Whether they realize it or not, ALL investors have an investment philosophy.
An investment philosophy is a set of ideas or beliefs about investing that guide and shape your investment decisions.
The problem is that the investment philosophy of most investors (financial professionals included!) is a recipe for disaster.
But it doesn’t have to be that way.
In the next two posts, I’ll discuss what happens if you have a bad investment philosophy, as well as the characteristics of a bad investment philosophy compared to a good one.
That way, you can know what side of the fence your current investment philosophy sits and whether or not you should consider making any changes.
Why your investment philosophy matters
Your investment philosophy is like a map or the GPS system in your car that you follow on a summer road trip. It guides you on your investing journey. And just like a map, if it’s a good one, then it will help get you where you want to go safely and efficiently.
On the other hand, if it’s a bad one, it might leave you stranded in a ditch on the side of the road, or worse, headed the wrong direction down a one-way street.
So, what happens if you’re like most investors and you have a bad investment philosophy?
Typically, three things will happen if your investment philosophy isn’t a good one.
1. A bad investment philosophy will lead to poor decision making
If you assume the financial markets work one way, when in reality they work another way, then you’ll make poor investment decisions because these decisions will be based on faulty assumptions.
For example, if I believe that I can outsmart the collective knowledge of millions of market participants and consistently pick the next Apple or IBM, then I’ll likely make a lot of poor investment decisions along the way.
In doing so, I may occasionally (or frequently) pick a big winner, but financial scientific research has proven that the success I’m experiencing doesn’t mean I’m any smarter than a “blindfolded monkey throwing darts at a newspaper’s financial pages…”
This illustration comes from Burton Malkiel’s bestselling book, A Random Walk Down Wall Street where, as you can see, he implies that most investment professionals aren’t any smarter than monkeys.
Of course, some might argue that comparing most investment professionals to monkeys is rude because…well…it gives the monkeys a bad name.
In fact, Rob Arnott, from Research Affiliates, had these words to say after conducting an experiment similar to what Malkiel describes in his book:
Malkiel was wrong. The monkeys have done a much better job than both the experts…
You can read more about his research findings here.
Unfortunately, with a bad investment philosophy, poor decision making is just the tip of the iceberg.
2. Poor decision making will lead to taking unnecessary risks
For example, let’s say you don’t agree with Malkiel’s statement above regarding one’s inability to outsmart the financial markets consistently over long periods of time.
Instead, you believe that through research, watching CNBC every day, and employing the help of a financial professional, you can consistently and successfully pick winning stocks or mutual funds and avoid poor performing ones.
Research still shows that you’ll be routinely taking risks that aren’t typically compensated by a long-term, scientifically documented relative increase in expected returns.
There’s no such thing as a free lunch in investing.
In other words, when you make an investment decision that increases your risk above that of the overall “market,” you should be compensated for the increase in risk by an increase in your expected return.
But with the way most people invest, that isn’t usually the case.
Instead, investors and advisors usually end up increasing their risk without any (or very little) increase in their expected return.
3. Unnecessary risks will lead to unnecessary stress
When the financial markets are moving in the right direction, everyone’s happy. Even bad investment philosophies might make money if the financial markets are cooperating.
But when something goes wrong, watch out!
By making poor investment decisions that lead to unnecessary risks, your investment sails will be tossed to and fro in the ocean of investment uncertainty.
You’ll likely begin to stress out over every negative newsworthy event around the world and worry about how it might affect your investments.
Tsunami in Japan?
Civil war in Syria?
Housing market collapse in the United States?
Lions and tigers and bears, OH MY!
You might also find yourself saying or thinking things like…
- Should I have bought that stock? Maybe it wasn’t the right time.
- Is it time to sell? Maybe I should hang on a little longer?
- Seems like things are getting risky. I should get out of the market for a few days (or weeks or months).
You might also be glued to the television or your smartphone and constantly check to see how “the market” is doing throughout the day. You may even lose sleep because you’re so stressed about your investment decisions and whether or not you’re making the right ones.
Granted, the true root of these symptoms isn’t the result of a poor investment philosophy.
Rather, it’s the result of putting your hope and trust in anything other than the One who said, “Come to me, all who labor and are heavy laden, and I will give you rest…For my yoke is easy and my burden is light.”
But a bad investment philosophy that leads to poor investment decisions and unnecessary risks certainly doesn’t help!
Investing tips from a ‘fat cat’
At one point in the classic novel, Alice in Wonderland, Alice comes to a fork in the road and doesn’t know which way to turn, so she asks Cheshire Cat for directions…
“Would you tell me, please, which way I ought to go from here?” asks Alice.
Cheshire Cat smirks and replies, “That depends a good deal on where you want to get to.”
“I don’t much care where,“ says Alice.
Cheshire Cat responds with another mischievous grin, “Then it doesn’t matter which way you go.”
The point behind Cheshire Cat’s statement is that if you don’t know where you’re going, any road will get you there.
In the same way, if you don’t know what you’re trying to accomplish with your investing, then it doesn’t matter what your investment philosophy is because anything will get the job done.
But my guess is that you do know where you’re trying to go in terms of your investing goals. And a good investment philosophy will help you get there.
In the next post, I’ll show you what a good investment philosophy looks like compared to the typical investment philosophy of most investors and their advisors.
Until then, feel free to email me or leave a comment below if you have any thoughts or questions about YOUR investment philosophy.