Rules of the Game: Investment Philosophy

 | Nov 19, 2013 | 1:00 PM EST
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What's your philosophy? You do have one, right? And it matches your financial plan, doesn't it?

You don't? Say it ain't so. 

I'm noticing lately the number of people who tell me they are happy with their investments because they have "done well." I'm happy for them. And for anybody with a pulse who has watched the U.S. equity markets in 2013 understands the meaning of "done well."

But what does that mean for the outcome you're looking for? I come from a background of looking for "winning" trades, or the kind of high-beta momentum stocks that zoom big, but can drop just as fast. It's fun, it's entertaining, it's exhilarating. It feels good to grab something like Noah Holdings (NOAH) before a rally.

But can you say how Noah Holdings, 3D Systems (DDD), Jazz Pharmaceuticals (JAZZ) or Akorn (AKRX) are relevant to your objectives? Do you know the expected return from your stock trading? Can you project how these trades will contribute to the inflation-adjusted income streams you need? Most people can't. That means there is no philosophy.

Use the analogy of the medical industry. How many doctors compete based on the number of lab tests they do? Do they brag about lab tests with accurate results? Of course they don't. People seek physicians because of the outcome -- that their pain or illness is cured -- not the number of lab tests that get ordered.

It's absurd to think about it like that, but the financial services industry thrives on a "more is better" mentality that ignores the outcome. Wall Street and its media accomplices have a lot to gain from keeping people trading. Outcome, schmoutcome. It's about this great stock or that great mutual fund. It's all in a vacuum, with no relationship to the actual outcome that investors need.

Why invest at all? Most people would say, "To make money," but that would be wrong. We invest to meet future liabilities. We could spend the money today, rather than invest it. Plenty of people do that. They're known as "ordinary Americans." But if you don't invest it today, you won't have it tomorrow, when you no longer have income, and you need money to live on.

Readers of this site put money into stocks and other instruments, but probably not everyone has an investing philosophy. Making money and doing well are not philosophies. What is a philosophy? It is investing in a balanced, diversified portfolio and understanding your holdings and your expected return – and most importantly, how your portfolio will give you the income you need.

Most traders and active managers (including retail investors who believe they have to trade frequently in their own accounts) constantly strive to take advantage of mispricing. Investors have to take risk, of course, but not every risk comes with a reliable expected return. Betting on countries or sectors, or trading based on opinions about what economic events may occur -- that's not a philosophy either.

Stick to diversification, rebalance tactically, and above all, understand how your investments will enable you to buy what you need tomorrow and next year and 25 years from now. That sounds a whole lot more important than finding the proper buy point of Noah or Yandex (YNDX).

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