Developing An Investment Philosophy Part 3 3 comments

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I have described investing as being more of an art than a science, and the problem (or beauty, depending on how you look at it) with topics relating to humanities and arts is that there is no absolute right answer. The corollary of this is that one often does not know whether he is doing things properly or not. Even though there are many ways to skin a cat, one must at least know whether he is improving his technique in successive rounds.

How often is it that the individual investor wonders whether he is actually improving on his investing/trading technique? He might be able to calculate all the ratios and parse all the financial statements ie. get the technical aspects right, but he still cannot be sure about whether his stock-picking skills and system are systematically improved upon over the years, whether he is adopting a better buying/holding/selling strategy than before. And the experts are not helping. For stock picking, Warren Buffett says buy value at distressed valuations, Peter Lynch says take a walk around the malls, John Neff says buy low-PE. Never mind, one can say, they have different stock-picking approaches, that's fine, it ties in with investing being an art. But the real frustrating pieces of advice come in the "when to buy" and "when to sell" segments. Some argue for buying before the turning point (Warren Buffett), some argue for buying at the turning point after the price has "vibrated" around a range for some time (Peter Lynch), some argue for buying after the turning point (John W. Henry, a succesful trend-follower). As for selling, some argue for a fundamentals-based approach (which implies stop-loss may not be practised), others argue for a risk management approach (strict stop-loss though running the risk of being constantly whip-sawed). When one's holdings show a profit, some say let the profits run (Peter Lynch's multi-baggers), others say do not be greedy (Max Gunther and his 12 axioms). The investor is constantly bamboozled by all kinds of such advice, to the extent that the more he reads, the more confused he becomes. I have been through that phase, especially when I experience a period of poor performance following a period of good profits; self-doubt starts to set in and I wonder if I might have regressed.

In normal work, the way to gauge whether skill levels have systematically improved is through performance metrics such as productivity (manufacturing) and economic value-add per person etc. For investing the performance metric is clear -- investing/trading profits. However, to use this as a reliable gauge of the efficacy of one's overall investing/trading methodology, one should look at the long-term portfolio results, preferably over one up-down market cycle which would bring overall portfolio risk management (especially in a down cycle) into focus as well. Problem is, the "long-term" (one market cycle) is about 5-10 years or so, and certainly such a top-level assessment based on profit comparisons may not tell one which part of his investing methodology is lacking. The investor ages, but he is still not sure whether his methodology is improving with age, or whether it has stagnated.

A leading engineering designer once told me that the key to successful design involves accumulating a wide body of knowledge so that when one encounters a problem, he will be able to draw from this mental toolbox and seek the appropriate engineering solution. So it is with investing. I have realised that one need not worry about the knowledge application, but rather seek to improve his knowledge base instead. The application skills will follow. By seeking to improve one's understanding of the market both in depth and in breadth, and by recognising the opinions of the various gurus (as mentioned above) as various perspectives rather than cast-in-stone truths, one will be able to develop his own brand of thinking over the years. Knowledge breeds confidence, confidence inculcates discipline, discipline promotes consistency.

And in developing such a knowledge base, the keyword is "framework". There is structured learning and unstructured learning. The former involves learning according to a set of defined objectives: academic learning in schools is structured learning. The latter often involves on-the-job training, an experience-based approach. By default the investor undergoes unstructured learning in the market (OJT), and yet this will lead to confusion if he does not learn how to pigeonhole his experience. That is why some elements of structured learning should be introduced, in particular developing a framework to structure one's knowledge.

I have found, personally, that structuring my knowledge base around the subject of "businesses" and of "people" is a simple yet effective way framework to build on my knowledge. That stock prices are primarily driven by business earnings and potential is a given fact (especially clear after the dot-com bust), so a good working knowledge of industry dynamics within different industry sectors will be important. One does not have to go all out to learn about different sectors, for that would exhaust him --- there is too much to learn. But the unique opportunity to anchor in his knowledge of a particular industry is there every time he buys a stock, the chance to learn more about the demand and supply dynamics, the key players, the competitive advantages. A methodical mental classification of this knowledge over the years constitutes a powerful advantage in providing breadth of investing choices that one can be comfortable with.

The "people" knowledge base is less obvious, but what is the stock market but a collection of traders and service providers with different mentalities driving their various decisions? If one categorises the key players into various sub-groups such as service providers (stock exchange, brokers, investment bankers, independent research houses), securities issuers (the companies, their directors, their independent directors), securities buyers (gurus, institutional fund managers, house traders, retail investors, professional traders, short-sellers), there is so much to learn about the thinking and operations of each. On the very top level, service providers benefit from high trading volume, securities issuers benefit from strong stock sentiment before they issue their securities, securities buyers benefit from volatility and (with the exception of short-sellers) a rising market. The actions and operational strategies that each adopts to achieve optimisation of their objectives will be different. There is so much to learn about each sub-category: under the buy-side, for example, one can seek to understand how fund managers make their stock selections, when they buy and sell. Understanding the buyers and the sellers, in my mind, is the key to risk management and stock selection in the stock market.