10 Commandments of Investment Strategy
How Does Your Portfolio Measure Up To These Proven Success Principles?
Key Ideas
- Use the “expectancy principle” to stop gambling and profit regularly with confidence.
- How to combine offensive and defensive investment strategy for reliable investment performance.
- The 3 investment mistakes you never want to make.
Smart investing isn't as hard as it seems.
You just need to know the right principles, and you need to follow them with discipline.
Unfortunately, much of what is taught about investment strategy is a dangerous half-truth that can be expensive.
Below are ten proven principles to help get you on the path to greater investment success.
1st Investment Strategy Commandment: Thou Shalt Not Gamble
“Expectancy” is what separates investors from gamblers. If you follow hunches, guess, take tips, or “play the market,” then you are a gambler — not an investor.
If you put money at risk on “one-off” investments, special situations, or economic forecasts, then you're also a gambler because you're betting on an unknown expectancy.
Expectancy is a formula that shows the average amount of money you can expect to make per dollar risked if you follow your investment strategy consistently enough to achieve statistical validity. It tells you what profits to expect.
Expectancy literally determines the compound growth of your wealth. It's an inviolable mathematical rule whether you use it to your advantage or not.
Gamblers put money at risk on unknown or negative expectancy situations. Investors only put money at risk on known, positive expectancy situations.
Thorough and accurate research is required to know your investment strategy's expectancy with confidence. You must understand the assumptions underlying the research and know when those assumptions may no longer be valid.
Anything less is gambling.
The principle of expectancy implies a systematic and methodical investment strategy (an investment plan). Otherwise, you can't have confidence that you will ultimately profit.
Your disciplined investment strategy should include one or more of the following characteristics to create positive expectation:
- A positive paying attribute: For example, positive expectancy results from certain value-based strategies in the stock market such as Tobin's Q-ratio and Graham's intrinsic value. Additionally, well-located and properly purchased investment real estate is so well known for it's positive expectancy under most economic conditions (not all) that a myth about “real estate never going down” resulted (just ask anyone who owned investment real estate beginning in 2008).
- An exploitable inefficiency: For example, many bond mutual funds are mispriced during rapidly moving interest rate markets. This is because of the infrequent trading of the underlying portfolio of individual bonds and mark-to-market accounting rules.
- A competitive edge: For example, some people have a competitive edge in real estate foreclosure through their banking network and marketing systems. In paper assets, some firms have a competitive edge in computer systems to exploit option pricing inefficiencies. Competitive edge is usually the result of a business system or specialized knowledge applied to investing.
Most people don't want the scientific rigor and discipline of mathematical expectancy. They prefer the fun and adventure of “story” stocks, investing by the seat of the pants, or trusting in an advisor.
You must ask yourself, “do I invest for fun, or do I invest for profit?”
Don't confuse the issues. If you want financial security and consistent profits, then expectancy is a required investment discipline. There's no way around it.
Growing wealth is governed by mathematics. It's science-based around the core principle of mathematical expectation.
Insurance companies don't gamble, and neither do casino owners … only their customers do.
Both types of businesses rely on mathematical expectation to profit reliably. You should do the same with your investment strategy.
You either invest scientifically with the odds in your favor based on known, positive, expectation strategies, or you gamble with your financial future. There aren't any other alternatives.
Get This Article Sent to Your Inbox as a PDF…
2nd Investment Strategy Commandment: Thou Shalt Forsaketh the Advice of False Prophets
Never try to outguess the market by following forecasts from the financial media or the latest investment guru. Don't fall prey to cover story articles about “10 Hot Stocks to Own for 200X“.
Financial forecasts are little more than entertainment, and should never be part of your investment strategy.
“The greatest obstacle to discovery is not ignorance – it is the illusion of knowledge.” – Daniel J. Boorstin
Three types of information exist in this world: known, unknown but knowable, and unknowable. Foretelling the future (forecasting) is unknowable.
Any investment strategy predicated on any forecast for the future is inherently flawed because the unknowable has no mathematical expectancy.
It's gambling — not investing.
3rd Investment Strategy Commandment: Thou Shalt Do Thy Due Diligence
Only invest in what you understand.
If you don't understand it, then don't invest. One of the best ways to expand your investment knowledge is through the due diligence process.
Never skip due diligence and rush into an investment strategy because of time deadlines, someone's recommendation, or because you believe you should put your capital to work.
Don't succumb to the temptations of sloth, laziness, or avoiding inconvenience by neglecting due diligence.
What you don't know will cost you when investing … big time. Due diligence is how you learn what you need to know to make an informed investment decision.
Your first task in due diligence is to determine the mathematical expectation for the investment strategy so that you add only investments that increase the expectation of your portfolio. Understanding expectation includes understanding the source of returns and the assumptions underlying the persistence of returns in the future (see Commandment #1).
Your second task in due diligence is to determine the correlation of the investment strategy so that you can build a portfolio of uncorrelated risk profiles to minimize overall portfolio risk (see Commandment #5).
Your third task in due diligence is to understand what risk management strategies will apply to the investment so that you can accurately assess your risk/reward ratio and know how your capital is protected from permanent loss (see Commandment #6).
There are many other criteria to consider for a complete due diligence process, but mathematical expectation, correlation, and risk management form the foundation by which 95% or more of all potential investments can be eliminated from your portfolio.
4th Investment Strategy Commandment: Thou Shalt Compound Returns
Albert Einstein declared compound growth the eighth wonder of the world … and for good reason. Compound growth is how the average person can attain extraordinary wealth. It's how lots of little things done right can grow into very big results during your lifetime.
