An athlete who wants to enjoy risky sports has to follow safety rules; in like manner, any individual who wants to produce superior investment returns has to follow foundational principles and benchmarks that have been used by several successful investors and has proved to work most of the time in both bull and bear markets.
Our job as professional investors is to do a superior job, and our superiority comes from producing good returns earned with the risks under control.
In the final analysis, nobody can provide a set of rules that works all the time. The key is to have a way of thinking that works all the time. In this article, I have outlined some key principles that can help shape the thinking of investors and also serve as guiding principles for anyone looking to have a career in investing.
I must say, that some of the principles outlined in this article are pretty advance and goes contrary to mainstream knowledge and opinions about investing which you might have already gotten to know. This write up has been particularly designed for individuals and institutions who are in the business of investing for a living or considering to do so and may therefore not be suitable for everyone.
In proceeding further, here is what I consider tenets of successful investing;
THE IDENTITY PRINCIPLE;
Just like every other profession; professional Doctors, Teachers, Lawyers and so forth, the field of investing is a professional field and must be seriously considered as such.
Very often you will find people take an introspective look at themselves, strip away all their illusions and make careful thoughts and considerations before venturing into any professional field of endeavour from which they expect to make ends meet. Same goes with investing!
The identity principle therefore simply states; know thyself. Thus, the first step to succeeding in the field of investing is to take an unbiased introspective look at your personality, values and beliefs in the first place, to consider whether this is something that aligns with your purpose in life and you really want to bet your life on. If the answer to this exercise comes out as a clear “NO” then your journey probably ends here and the rest of this article may not be suitable for you.
A piece of good advice for you is to hand over your investment funds to a professional money manager or fund manager to invest them on your behalf and charge you some billable fees!
It is essential that anyone looking to produce superior returns from investing that outperforms market averages must first be in sync with their own personality. Essentially, investing is an art that employs human judgments, perceptions and expectations in making investment decisions from time to time.
As a field that requires the use of so much individual judgment and perception, investors are always battling with the demons of judgment bias and perception bias. Judgment and perception bias is the human tendency to subjectively err about events. Leading us to make bias interpretations and conclusions which are likely to deviate from reality. It is the tendency we have to create our own reality other than what actually prevails.
A person aspiring to reach the level of professional investing must take to the habit of deliberately and consistently monitoring their thoughts, and carefully examining their thought patterns to identify how their own personality and mental makeup can distort their goal of wanting to think objectively when making investment decisions and always counter non-objective thoughts with objective ones. I can’t describe enough how hard doing this can be.
Additionally, when we talk about the identity principle, it also has to do with the time horizon of investing that is in sync with a person’s personality and way of life. Thus, being able to establish as to whether you are more predisposed to short term investing, medium term or long term. This is key in helping to choose the assets and investment modules that will best suit you. Studies have revealed that individuals who are very much action oriented, who love fast cars, fast motors and often find themselves in lots of action in life are more predisposed to high frequency, short term investment modules with high risks and high returns, whiles individuals that are more reserved, cool, calm and collected and don’t engage themselves much in high adrenaline activities are much more suited for long term investment modules, since such folks will want to deeply understand the nature of whatever it is that they are investing in.
THE RISK PRINCIPLE;
The risk principle of investing may sound like a cliché. It makes us understand that all else being equal, high yielding investments ventures embeds in them potentially high risks of loss whiles low yielding investments carry relatively less risks of loss.
I stated earlier in my opening paragraph that the job of a professional investor is to do a superior job which has to do with producing good returns (that outperforms market averages) earned with the risks under control.
Essentially, one of the key difference between a professional investor and all others is that they are able to effectively manage and control risk while producing good returns. Effectively controlling and managing risks entails a number of factors;
The first amongst them is to openly and genuinely know and accept the risk of potential loss in the first place.
There is always the tendency for investors to erroneously underestimate risk in many instances. Miscalculating risk can be very costly in the field of investing and professionals should not be fond of this. As such, knowing the risk implies that all considerable effort has been put in place to ensure that the appropriate degree of risk of loss is carefully ascertained and catered for. Additionally, the next step after knowing the risk is to genuinely and wholeheartedly accept it. Risk that has not been genuinely and wholeheartedly accepted cannot be effectively managed and controlled in the first place. To properly communicate what it means to wholeheartedly accept the risk of loss may sound somehow like this; assuming that you are wrong, the moment after making your investment decision. It also means that you are able to sleep well, even when your investment is going bad.
