My Investment Policy Statement begins, as recommended by the textbooks, with my Investment Philosophy. In this blog post I’ll provide a bit more detail about how I developed this Philosophy. I’d love comments about it. How much of it do you share, and if not, why not?
Pillar 1: Diversification.
By my nature I am a cautious, suck-it-and-see individual. I have always been thus. I test things if possible before developing them. I don’t have massive courage in my own convictions.
As well as this, I have studied statistics to quite a high level (degree level). I have also studied Economics at university And I have worked adjacently to the finance industry for some time, and am reasonably familiar with a lot of modern finance teachings – such as Modern Portfolio Theory, the Efficient Frontier, the Capital Asset Pricing Model and suchlike. This education has given me some intuitive feel for how a wider basket of goods has less volatility and can indeed have a better risk/return profile than individual holdings.
The above is a longwinded way of saying that Diversification is for me holy scripture. It is the only free lunch in investing. I eat a lot of it. I diversify on multiple dimensions. I hold a lot of holdings; I have multiple accounts; I use multiple investment approaches (I have a High Yield Portfolio, a Dividend Growth Portfolio, a Tech portfolio, a Passive portfolio etc); and so on.
Pillar 2: Cash cash cash.
My background is business. As they say in business, ‘Cash is King’. I am also a UK investor. The UK stock market is famous/notorious for preferring profits, dividends and short term cashflows versus growth, risk and long term big bets. I am a creature of my environment and I too like profits, dividends and short term cashflows. Yes please.
I have had some experience with private company investing. One of the big lessons for me here is the lack of liquidity. I.e. you can not sell your private company shares. Whether this is a holding in a venture capital firm’s fund, shares in your mate’s restaurant, or some shares you were given instead of salary by some hot new startup – none of these will buy anybody beers. The internet tech boom in 1999/2000 was notorious for creating ‘paper millionaires’ who ‘lost everything’. I knew a couple. I won’t make the mistake of confusing paper value with cash value.
I prefer Inc funds to Acc funds. I prefer ETFs to Unit Trusts (not by much, admittedly). I like cash.
Pillar 3: Minimise costs and taxes.
It is obvious to a lot of people that tax is something to be avoided. I won’t dwell on that here. But in the world of financial income you really can avoid tax a lot more easily than you can in the world of work. The real trick is not losing in fees what you gain in tax. A successful high net worth friend of mine with a background in private equity inadvertently taught me this; he inordinately focuses on minimising tax, and has set up a complex family onshore/offshore structure which pays diddly squat to Her Majesty. It costs him about 2% a year to run. Go figure. This isn’t my game.
I now have a notional cost against every holding in my portfolio and I track my blended expense ratio. I have some high-cost investments but my weighted average is under 50bps. I am OK with this. Historically it was over 100bps, and my gross returns were lower. I was paying more for less.
Pillar 4: Passive, not active.
I have tried and tested active investments. I used to think that maybe with my business skills, careful analysis, and my ear to the ground I had a reasonable chance of stock picking. I have done something like this for about 20 years.
I now have good data on my active investments’ returns. And what I now know is that I outperform my paid-for advisory investments by a lot, but I don’t outperform the markets by very much, if at all. I can’t claim The Escape Artist’s 12% or WheelieDealer’s 10-15%. I can claim 8-9% per year. But I can obtain this through passive investments. Passive represents very good value for money.
The only caveat I would offer here is that once you have enough individual holdings you have an exposure a lot like a market tracker, and you aren’t paying even the 9bps that the cheapest ETF charges. I’m not convinced that the need to track the market precisely is worth the tracking cost. But this isn’t a big deal; the real point is not to try to beat the market, which I don’t.
Pillar 5: Allocation, allocation, allocation
As I learnt in my finance classes, uncorrelated investments produce a better risk/return profile. I have direct personal experience of this. From this it is a short step to ask: what is the right blend, of what assets?
They say over 80% of a portfolio return depends on the asset allocation, and only 20% depends on the actual security selection. I am a big believer in this. The US stock market has returned over 40% in two years, while the UK stock market has taken almost 10 years to do this. If you haven’t had US exposure you have missed out.
My allocation thinking is pretty traditional: shares, property and bonds are my bedrock asset classes. Bonds I have always found a bit conceptually difficult – why invest in things with a return of under 5% and massive inflation risk – but the last few years in which bonds have outperformed equities have helped illustrate bonds’ merits. In the USA bonds have performed almost as well as equity over a 20 year period.
I then really like the ‘allocate, review, rebalance’ approach as it suits my style well. It formalises ‘buy low, sell high’ and exerts discipline that helps counteract my cognitive biases (to sell things which tank, to back winners, to anchor off previous prices, etc). I try to rebalance entirely by buying using cashflow, and not by selling positions.
To summarise, the Investment Philosophy I’ve put in my Investing Policy Statement looks like this:
- Diversify. In as many ways as possible.
- Tax-efficiency regarding the investment owner and account, not regarding the actual holding.
- Strong preference for liquidity, paid-out income, rising income, and low fees.
- Presumption that passive investments are better than active investments.
- Monitor progress against a target allocation; incrementally invest to rebalance underweight components; buying is much better than selling.
In the next post I explain my approach to Asset Allocation.
11 thoughts on “My IPS, 1 of 5: Investment Philosophy”
Yeah, this is solid advice and my own investment philosophy is broadly similar.
But why do you prefer Inc to Acc funds?
My preference for Inc funds is for a couple of reasons. One is because I like cash, and take the view that my portfolio’s job is to produce it. I would rather have cash thrown at me than have to sell down. Second, I use this cash to rebalance by reinvesting selectively. I don’t much like automatic reinvestment , and view Acc funds as essentially automatic reinvestment. Against this, I am nervous of the tax difference. I assume (but am not quite sure) that Inc funds are creating taxable income (marginal rate 40-45pc) vs acc funds creating taxable capital gains (at 28pc). But I haven’t quite bottomed that out. And I have generally felt that acc funds haven’t outpaced their inc funds by as much as my intuition says they should.
I use the Acc funds because I keep them in tax sheltered accounts and I’m happy only to rebalance with new money. My motto is to keep things as simple as possible. Sorting out the tax on Inc funds outside of ISA and pensions would be a headache for most people.
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Be cautious of acc funds outside of a tax wrapper, you still need to pay income tax:
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