Friday, October 06, 2006

Developing An Investment Philosophy Part 4 1 comments

(P.S: Sorry for any disturbances the advertisements above may have caused you)
It is useful to consider a few instances of investment philosophies here, for those who thrive on examples. There are many categorisations (the fundamentalist/technicalist categorisation, the contrarian/momentum categorisation, the macro/micro categorisation, the growth/value categorisation etc) but one useful set of examples is a classification by Charles D Ellis, one of the leading thinkers in investment management.

The "Show Me The Money" column in the Business Times every Saturday by Teh Hooi Ling is a weekly staple reading for me, because she discusses perspectives to investing that broaden my mind. In today's column, Charles D Ellis' views were discussed, where he classified investment methods into the intellectually difficult, the physically difficult and the emotionally difficult.

A brief overview: the "intellectually difficult" way is pursued by those who understand the "true nature of investing", and are willing to take long-term positions based on their views that might seem unpopular at that particular time. They are otherwise known as value investors, though they could also easily be known as growth investors, since Warren Buffett, who obviously has been classified in the intellectually difficult group, practises investing in growth at a reasonable price (GARP) as much as he practises distress investing. The "physically difficult" refers to those who try to beat the market by working physically hard: staying late, reading many reports, going for more meetings with analysts and generally trying to outperform the market by outworking the competition. The "emotionally difficult" approach is the most straightforward: working out the individual's own long-term investment policy, then sticking to it despite others' exhortations to enter or exit the market because the market is "too hot to miss out" or is "going to crash". Often this involves staying out of the market for long periods (waiting for market indices to revert to the mean) while everyone else around boasts of how much they have made. In all three cases, we can see what are the difficulties in practice, hence the terminology.

These are obviously three philosophies (or you can call it manner of thinking) in which market players seek to make money on the stock market, and I will build a discussion further on it below. Firstly, it would be wrong to operate along one, and only one, of these lines of thinking, in one's search for market success, but rather, one should be aware of the stocks and investment horizons that are suitable for each approach. The "intellectually difficult" approach entails at least a medium-term investing horizon because that's when the (perceived) fundamental strengths of the business behind the stock weigh in, and often the stock in question would be considered "low-probability" (in terms of price appreciation) at the time of purchase. And surely this approach involves scuttlebutt such as talks with management(where possible), real-life assessments of product popularity at the mall, stock- scanning and what is that but a facet of "physically difficult" investing? On the other hand, "physically difficult" investing would probably involve shorter-term horizons with "high-probability" stocks --- high probability because the emphasis for such physically difficult investing tend to be on catalysts for the stock (earnings surprises, contract announcements etc) that will move the price. "Emotionally difficult" investing is essentially a contrarian approach which often ties up with the psychological propensities of "intellectually difficult" investors. So the three classfications are inter-linked. Furthermore, what's to stop one from practising say, "intellectually difficult" investing together with "physically difficult" investing? The greatest danger is to pigeonhole oneself into one of these classifications and say,"I don't try to outwork fellow investors" etc. However, if one sees his competitive advantage in one of these (read a related article: "Full-time investing/trading Part 2"), say in his ability to predict fundamental trends, then he should focus on that type of investing. However, my view is, never rule out the rest: the only rule should be that the investment that maxmises the perceived potential-risk ratio should be chosen.

Which brings us to the second point, which is that "intellectual-based" investing tends to be glamourised. It is no surprise since most would rather be called smart than hardworking or mentally strong. Yet investing involves hard work and mental discipline. For myself, I seek to build on two aspects of competitive advantages: the advantage of speed and flexibility vis-a-vis the big institutional investors (see "Advantages of Being a Small Investor") and secondly, "to outsearch, outread and outthink on business fundamentals" vis-a-vis fellow retail investors (see "My Investing Journey: Hypothetical Situations"). The first involves some elements of contrarian thinking and conquering mental instincts, while the latter involves real hard work. Other fellow investors (ThinkNotLeft in "My Investing Journey: Hypothetical Situations") have said that some of their more important competitive strengths lie in certain emotional edges (i.e. discipline, patience etc) which allow them to suffer the ravages of the market (which suggest he is a contrarian). Although it is certainly ego-boosting to be able to claim at parties that your stock has risen several multiples through ups and downs over the years (implication would be that (1)you had good judgment and chose wisely; (2)you had the courage of your convictions to hold, just like Warren Buffett), it is difficult in practice to buy the "correct" stock without examining all the possibilities and doing all the extensive reading for likely future trends.

The point in all the above, is that (1)it is ok to mix-and-match; (2)do what's right (and suits your personality and abilities), not what's fashionable.