In general, assuming that you are wrong helps to minimize the psychological pain the average investor experiences whenever they lose their investments.
Prepare for the downside; if you can properly contain the downside of loss, you can control risk effectively.
THE PRICE PRINCIPLE
In investing, price is the leading indicator of all market variables. Whether your area of specialization is real estate, precious metals, commodities, natural gas, currencies or stocks, you would have to interact with price every time. Essentially because many high yielding assets tend to experience relatively higher price volatility. In view of this, being able to accurately tell the general directional bias of the market you are involved in from time to time is key to your long term survival.
Price is King
At the very fundamental level, the winners in every market are those who are able to accurately pick the right market direction in both bull and bear markets and also have the appropriate psychological resources to make timely decisions without wasting time on regrets and wishful thinking. To survive long term one must be able to change their perceived market directional bias immediately markets change; as price seems to say to investors, “follow me and I will show you the way to riches”.
Legendary investor, Paul Tudor Jones put it out very well, he said, “Your job is to buy what goes up and to sell what goes down. The whole world is simply nothing more than a flow chart for capital”. Sometimes the challenge is that some investors are able long in bull markets but for some reasons are unable to sell short in bear markets. In forecasting the financial markets, price is the leader of the market crowd.
THE CAPITAL PRINCIPLE
The capital principle entreats investors to invest with money they can afford to lose – especially when it has to do with high yielding investment ventures where the risk of loss are extremely high. Because asset prices are predominantly influenced by economic and political happenings which are most of the time unpredictable, there is some degree of uncertainty associated with market price movements.
In view of this, it is always essential that one invests with money/resources that will not put them in any financial mishap when lost. Investing with money you can afford to lose generally gives you security and peace of mind so you don’t have to interfere with your investment before the maturity period.
Also, ensure that to the best of your knowledge and all else being equal, you will not need the said capital for any other use during the life of the investment. This enables you to hold the investment up to the stated maturity period so as to be able to earn all the associated returns. Many money managers and investment firms will actually charge you commissions and in some cases deny you part or all of the accrued returns if you are to liquidate your investment before the stated maturity date. Investing with money you can afford to lose and do not need for immediate use gives you enough room to accommodate all the inherent risk and also hold the investment up to the stated maturity date.
THE LEVERAGE/GEARING PRINCIPLE
The principle of leverage simply states: get high leverage! The leverage principle encourages investors to make use of borrowed funds or debt to magnify investment returns. It is the act of investing with third party funds and/or investing in leveraged assets. Despite the merits of financial leverage, readers must note that, this is an advance principle, used by highly experienced investment professionals to scale up their marginal investment returns.
The principle of financial leverage is mostly used in big-ticket investment transactions with long term returns such as; sovereign debt, real estate and in commodities such as oil, Gold and Silver where huge investment funds are required.
Sometimes you may come across a potentially lucrative investment opportunity but may not have all the funds needed to take advantage of the investment opportunity. In such instances, gearing is the key. One may have access to leveraged funds through prop firms, supportive friends and relatives, a network of investors, collective savings and investment groups or simply through fundraising. The objective is to raise long term funds that have very relaxed terms and conditions and at a little or no interest, so the investor can have the ease of time and space to go about their investment with peace of mind.
On the whole, to be able to raise funds much more successfully requires that one has integrity and a good track record of successful investing.
The key to applying leverage successfully is to be able to keep the downside risk under control, in that, if you can manage and contain the downside of possible loss effectively, you can control leverage risk. This can be done by brainstorming the worst case scenarios that can arise and then appropriately aligning effective risk mitigation measures that will curtail those probable downside risks. Failure to do this may signal that the risk you are going in for is probably bigger than you can handle.
The other aspect of financial Leverage is in the use of various financial instruments that requires the use of margin such as CFDs (Contract for Difference). The use of margin requirement allows an investor to invest in financial security by putting down only a certain percentage amount of the actual value of the security with cash. Thus, it allows investors to invest in security without having to pay for its entire value with cash.
