It is the exceptions to the rule. For example, the buy-and-hold investor normally does just that: buy and hold. But under what circumstances does he change this philosophy? A change in the fundamentals, yes; but what exactly constitutes a "change in the fundamentals"? Another example: some(but not all) advocate "letting profits run", yet it is clear (from the dot-com boom, for example) that often it may be better to overcome one's greed and take profits; so where does one call the exception to the rule? That is the meaning of my "provisos".

Ultimately, the acid test of one's investment philosophy is one's stock portfolio performance. If one has been consistently underperforming the market, it is time for a re-think on one's entire investment philosophy and stop trying to develop "provisos" or exceptions to the philosophy. When I started out, I constantly targeted low-PE stocks, adopting a pure contrarian strategy, but I found that this pure "low probability-high potential return" strategy gave me average returns for the general reason that efficient markets generally are the rule; the low PEs were there for a reason, whether low growth potential or a peaking of the cycle. Now I adopt a mixed portfolio of "low probability-high return" stocks (as per previously) and "high probability-average return" stocks, the latter selected on a predominant basis of favourable business trend and margins. I find that they serve my pocket and my sleep patterns better.