Learning Outcomes. After completing this video, you should be able to, list down some common investment philosophies, understand the importance of time horizon in investing, list down the steps involved in developing an investment philosophy. In this third video, we will talk about investment philosophies. I will describe some common philosophies people follow and how to go about developing your own personal investment philosophy. One set of investment philosophies are market timing versus asset selection. Market timing is the decision to buy or sell financial assets by trying to predict future stock price movements. Whereas, asset selection is the ability to find assets that are mispriced. Both philosophies, encompass a wide range of strategies. Market timing may refer only to timing the stock market or may refer to timing of broad range of asset markets like currency, commodities, bond, as well as real estate markets. Identifying mispriced securities may be based on technical analysis and/or fundamental analysis. Technical analysis is trading based on past patterns and price volume, etc., and assuming that the same patterns will repeat over time. Fundamental analysis is trading based on the analysis of a company’s financial statements and other publicly available information. Another set of investment philosophies are Passive versus Activist investing. Passive strategy is when you invest on a stock and the investment pays off at some future point. The decision to invest is based on identifying a potentially mispriced stock and the payoff occurs when the market corrects this mispricing. An example of a passive strategy is when a portfolio manager buys a stock with a low price earnings ratio but stable earnings. Under activist strategies, you invest in a company and then attempt to change the way the company is run, and in the process, make it more valuable. Venture capitalists are examples of activist investors as they take positions in young companies, and attempt to impact the way they are run. Activist investors are quite very different from active investors. Active investors attempt to beat the market through their strategies. They could achieve their objective by following either passive or activist strategies. One important thing to note about the different investment philosophies is that they have different time horizons. The time horizon of an investment philosophy depends on the nature of the adjustment that needs to occur for the strategy to profitable. For example, markets tend to overreact when a company announces a bad earnings. Prices typically drop by more than they should. Your strategy would then be to buy the stock, wait for a few weeks hoping that the market corrects itself, and then sell the shares. On the other hand, if you invest in neglected companies, then the time horizon would be much longer. It may take months or even years before your strategy pays off. An interesting facet of investment philosophies is that, investors with similar philosophies may have very contradictory news about the market. For example, there may be some market timers trading on price momentum who believe that the market is slow to learn information while there maybe other market timers who are contrarians, and believe that market overreacts to information. Similarly, there may be some asset selectors who buy value stocks, as they feel that growth stocks tend to be overpriced. Whereas, other asset selectors may buy growth stocks, as they feel that these stocks tend to be underpriced. The heterogeneity in philosophies and market views are useful in keeping markets in balance. Further, different investment philosophies can coexist as investors have different time horizons, different views on risk, and different tax statuses. The first step in developing your investment philosophy is to understand the fundamentals of risk and valuation. This requires you to understand how to measure risk and relate it to expected returns, how to value different types of assets and the different ingredients of creating cost. In the process, understanding the trade off between the speed of trading and the cost of trading. The second step in developing your philosophy is to develop a point of view about how markets work and where they might break down. This primarily depends on your view of human behavior and irrationality. But, also examine the wealth of research on what strategies beat the market. As an investor, you should review all these strategies before deciding on a philosophy for yourself. However, keep a few things in mind when you look at these strategies. The most important thing about these strategies is that, they have been profitable in the past, but that is no guarantee that they will be profitable in the future as well. Furthermore, most of these strategies are based on hypothetical portfolios, which ignore transaction cost. Factoring in these costs may make these strategies less attractive, or even unprofitable. Finally, pick a philosophy that provides the best fit for you. This is determined by your risk aversion, the size of your portfolio, your investment horizon, and your tax status. Given this, it is no surprise that investment philosophies that work well for some investors, do not work well for others. In the next video, we will get started with the idea of time value of money and why it must not be ignored.
