Why You Should Have an Investment PhilosophySubmitted by David Vaughan Investments, LLC on March 3rd, 2017
by Pierce Timko, CFA, CFP ®
March 3, 2017
Tweets. Texts. Notifications. Emails. It’s always exciting when you hear the ping from your smartphone, or see one of these alerts pop up. We can’t help it. Recent studies show that these alerts trigger the release of dopamine, better known as the “feel good” chemical. It also happens to be the same chemical that makes you curious to seek out new information, designed from an evolutionary perspective so that we as humans can continue to learn about our environment in order to adapt and survive. It’s in our nature. With more computing power in your pocket than astronauts had when they first landed on the moon, we’re constantly being bombarded with data. This can sometimes be a good thing when you need to know the location of your Amazon package you just ordered from your phone an hour ago. The problem is that when it comes to investment news, this constant influx of data makes it even more challenging to cut through the noise and distinguish between information and knowledge. Believe it or not there are a lot of “experts” out there with a lot of different opinions. Have you heard the saying “information is knowing that a tomato is a fruit, but knowledge is knowing that it doesn’t belong in a fruit salad?” This concept applies to investment information as well. Therefore, you need some sort of filter to parse through all this information to make sure you are only paying attention to the knowledge. This could generally be referred to as your belief system, or in investing, your investment philosophy.
An investment philosophy is simply a guiding belief system as it pertains to your investment decision-making process. Successful, long-term investors recognize the importance of having an investment philosophy to help cut through the noise and keep them laser focused, which is especially important during the tougher times in the market. Your investment philosophy should be the foundation that your investment strategy is built upon. Anything built to last needs to have a solid foundation, since the slightest weakness in your foundation could cause the whole thing to come crumbling down when put under pressure. When things are going well you can get away without having a solid investment philosophy. The market is moving up, your investments are gaining value, and things are great, right? It’s hard to lose money when the markets are grinding higher. A house built on a shoddy foundation isn’t likely to crumble when there isn’t an earthquake. It’s when things aren’t going so well, such as during a recession or bear market, that the strength of an investor’s foundation, or their philosophy, is truly tested. The successful investors have built their investment philosophy knowing exactly what they will do (or better yet not do) when these market earthquakes come, and they have built a solid foundation to withstand these inevitable tremors. As Warren Buffett puts it, “only when the tide goes out do you discover who’s been swimming naked.”1
Investing can be an emotional endeavor. For most people, they are investing their hard-earned money with their futures at stake. When emotions are high, we don’t always make the best decisions thanks to the fight-or-flight response triggered by our bodies sending a rush of adrenaline and cortisol when danger is present telling us to take action (we’re only human, remember?). Studies show that investors have the same physiological response to an investment loss as they do to imminent physical harm. Unfortunately, the common response is flight (sell) at the very time that stocks are relatively cheap and you should fight (buy). When you combine this response with the constant influx of information from the “experts” and the fact that trading these days can be done with the tap of a finger from virtually anywhere in the world, it can be the recipe for disaster.
For example, in the midst of the financial crisis, on October 6, 2008, Jim Cramer appeared on the Today show and rather infamously told investors to get out of the market.2 While his words weren’t quite this cut and dry, taken out of context there were probably a lot of investors who were experiencing the “fight or flight” response and were already questioning their own investment strategy because they didn’t have an investment philosophy to guide them. As they were starting their day that morning, they only heard the word “sell” from a top industry “expert” and that was the final straw. Their foundation cracked and they clicked the sell button near market lows, just 5 months before the start of one of the strongest bull markets in history.
Therefore, having a well-conceived investment philosophy is the counterweight to help fight back against your body’s natural response to the perceived dangers of the market, filter out the noise, eliminate second guessing, and keep you focused to help avoid making a decision that could cause irreparable damage.
Now, an investment philosophy doesn’t have to be overly complex. Looking at Warren Buffet’s philosophy, one of the world’s most successful investors, it can really be quite simple:
Buy wonderful businesses at a fair price with the intention of holding them forever.3
In fact, the more concise the better, and the stronger your conviction will be. Warren Buffett has seen many up and down markets, yet his investment philosophy has never wavered regardless of what was happening around him. This allowed him to ignore the noise and focus on the opportunities. As you develop your own investment philosophy, make sure you have a clear understanding of your own personal objectives and your attitude toward money and risk. In other words, be honest with yourself. This will help create stronger conviction in your investment philosophy. Defining your risk tolerance can be particularly challenging because it is such an abstract concept. One exercise to help you get a better sense of your own risk tolerance is to think about losses in terms of dollars and ask yourself the following two questions: “How much money would I have to lose before I start to feel uncomfortable?” and “How much money would I have to lose before I start to lose sleep at night?” While it’s normal to sometimes feel uncomfortable, you should never be kept up at night questioning your investment philosophy.
Regardless of what investment philosophy you adopt, one of the most important things you can do is to work with an investment advisor who shares your core values and beliefs about investing. Your advisor’s investment philosophy (be cautious of advisors who don’t have one) should match yours. And remember, there is no silver bullet to investing and not one size fits all. There are some investors, who perhaps have not adopted an investment philosophy, that hop from investment strategy to investment strategy either chasing returns or being “sold” on the next greatest thing only to lose patience before moving on to something different. This is the equivalent to running in place. For instance, you could discover the best investment strategy in the world, but if the investment philosophy that underlies that strategy doesn’t align with yours and you abandon ship because you don’t have the faith to stick with it when that strategy is being tested, you probably won’t reap its benefits. So do yourself a favor and make sure you stick with your philosophy, because you are more likely to be successful sticking with an investment strategy that you have faith in than investing in a “better” strategy that you don’t.
1Janet Lowe, Warren Buffet Speaks: Wit and Wisdom from the World's Greatest Investor