Looking Within
“The difficulty lies not so much in developing new ideas as in escaping from old ones.” –John Maynard Keynes
Investment philosophy books and statements usually tend to agree on one core concept: to build a satisfactory portfolio an investor needs to look within first. Knowing oneself makes it easier to establish a set of guiding principles around risk, time horizon, diversification, values, and the broader goals behind the investment itself.
Knowing oneself isn’t easy. At times, we overestimate our risk tolerance, or our decision-making abilities under uncertainty, only to realize that we need to reassess how we think about risk, or how we make decisions when things aren’t going as planned.
What is an investment philosophy, and how can it be helpful?
In Investment Philosophies, Aswath Damodaran defines it as “a coherent way of thinking about markets, how they work (and sometimes do not), and the types of mistakes that you believe consistently underlie investor behaviour.” The ingredients of an investment philosophy according to Damodaran include a set of assumptions about human psychology and behaviour, market efficiency, and a set of tactics and strategies that build upon the philosophy.
In other words, crafting a successful strategy involves figuring out your assumptions about how you and other investors behave. Do you believe markets are efficient or inefficient? What do you believe is long term economic growth? What do you think is a “fair” interest rate? Understanding your core beliefs about such issues makes it easier to design a portfolio that doesn’t keep you up at night and doesn’t propel you into panic during inevitable market volatility.
“The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” –Friedrich von Hayek, The Fatal Conceit
There is no “best practice” or magic formula with respect to any investment philosophy. The pioneers of investment theory, such as William Sharpe and Eugene Fama, developed their investment philosophy based on assumptions that the market is efficient and investors are rational. In other words, they believed that any new information is incorporated into the price of assets by market participants that carefully weigh risks and returns. Other theorists, including Daniel Kahneman, Robert Shiller, Richard Thaler showed that psychological factors, including irrational behaviour by other investors, can lead to market anomalies. They developed investment theories that showed how investors can navigate a market where bubbles emerge.
All these theories are simultaneously key cornerstones of finance, even if they are based on assumptions that contradict each other. Building different portfolios based on different assumptions can be shown to do well over the long term, even if they appear less successful at a single point in time. Markets can be irrational some of the time. The gravitation pull of value dominates in other times. What matters is the intellectual coherence of the portfolio. The question to individual investors is what assumptions do you find most compelling?
An investment philosophy serves as a guide or a north star. It’s like laying down solid foundations to construct a robust building. Without proper foundations, a building could easily collapse with the slightest earthquake. Similarly, without an investment philosophy, investors and portfolio managers may not be able to devise a clear investment strategy.
Imagine building a portfolio based on a philosophy of value, abandoning it because of a “fear of missing out” as a bubble emerges, only to experience the bubble bursting. That’s the worst of both worlds. It’s also unfortunately all too common.
Investment philosophy is not a strategy
“Plans are worthless, but planning is everything.” –Dwight Eisenhower
To illustrate the difference between a philosophy and a strategy, consider the following example. If you believe that companies with strong fundamentals may be mispriced by the market, you may adopt a value-oriented investment philosophy. That philosophy could inform a variety of strategies you can implement, such as buying stocks with low price-to-earnings ratios or investing in companies that have strong cash flow. This would then be followed by a set of processes, such as market research and analysis, to choose which stocks to buy, in a way that is compatible with your strategy, tax and efficiency goals, and other parameters.
An investment philosophy asks questions related to constraints, values, beliefs, and goals.
A strategy is more concrete: it guides choices about portfolio construction, asset allocation, and risk levels. It addresses questions of fit, trade-offs, and coordinated action within those constraints. A plan or a process is more hands-on, addressing operational questions about markets and assets, including how securities are identified, evaluated, selected, monitored, and revised over time.
This distinction matters most when investing stops being a solo act. When responsibility is shared, philosophical differences that seemed abstract become operationally problematic.
Investing as a Shared Responsibility
The lack of an investment philosophy may have many negative consequences, including vulnerability to trends or charlatans promising a magic formula, as well as a mismatch between personal risk exposure, and risk appetite.
Developing an investment philosophy is not straightforward. A variety of elements help shape it, including experience and knowledge about investments, portfolios, and the market; introspection to learn about one’s own beliefs and worldviews; as well as dialogue with others, financial advisors, and other investors, to exchange ideas and broaden perspectives.
Since investment philosophy hinges on an active role and continuous self-examination, it is often either relegated to a secondary role, presented as a generic framework, or offered as a ready-made catalogue with a list of predetermined philosophies for clients or investors from which to choose.
If you’re an individual investor managing your own portfolio, you are responsible for your own decisions, and the feedback loop may be relatively immediate. Over time, experience can help you gradually develop an investment philosophy of your own, with the help of experimentation.
However, once investing shifts from an individual activity to a shared responsibility, for example between an investor and a financial advisor, an investment philosophy acquires a more fundamental and multifaceted role.
“When everyone is responsible, no one really feels responsible” –Albert Bandura
In professional relationships between advisors, investment decision-makers, and their clients, the consequences of divergence that tend to unfold over the long run can be far-reaching. As a result, it is necessary that, from the beginning, the two sides establish common ground on investment philosophy, financial goals, and strategic orientation before attention can meaningfully shift to processes.
When disagreements and conflicts do arise, they most frequently play out at the level of results, execution, or even strategy. Yet the root cause of these differences is, typically, philosophical: each side bases expectations and analysis on a radically different set of assumptions, beliefs, and, more broadly, worldviews.
So when various parties are involved, the question that stands out is the following: whose investment philosophy is it anyway?
Philosophy as a Conversation
Choosing an investment philosophy from a predefined list of options can only be suitable by accident. The uncomfortable truth is that many so-called “investment philosophies” are either marketing slogans or inherited dogmas. The important question is how different options can be brought into a coherent relationship.
Many portfolio theories and investment philosophies, particularly in their most technical formulations, centre around one major question: how to optimize a portfolio given certain risk and return parameters. These approaches are extremely valuable for financial professionals. But they are often developed with an abstract investor in mind. They tend to overlook the context of each individual.
Andrew Lo and Stephen Foerster in In Pursuit of the Perfect Portfolio arrive at a deceptively simple conclusion: In the end, our approach to the Perfect Portfolio leads us to an important conclusion, the ancient Greek philosophers’ maxim “Know thyself.” Easier said than done, but at least we have principles, a process, and a path to guide us on where to start in designing our own Perfect Portfolio.
So, whose investment philosophy is it anyway? If the answer is not clear before the money is invested, it will be painfully clear after.