The margin requirement is the percentage amount that an investor must pay with their own cash when investing in marginable securities whiles maintenance margin is the minimum amount of equity/cash that must be maintained in a margin account in order to hold an investment position.
In practical terms, the maintenance margin serves as a collateral for the use of leverage in a margin account and your investment broker would give you a margin call, requesting you to add up additional funds, should your account equity fall below the maintenance margin at the same time that you have an open investment position in your margin account.
Investing in leverage securities can be done by investing with brokers that offer margin accounts for investment purposes. Some brokers offer as high as between 25% to 50% maintenance margin. A 50% maintenance margin implies that, you are only required to maintain 50% of the actual value of the security in your account to have an open position on the margin account. For example, if you were to go long on Gold in a margin account at a price of $1000 per ounce, a 50% maintenance margin implies that you are required to maintain a minimum of 50% [$500] of the actual value of this investment in your margin account in order to maintain your open long position on gold. If your account equity is to fall below this value, your broker would request that you put in additional funds by given you a margin call.
Notwithstanding the benefits of financial leverage in magnifying returns on investment, investors must be aware that using leverage can only be rewarding when the going is good, but it can also wipe you out if events do not conform to expectations.
THE PITCH PRINCIPLE
The pitch principle in investing essentially has to do with knowing what to do and when to do it – which is very crucial in determining long term investing success or failure. Essentially, the pitch principle entreats investors to know how to lie in wait for the “perfect” time to make an investment move.
Given that market cycles are binal; primarily bull and bear cycles, an astute investor should be able to properly tell the general directional bias of markets from time to time and be able to unemotionally react accordingly.
Know what to do, and when to do it
Generally, there are basically three options available to every investor in the moment of decision; you are either short, long or you stand aside. Which is pretty simple, but very hard to do. Shorting in bull markets will make an investor go bankrupt just as going long in bear markets.
ASSET SELECTION PRINCIPLE
Essentially, the asset selection principle states that; one should own more of the things that do well and less of those that do poorly. In selecting assets or securities that do well, it is essential not to limit yourself to only domestic assets, but also to consider foreign assets as well. This helps so that investors don’t have to limit themselves to only those assets that are within their country even when they are not performing well. One may look out for global assets that are doing well and invest in them through Global brokers.
Again, in asset selection, the objective is to pick assets with a high degree of liquidity. High liquidity assets are fast moving assets that allow you to get in and out with ease whenever you want to. This helps in ensuring that you are able to get out the moment you realise you have made a wrong decision. Highly liquid assets allow you to liquidate your investment position quickly when you are wrong without having to lose a significant amount of your investment funds.
CYCLICAL POSITIONING PRINCIPLE
This principle is what entreats investors to have more invested, more aggressively when the times are right and have less invested, more defensively when the times are wrong, thereby fluctuating between offence and defence in harmony with economic and market cycles.
The choice at any given time between offence and defence is the most important choice that an investor makes. In that, the most important thing is to know and decide whether to be aggressive now or defensive. When this is done right, all the other things will fall into place, otherwise, the rest of the process wouldn’t yield much. Relative to your normal risk posture, you should be able to tell from time to time whether to be more aggressive or defensive. To be aggressive means having more assets and riskier assets whiles to be defensive implies having fewer assets and safer assets. Knowing how to do this well is really the key!
THE CONSISTENCY PRINCIPLE
Last, but not least, once an investor has been able to adopt a system of investing that works by producing results that outperform market averages they should be able to stick with it and be consistent with its application. Additionally, once an investor has been able to settle on a class of assets they are comfortable with, they should be able to stick with those assets primarily and review them from time to time. As always, getting to know what works and what doesn’t in the field of investing can be a very challenging task and same applies to find assets which do well. When you are able to figure out these two key essential ingredients of investing, that is your signatory moment and you must pride yourself with it by being consistent in your approach to investing.
E.O. Essien is a Chartered Economist with accreditation from the Global Academy of Finance and Management (GAFM) and the Association of Certified Chartered Economist (ACCE). He is a professional currency speculator, economic columnist and an Investment Analyst. You may reach him via email on firstname.lastname@example.org or on 0203656160, he will be glad to hear from you.