Investment Philosophy - Part 3

EVIDENCE-BASED INVESTING AND THE ZORA FINANCIAL PHILOSOPHY


Markets Work

Markets work.  By this, I mean that within a freely functioning market, prices are accurately set by the buyers and sellers of securities and investors can expect to be rewarded for taking risks over the long-term.  This expected reward is not tied to choosing the right stocks or determining the best time to get in or out of the market.  Instead, it is a reward for supplying the capital companies need to fund their growth.  Not every investor agrees on the amount of the expected reward, so some are more willing than others to pay a higher price to the seller.  The seller will also make a judgment on the amount of expected return, and when they align, a transaction is made.  This leads me to the efficient markets hypothesis, formulated by Professor Eugene F. Fama of the University of Chicago.  It is an organizing principle for understanding how markets work, it asserts:

  • Securities’ prices reflect all available information and expectations.
  • Current prices are the best approximation of intrinsic value.
  • Price changes are due to unforeseen events.
  • Although stocks may be mispriced at times, this condition is hard to recognize.

There are very important implications when markets are viewed as efficient.   If current market prices offer the best indication of value, stock mispricing should be viewed as an anomaly which cannot be systematically exploited through analysis and forecasting.  To take it a step further, if new information is the primary driver of prices, only unexpected events will cause price changes.  This may explain why stock prices seem to behave randomly over the short-term.

 

Diversification

If markets work, then how do you decide which investments to pick?  The answer is diversification.  The key is to spread your investment dollars across different asset classes.  Asset classes can be defined as, a group of securities that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations.  They can be grouped by company size, location, sector, fundamentals, investment type, etc.  Investors should have a globally diversified portfolio and cast a wide net.  When I say buy an asset class, I don’t mean a few different securities, I mean owning hundreds and many times thousands of investments within that class.   If you buy one investment, it might go up 1000%, but it also might go bankrupt, which leaves you with a wide range of potential results.  But if you buy almost all of the investments within the asset class, suddenly your range of expected results has been significantly narrowed.  Some will go up, and some will go down; some will hit it big, and some will go out of business.  Think of this type of diversification as a narrowing of expected results, which allows you to more accurately assign an expected return to the amount of risk you are going to take.  Fortunately, we have years and years of data to help us understand the risk assigned to each asset class and the amount of return we should expect.  Never take the unwise risk of improper diversification.

 

Allocation

First, you need to determine the investor’s risk tolerance and time horizon.  Risk tolerance can be defined in its simplest form as how much loss an individual can tolerate before abandoning their investment strategy.  Time horizon refers to the length of time investors plan on keeping their money in the market before cashing out.  Second, you need to pick an optimal mix of stocks, bonds, and alternatives.   Next, you decide the proper percentage weight between domestic, international developed, and international emerging markets.  Once these decisions are made, weightings are assigned to the sub-asset classes, such as company size and company fundamentals.

Each one of these decisions relies on the other.  These allocations are not picked at random or by performance; they are mixed to gain efficiency in a portfolio.   By combining different asset classes of varied weights, you are actually able to decrease the risk (as measured by standard deviation) in the portfolio.  Think of it in simple terms: if one asset class is doing poorly, there is probably something else that is doing well in your portfolio.  Bonds go down and your stocks go up.  Real estate does well and emerging markets tank.  By the way, these are not meant to be rules or exact examples, but I think you get the idea.   To throw a bit more complexity into the matter, there are certain types of investments that have proven to outperform others in the long-term and across differing markets.  For these asset classes we assign a higher weighting - but not too much to throw off the benefits of risk diversification.

 

  Perseverance and Rebalancing

As shown in the previous blog posts, Investment Philosophy Parts 1 and 2, the success rate for conventional (active) investing is dismal.  Because of these realities, we choose to stay in the market and persevere through tough times.  We let our diversification and allocations do the risk mitigation for us.  This is why it is so important to take the time up front to engineer a portfolio that is right for each investor.  We do not make investment decisions from emotion or hunches; we maintain a disciplined strategy.

Now that you have picked an allocation and you know you are going to maintain your strategy through good times and bad - what’s the next step?  It is actually the most important one of all - rebalancing.  At given times (at least once a year), the portfolio needs to be rebalanced back to the investor’s original allocation (assuming risk tolerance and time horizon are still consistent with this mix).  To rebalance a portfolio is the only way to consistently, without fail, buy low and sell high.  Think about that statement for a second.  This is what everyone is trying to achieve but cannot seem to accomplish.  By rebalancing, you are forced to sell the assets that have outperformed and buy the ones that have underperformed.  For example; if you had a portfolio of 50% stocks and 50% bonds at the beginning of a period where stocks outperformed bonds.  By the time it came to rebalance, your portfolio might be 55% stocks and 45% bonds.  So, you sell 5% of the stocks (outperformers) and buy 5% bonds (underperformers) to get back to the 50/50 split.  Once again, this is investing discipline paying off.  This principle is compounded when you are looking at multiple asset classes and markets. 

 

The Rub

All of the principles we have talked about lead to an investment strategy and if followed properly, a discipline.  This strategy and discipline does a few things but most importantly, it takes the emotion and guess work out of investing.  If you follow the crowd and believe the hype, you will never be able to properly invest.  Pick a strategy and maintain it.   At Zora Financial, we have an investment philosophy that focuses on individual strategies and promotes confidence in investing for our clients.  I hope you contact us to learn more about giving your money purpose and finding confidence in investing.