What is an investment philosophy?
Philosophy is defined as a theory or attitude that acts as a guiding principle for behaviour. An investment philosophy is a set of core beliefs and principles which are used to guide an investors decision making process. These beliefs are a way of thinking about the markets and how they work, the behaviour of investors and the process of investing within the markets.
The application of a philosophy allows an investor to choose and manage their investments based on their beliefs and the attitude which they have towards investing. A philosophy can be applied in order to develop and guide your investment strategy.
Why you should develop your philosophy for investing
Investing is a simplistic idea with many intricacies. It is tough to make positive returns, especially for beginners, with even the most experienced investors finding difficulty on their journey. Investing requires time, effort, knowledge and research.
When you develop your investment philosophy, you develop a fundamental set of thoughts which can be used to guide your investing decisions. A philosophy can be considered as essential to setting the foundations when choosing your investments. An investment philosophy is useful as:
– It provides a clear belief of how you should be investing
When you define your philosophy, you decide what you believe about the market and investing within them. Knowing what you understand helps to inform your decisions when investing. Your idea of how the markets work will help you choose investments which match your principles.
Without clear beliefs, you may find yourself at a loose end, moving between different ideas. An inconsistent philosophy is said to lead you astray and is often seen as a way for you to lose your money. Having a philosophy helps to provide an ideology to follow on your investing journey.
– It helps you choose an investing strategy
By having those clear beliefs, you understand what you know about investing. With those principles guiding you, you will be able to use your philosophy to lead you towards an investing strategy which is suitable for you. Having a clear strategy provides focus to achieving goals. You will be able to find a strategy which follows your beliefs and works for your personal needs.
Without a clear direction from your philosophy, you may find yourself switching between strategies to try and find quick and positive returns, which can prove costly. When you switch between strategies, you are effectively betraying your values in search of profit. You will be taking on risks you didn’t plan to and choose investments which don’t match your goals. Therefore, you may encounter losses in the search of potential gains.
– An investing philosophy can create a strong focus to investing rationally
Investing can be done one of two ways when breaking it down into a behavioural sense: rationally or emotionally. When it comes down to it, investors are heavily influenced, and emotion often overrides rationality. Seeing others make good returns on their investments can lead you to following the success of others blindly. The fear of missing out, or the need for greater returns may mean you choose investments which you don’t know about, don’t understand and don’t actually believe in.
Having an investment philosophy can help to keep you on track on your investing journey. With a clear focus, you know what you understand and have a strategy in place to choose your investments. The use of a philosophy essentially helps you to invest rationally. You can refer back to your philosophy and create a portfolio which matches your beliefs.
How to define your philosophy
When it comes to defining your investment philosophy, it is all about you and what you believe. You should develop your own ideas in order to choose the right investments for you.
1. Understand your reasons for investing
Your investing philosophy starts with you and your investing journey. Therefore, it should fit within your personality, be targeted towards your goals, and ideally work for you and your needs. Creating a philosophy around you will help you stick to following your beliefs. Your philosophy should tie your own ideas together and support you to stay disciplined, amidst the noise, fads, and investments which you don’t believe in.
Therefore, you should take time to reflect on yourself as an investor. You will want to try and understand why you are investing, to give yourself a purpose. Knowing your reasons for investing creates a clear focus as to what you wish to accomplish on your journey. It will allow you to understand the types of investment you may wish to make. A purpose will help you consider personal influences you will be incorporating into your decisions, in order to achieve your desired returns. It creates a pathway to choosing investments which match your purpose.
Having that purpose to your investing journey creates a foundation to develop the framework of your philosophy. Your philosophy enables you to outline a set of principles which guide your investment decisions. You can begin to define your beliefs of the markets, investing behaviour and how you can invest within the market, in order to choose investments suitable for serving your purpose.
In short, find a purpose for your investing journey which you can mold your beliefs around, and use to guide your investing decisions.
2. Define your views on the market and how you can invest within them
The key part of your philosophy is your principles which you create. When it comes to forming your investment philosophy, you will want to define your beliefs on how the market works, your idea of investor behaviour and how the markets break down in order to invest within them. Doing so will help you to set your own standards which you can apply to invest within these markets.
· Are Markets Efficient or Inefficient?
The idea of investing in the stock market comes down to whether you believe it is efficient or inefficient. The prices of stocks and shares are based on supply and demand and represent a market price based on what investors believe to be correct.
Academics, professionals and regular investors alike all fail to agree on a standard for the markets. There are arguments both for and against efficient markets. There is no right or wrong answer either. It is completely based on your view, and so will be central to your own personal philosophy.
