Investing in Human Behavior
As an investment advisor, I’m often asked “What do you think of the market?” or “Hey what is a good stock to invest in right now?” Ironically enough, I have a really hard time answering those types of questions. Investing in good stock stories or pretending I can predict the direction of the market is something I avoid at all costs. Predicting short-term price movements in a market is extremely difficult and even though there are lots of companies I’m optimistic on, whether or not they are good investments is an entirely different story. In my opinion, stocks are rarely priced based on economic data or business fundamentals. For that reason alone, I don’t feel comfortable handing out stock tips, investing in fads or jumping into an investment based on what a stock chart looks like.
Over the next few weeks, I thought it would be helpful to share some thoughts on my own investment process. Although my ideas are hardly novel, I think most will find the general investment philosophy far different than traditional investment styles. My strategy is largely quantitative and revolves around market factors related to how human behavior affects prices.
If you google “quantitative investing” you will see the following:
Quantitative investing represents an investing technique typically employed by the most sophisticated, technically advanced hedge funds. These firms employ fast computers to find predictable patterns within financial data.
That seems overly complex. When I say my strategy is “quantitative” all I mean is that I base most investments on historical probabilities and simple technical indicators. I am not a “technically advanced hedge fund”, I don’t believe many patterns are “predictable” and the “fast computer” I use is a 21” iMac . Don’t let the word scare you.
Today I will outline some general ideas that set a foundation for my strategy. Next week I will specifically discuss the behavioral phenomena of value and momentum within markets and how they can be used for selecting investments. Finally, I will discuss how a defined process is needed to meld the pieces of a strategy in a way that they can be executed successfully.
The goal of my investment process is to achieve long-term capital appreciation while at the same time preserving capital in adverse market conditions. Some will tell you that capital appreciation and preservation are two diametrically opposed goals, but I disagree. I aim to achieve consistent investment results while at the same time limiting volatility. Timeframe awareness, diversification and risk management are three broad areas that I believe help align my strategy with its stated goals.
Avoiding the Noise
Markets are very finicky. Short term prices are largely based on sentiment and its difficult to tell how the market will react as new data becomes available. I don’t dedicate any amount of time to short-term price movements. I find them nearly impossible to predict and they don’t align with my overall investment goal (long-term capital appreciation). The 24/7 news cycle makes this timeframe very noisy and those following the information firehose in and out of investments are more prone to make emotional decisions. If you are investing for the next 20-30 years, the price of a particular investment over the next week, month or quarter doesn’t matter much. Focus on the long-term and relax.
Singles vs. Homeruns
Since there are no crystal balls, I look at investing as a game of probabilities. If a particular type of investment has a 60% chance of working in my favor, investing a small amount across many of those investments puts me in a better position than investing a big amount in one of those investments. In other words, I’d rather play many small games with favorable odds than one big game with the same odds. If I only play one big game a year, there’s a 40% chance I’m wrong and come away with nothing. But if I play the game many times on a smaller scale throughout the year, I have a much better chance of ending the year on top. Hitting singles and slowly working towards my goal in a consistent way is more preferable to me than the occasional home run. Singles might not be as exciting as home runs, but when investing, excitement doesn’t matter.
Past Results Don’t Drive Future Returns
Probabilities play a big role in how I invest but I’m careful to avoid anchoring my strategy on historical information. It is important to keep an open mind while at the same time not be fooled by randomness. As I mentioned above, making many small investments rather than few large ones is one way to mitigate risk but there are still times when entire markets might not be favorable for the type of investments I make. During these times my preference is to protect capital. This risk management process doesn’t have to be complex. For me, it is simply a way protect major downside risk and wait for better opportunities to develop.
Next week I will discuss more specifics as to why I believe investing in momentum and value are sound investment strategies and why they have become so important in shaping my overall investment philosophy.
This is part one of a three-part series on my general investment philosophy.