Weekend Edition - You're Probably Speculating - Part 2

Weekend Edition – You’re Probably Speculating – Part 2


Most recently, we delved into the topic of speculation and how you’re probably doing it whether you realize it or not; if you haven’t already, be sure to read You’re Probably Speculating – Part 1 before continuing with today’s piece, which takes a deeper dive into what it means to build an investment process.

To summarize, an investment process is a set of rules and guidelines designed to help steer your research efforts in a particular direction based on your overarching asset allocation plan. Researching without an investment process is a form of speculation because you’re looking at opportunities on a stock-by-stock basis rather than relying on a more consistent approach to discover and evaluate them [see also A Contrarian Approach to Dividend Investing].

How to Build Your Investment Process

investment processBuilding an investment process isn’t something you can check off your to-do list on a Sunday afternoon; it takes time to formulate and even more time to refine. In fact, it’s arguable that you can never really consider this task “done” because there is always room for improvement (you’re bound to learn a lesson or two after you actually put your plan to use).

As such, consider the steps below as guiding principles, rather than rigid rules, when it comes to taking the first steps in building your investment process:

  • Start with Asset Allocation: Your investment process should be centered around your overarching asset allocation plan; this refers to how your portfolio will be divided between stocks, bonds, and any other asset classes you wish to be exposed to. The other component that will define your asset allocation plan is your investment horizon, which goes hand-in-hand with your risk tolerance; for simplicity’s sake, the younger you are, the more risk you’re capable of taking on, and therefore you’re likely better off holding a greater portion of your assets in stocks instead of bonds.
  • Define Your “Edge”: You must be able to describe exactly how you plan to make money in the market; more specifically, you should be able to pinpoint your competitive advantage. For example, do you rely on external data sources that you then synthesize using a custom valuation model? Or perhaps you have a screening methodology that helps you narrow down solid stocks with low price-to-book ratios. No matter what, if your strategy is to buy “undervalued” stocks (or sell overvalued ones), you must be able to define exactly what qualifies as undervalued in your view. Remember that consistency is a key component of any process.
  • Utilize Controls: After you have formulated a strategy, you must then create “checkpoints” for yourself to make sure you are always staying in line with your plan. This includes outlining how and when you will review your portfolio, as well as rules for how you will manage profits and losses. Basically, you need to create “reminders” for yourself so that the next downturn on Wall Street doesn’t prompt you to make a sporadic decision that falls outside of your regular process. Having a process is great, but it becomes worthless if you can’t stick to it whenever your emotions start running wild (and they will).
  • Record, Review, and Refine: Although it may seem trivial and a hassle at first, writing down your process and the subsequent trades is absolutely essential. After you’ve put your plan to work for some time, make an appointment with yourself to review your success and, more importantly, the process that led you to make the trades that you did. Refining your strategy will be an ongoing challenge, but it’s well worth the trouble since it’s a surefire way to remain consistent in how you incorporate what you learn over time back into your strategy.

Once you’re more familiar with the concepts outlined above, take the time to review a real life investment process. Alpha Architect’s Quantitative Value Philosophy is among the most comprehensive investment strategies out there and can serve as an excellent educational/inspirational starting point for any type of investor.

The Bottom Line

Being successful in the markets is challenging, if not altogether impossible, without a clear-cut process to guide you along the way. Your investment process doesn’t need to be complicated, it just needs to be replicable so that you may regularly review what has been working and what hasn’t. As is the case with any other discipline, remember that practice makes perfect, and portfolio management is no different.

Have a great rest of your weekend.