Your view on the market will likely be key to your investing strategy and the investment decisions you may choose. Below are both options highlighted to help you form your view, and how you may invest if you take on a particular view:
An efficient market is said to take into consideration all information and comes to a price for a company which is both ‘accurate and correct’ based on that evidence. It suggests that all the factors affecting a business – both directly and indirectly, have been considered, meaning investors have access to everything they need to know. An efficient markets proposes that prices incorporate all information in a timely manner. It also suggests those investing in the market are completely rational and have determined a price which is fair at this exact moment in time.
This essentially means that it is impossible to beat the market. Incorporating a belief of efficient markets into your philosophy may mean you choose to follow the market, investing with it rather than trying to predict against it.
The opposite idea to an efficient market suggests that there are inaccuracies within the market. This could be down to the behaviour of investors, where there have been mistakes on the price due to overconfidence, information bias and other human errors. It could also suggest that not all information is available, and therefore is not priced in.
If the markets are inefficient, it means there are opportunities to find companies which aren’t accurately priced. Assuming a belief of inefficient markets means you will likely be looking for opportunities within the market, with the aim of beating it. This can be through taking advantage of irrational behaviour which has led to undervalued assets.
· Applying beliefs to investing in the markets
Your view of efficient v inefficient markets will enable you to set your core principles for investing and decipher how you can make decisions based on your idea of markets. You can begin to consider how the markets break down, and how you can begin to invest within them, which will help further your beliefs to apply them to your investing strategy.
– Asset Selection
When you invest, you will begin to decide on which assets you would like to put your money towards. You should base your decisions on how you view the market and its efficiency.
On the belief of efficient markets, you may choose to directly follow the market itself. This would mean investing in the market as a whole, and betting on the idea that it will go up over time. It may also mean you may decide to invest in individual assets, which would mean looking for assets which you think will increase. It is the idea of selecting good assets which will grow in an efficient market.
However, you may believe that markets are inefficient and that there are opportunities due to undervalued prices. When selecting assets, you may believe that the market as a whole is undervalued and choose an investment to match this belief. Or you may be under the impression that there are just some opportunities within the market and decide to invest in individual stocks which you believe are cheap.
– Asset Management – Active v Passive
You will likely either be a passive or active investor depending on your view of the markets (although it is possible to mix the two styles of asset management). The type of asset management you choose will be based around your belief on the market.
Passive investing means to take a position within an investment and wait for the market to correct itself. Upon investing passively, you may be looking to invest in assets which follow the market. Your idea of investing passively follows the belief that all information is priced within assets and you are simple waiting for the market to correct itself as the assets grow. The current price of assets should therefore have little effect on your decision.
Active investing means looking for opportunities within the market. It follows the belief that investors are emotional rather than rational and leave inefficiencies within the market. When you actively invest, you are aiming to play a role in correcting the markets, rather than assuming they are already completely accurate. You are likely aiming to buy under-priced assets.
– Investing Short/Long term
When you choose your investments, you will likely have an idea of how long you want to invest in them. You are able to use your beliefs to determine the length of time you may wish to hold these assets.
On the one hand you may hold your assets long term. If you are investing in the market, waiting for the prices to grow, then you are likely to hold long term in order to iron out the fluctuations within the price, and benefit from long term growth. Additionally, you may hold long term if you believe an asset is under-priced and wait for the market to catch up.
On the other hand, you could hold investments shorter term. You may have found an opportunity within the price which has led to you buying, and then selling once you believe the price is suitable. It depends on how you believe the markets will act upon your investment, which help you determine your length of holding.
3. Consider influences which will shape your philosophy
Once you have your core principles of the market and a belief of how you may invest in it, you should begin to consider influences on applying your beliefs. When using your philosophy, there may be certain ideas which effect your views, so it is important to contemplate how they may impact your investment decisions. You want to find the best philosophy for you based on:
Investing is effectively defined by the risk/return trade off. As you apply your beliefs based on your views of markets, you will find each investment you consider has a different level of both risk and potential rewards. The trade-off between risk and return will affect how you implement your philosophy.
As you choose your investments, you will have an idea of your adversity to risk. You will want to consider your tolerance for risk, and how you handle losses. The amount of risk you are willing to take on will affect your investment choice.
Subsequently, the level of risk you choose directly affects your level of return. Investors may choose high risk/return investments in search of larger gains. This could be an effective strategy based on your adversity to risk. However, your risk should be considered alongside your beliefs in the market to choose the right philosophy for you.
