In the wake of Friday's market action, it's a great time to ask: do you have an investment philosophy? Do you know what that means?
Let's start with what it doesn't mean. An investment philosophy is not some scheme for picking out beaten-up stocks because Warren Buffett supposedly invests that way.
It also doesn't mean going into panic mode and proclaiming "market in correction" when U.S. indexes show some selling. It doesn't mean making allocations because you read an article with someone's prognostications about the economy. No.
An investment philosophy means you structure your portfolio bases on several key tenets.
First is that markets work. It's fashionable among traders to believe that inefficiencies can be exploited, but academic research -- which has been successfully applied in the private sector -- shows that only about 3% of results can be attributed to anomalies.
Why focus on that tiny sliver of the pie when the majority of your results can be explained by proven factors? Asset class and market cap have more to do with your own results than whether Herbalife (HLF) or Three D Systems (DDD) sliced through moving averages.
Picking stocks, even when using somebody's methodology, is not a philosophy. It's a bet.
Diversification also is crucial to a sound philosophy. I used to believe that diversification equaled mediocrity, so I understand where that viewpoint comes from. The thinking goes: "why not focus on the best performers, rather than dilute results with laggards?" Good luck with that.
Trading systems would have you think it's a cinch to time your buys and sells. But think how easily those theories can be messed up. Throughout 2013, as the S&P 500 rallied to new highs, how many pundits and traders stuck to their predictions of an imminent decline? Who would have guessed that U.S. large-cap stocks would have had such a fantastic year?
It's easy in hindsight to say that investors should have been all-in the S&P. Traders and investors with some gains from U.S. large-cap are no doubt congratulating themselves. But over time, a portfolio constructed with various asset classes and market caps outperforms one that makes a bet on a single type of investment.
Another key tenet of proper allocation: risk and return are positively related. You get expected return by taking more risk -- but in the right places. Hiding in cash is risky because, in the current low-interest-rate environment, you won't keep pace with inflation.
On the other hand, an all-stock portfolio is taking on too much risk for a person in his or her 60s, who is beginning to think about retirement. I see all-stock portfolios all the time, and not once does the investor have a solid understanding of why he or she is invested that way.
Finally, portfolio structure explains returns. This means taking advantage of risk factors most appropriate for your tolerance and unique situation. For example, you want fixed income, because it allows you to buy low and sell high stocks! In other words, you can take advantage of movements in the different markets.
But just as all stock classes are not equal, neither are all types of fixed income. I'll leave you with that thought today, and continue with a look at duration and credit risk in my next column.