As investors, the investment process we follow has the most significant impact on our results. The importance of following a sound investment process is widely propogated. But what exactly is a sound investment process? What are its constituents? And how do we go about designing one that is the right fit for us? These are the questions I will attempt to answer in today's post.
A sound investment process is one that is born from logic and prudence. The right investment process for us is one which puts us at peace with our investments. But these are extremely broad definitions. To define these terms more precisely, we must understand the tenets behind them.
The first of them deals with the selection of an appropriate investment strategy. We must follow a strategy that is simple. We must also do what works for us. For some of us this could mean exclusively using index funds. For others it could involve picking stocks and/or actively managed mutual funds.
For some others it could mean following a factor based strategy. What really matters is that we define what works for us. We then need to create a strategy that focuses on doing the things that work for us. This increases our chances of sticking to our chosen strategy over long periods of time. And that in turn drives sustainable performance.
We must operate under the assumption that the Efficient Market Hypothesis is mostly true.
In such a case instances of mispricing in securities would be few and far between. Hence there would be little sense to forecasting security prices. Trying to profit from price movements would also be largely futile. Most of us would therefore be best served holding low cost products that offer diversified exposure and capture market returns.
A balanced approach to asset allocation is at the core of any mature investment process. A long term asset allocation of 60% equity and 40% debt is the most viable way to approach asset allocation. It offers enough to keep all investors happy. Aggressive investors would appreciate the fact that the majority of their portfolio is in risky assets like equity. At the same time, almost half the portfolio would be in debt. This would offer solace to more conservative investors.
From a behavioural standpoint, the 60-40 portfolio is very easy to stick to over long periods of time. This is not to say that it is wrong to add more than two asset classes in the portfolio. But running a portfolio with multiple asset classes requires greater effort. And most investors may not do justice to the kind of effort required. Sticking to an equity-debt portfolio with a 60-40 allocation hence becomes the most viable option.
A basic understanding of stock market history is also required to build a sound investment process. Data on historical returns cannot be used to predict future returns. But they can be used as an indicator to set realistic return expectations.
For instance, assume the 30 year CAGR of Nifty 50 and Sensex ranges between 12-14%. This equates to a post tax real return in the range of roughly 2.4% to 3.8% (assuming 6% inflation). This therefore represents the most realistic return one can expect from equity as an asset class.
Finally, we look at product choices and investment costs. It is important to pick products that are simple and transparent. This makes them easy to understand and use. Each product we hold in our portfolios must carry out its stated purpose effectively. We must be particularly be wary of products that serve more than one purpose. Such products are advertised to seem like they are too good to be true. They also claim to offer multiple benefits. But they effectively end up providing none. So when a product seems too good to be true they are likely to be useless.
As investors, most of us focus on the returns generated by our investment products. Very few focus on the costs that are inherent to their products. But while returns fluctuate, costs remain constant. And just like returns, costs too compound over time. Costs that seem insignificant today can eat up a significant portion of our wealth over time. Cost consciousness is hence vital to a sound investment process.
We must make sure that the costs of financial products and services we use can justify the value they add. This is especially true in the context of availing financial advice from professionals for a fee. The graphic given below substantiates this point.
This covers all the tenets of any investment process that is worth following. The process we follow would automatically evolve as we gain more knowledge and experience. It would result in a process that is logically sound. It would also be palatable in light of our preferences. Arriving at the investment process that is the right fit for us would simply be the natural outcome of this.
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