Your philosophy must consider risk/return in order to keep you in control and disciplined over your decisions. Your philosophy should allow you to choose investments which are within your personal limits. Risk and return work simultaneously with your core principles to apply your strategy effectively. It helps to determine the types of assets you will be investing in.
– Time Horizon
When you choose your investments, you will have an idea of how long you will be looking to invest for. Your choices of investment will be directly correlated to the time-frame which you have decided.
The time horizon of your investing journey will be influenced by your goals, your requirement for cash, your personal characteristics and your needs. As you set your time horizon, you will want to choose investments to match. Therefore, time will have an influence on the type and weighting of the assets which you choose.
A longer time horizon means you are able to choose riskier investments. As you leave your investments for a lengthier period, it allows any noise in the price to be processed out, allowing the investor to see long term growth over time. This may impact the type of assets you wish to invest it.
The philosophy you choose should match with your time horizon. It should ensure that the investments continue to match your core principles as well as your level of risk, whilst allowing you to hold them for an amount of time suitable to you.
When choosing an investment, you may have an idea on the kind of assets and securities you wish to invest within. However, you may wish to consider if the investment matches your own personal values as you build your philosophy.
When you consider you own personal views, you will have an idea of what you stand for, what you believe in and what you think is right in the world. You will want these values to match the investment. If they don’t match your own personal values, you may feel uncomfortable with your money being put to use in something you don’t believe in from an ethical point of view.
You should always aim to invest in what you think is right. If your aim is to purely profit, you may find values to be a non-factor in your investment decisions. However, there may be times where you spot an opportunity, but don’t agree with what the company is doing. This wouldn’t be the right investment for you because it doesn’t match what you believe in. Therefore, you should aim to build your philosophy around your own ethical standpoint.
When it comes to investing, you want to be as tax efficient as possible in order to maximise your returns. Whilst the majority of investors will be investing tax-free (based on the accounts they choose), it is worth considering how tax may affect your decisions. You want to ensure it is right for you. The types of investment you choose should make sense for the level of tax you pay.
Costs are inevitable when it comes to investing. Either through account fees, holding fees or trading fees, you will incur additional charges on top of your investments. You should aim to choose efficient investments which allow you to maximise your returns. Your philosophy should therefore be consistent with the fees you are willing to pay in order to invest.
How your Investment Philosophy may look:
When you consider your philosophy, you may wonder how to fit all that information into a compact sentence or two which you can follow. After all, your philosophy should be as simple and easy to understand as possible in order to help you in sticking to it. Your investment philosophy may look something like:
I believe markets are: efficient / inefficient
This is because I believe:
- Investors behave rationally / irrationally
- All information is priced in and available / not all information is priced in and available
Therefore, I will choose to invest by:
- Being active / passive in the market
- Following the entire market / looking for individual assets
- Choosing short term investments / investing long term
- Looking for growth / value
There are plenty of options which you could choose, you need to factor in your reasons for investing, and how personal factors will affect your choices. Make your investment philosophy fit you and your personality.
Applying your Philosophy
The success you have with investing comes from the consistent application of a robust process. Your philosophy spearheads that process, setting the standards for which you make your decisions. It helps create discipline amongst emotion to allow you to invest rationally.
When you begin to make your investment decisions, you should begin to consider how your philosophy can help you design and implement a strategy. Your strategy will be key in helping you meet your goals. It will help you begin to construct your portfolio, applying your beliefs to ensure you are consistent in your choices.
When you use your philosophy as a foundation for your strategy, it creates a clear focus. You will be able to consider if the investments are right for you. It will inform you in buying and selling assets, and when you need to make changes to your portfolio. It will also help you to understand the type of investments you should avoid.
Your philosophy is simply a guide, but its application can be key to the success of your decisions. It helps to form a strategy which can be used to build an investment portfolio which is right for you.
Summarising your Investment Philosophy
Your investment philosophy represents your beliefs. It will help keep you disciplined, give you a clear idea of how to choose your investments and help you to remain rational. Your investing philosophy should:
- Identify your purpose and reasons why you are investing
- Define your views of the market and how they break down
- Consider influences which will shape your philosophy, such as:
- Time horizon
Your philosophy should be short, and summarise your ideas of investing in markets in a couple of sentences. Your philosophy will be the foundation for your decisions and will represent your core principles of investing. Once you have an idea of your beliefs you can begin to consider the strategy you will use, and how you will apply your philosophy.