To put compound growth to work for you requires just four actions:
- Begin investing now (not next month or next year). Procrastination is the number one wealth killer. Every day wasted is another day that compound returns won't work for you.
- Invest only in known, positive mathematical expectancy investment strategies. Never risk capital on unknown or negative expectancy investments.
- Reinvest all profits from your portfolio. Don't spend the profits from your portfolio until after your passive income exceeds your expenses.
- Accelerate your compound growth by adding to investment principal from earned income.
When you follow these four steps, wealth changes from a question of “if” to the security of “when”.
5th Investment Strategy Commandment: Thou Shalt Diversify, But Not Di-Worse-ify:
Never place all thy eggs in one basket. Similarly, never spread thy eggs amongst so many baskets that your investment returns become average.
Thou shalt place thy eggs in a carefully selected group of baskets, each with positive mathematical expectation and an uncorrelated risk profile.
For example, don't attempt to diversify by adding a technology mutual fund to a portfolio already concentrated in NASDAQ listed securities. This will only cause your portfolio to more closely replicate the technology averages. The two assets are highly correlated.
Similarly, don't add another real estate asset from the same general location to an existing real estate portfolio. Property values are primarily determined by local economies, so each asset will behave similarly.
These are examples of di-worse-ifcation because they don't meaningfully change the risk profile of the portfolio. They also cause your returns to regress to the mean.
The objective of diversification is to lower the risk profile of your portfolio by adding non-correlated or inversely correlated investment strategies. This allows the performance of each asset to smooth the performance of the other.
When one zigs, the other should zag.
For example, an investment strategy utilizing gold and gold stocks is a natural diversifier for a conventional equity portfolio. They are low or negatively correlated to each other, and both can have a positive mathematical expectation when properly managed.
Real estate is another natural diversifier to a bond or equity portfolio for the same reasons.
The point is to never add more of the same risk profile to any investment portfolio. Instead, find other investment strategies with an equal or greater mathematical expectation coupled with a low or negatively correlated risk profile.
The result is lower portfolio risk, more consistent profits, and the ability to rest easier knowing you're diversified (not di-worse-ified).
6th Investment Strategy Commandment: Thou Shalt Invest Defensively
Your first objective with any investment strategy should be “return of” capital, and only after that should you concern yourself with “return on” capital.
The hallmark of consistently profitable investors is their focus on controlling permanent loss of capital through risk management disciplines. You'd be wise to do the same.
Carefully examine every investment strategy to determine its maximum downside risk should Murphy's Law prevail … because eventually, it will.
Your investment strategy must have built in safe-guards that manage risk exposure and control losses to an acceptable level under both normal conditions and worst case scenarios. The alternative is to accept too much risk into your portfolio (which is a bad thing).
7th Investment Strategy Commandment: Thou Shalt Invest Offensively
At first glance, offensive investing might seem contradictory to Commandment #6 . The truth is they work together synergistically to form a complete and balanced investment strategy.
Stated another way, you must invest offensively to seek gains while you invest defensively to manage risk and control losses. Either half of this equation without the other is an incomplete investment strategy.
Your objective as an offensive investor is to maintain and improve purchasing power. You can do this by achieving profits sufficient to overcome the ravages of inflation, currency devaluation, capital losses on other investments, taxes, transactions costs, and more.
History proves this doesn't happen by stuffing your money under a mattress or in Treasury Bills. An aggressive, offensive strategy is required.
The way you sleep at night investing offensively is by controlling risk through defensive investment strategy (see Commandment 6 above).
Isolating the risk exposure to acceptable levels for each strategy and diversifying among non- or low-correlated strategies in one portfolio can provide both strong, positive returns and a controlled, acceptable risk level.
In fact, offensive and defensive investing are flip-sides of the same coin. No investment strategy is complete without either half of the coin.
8th Investment Strategy Commandment: Thou Shalt Avoid Illiquidity
Liquidity refers to the ease with which an investment can be sold and converted into cash.
Certain hedge funds, partnership interests, and real estate are examples of assets that have the potential to become illiquid. Large cap stocks and bonds are examples of highly liquid investments.
The reason liquidity is important is because the risk management tool of last resort (see Commandment #6) is a sell discipline.
If an asset becomes illiquid, then you can't sell it, which means you can't control the losses during adverse market conditions. Loss of liquidity equals loss of flexibility.
Illiquidity places an extra premium on all other risk management tools because it eliminates the possibility of controlling risk by liquidating to cash. Experience has shown most of my worst losses have resulted from illiquidity restricting my ability to manage my risk exposure.
I've learned from the school of hard knocks to approach potentially illiquid investments very cautiously. You can learn from this experience and avoid the same mistakes.
“If you have made a mistake, cut your losses as quickly as possible.” – Bernard Baruch
9th Investment Strategy Commandment: Thou Shalt Respect (But Not Obsess About) Expenses
Expenses are a cost of doing business.
The business of investing involves management and transaction expenses such as taxes, brokerage fees, and more.
I've seen people lose fortunes because they refused to pay the taxes and transaction costs necessary to exit a formerly good investment.
I have also seen people miss out on great investments because they did not want to pay what appeared to be high management fees.
Neither approach is balanced. The question you must answer is whether the expense adds value in excess of costs.
Related: How Your Financial Advisor is Taking 75% of Your Retirement Income (or More!) Video, PDF download, or Audio.
Does the management company add value (greater return) to your portfolio net of management fees and expenses, or not?
Does selling the stock add value to your portfolio by lowering risk and redeploying assets to higher mathematical expectation investments net of transaction fees and taxes, or not?
You must strike a balance. Don't be a miser on expenses and miss your next great investment. And don't be wasteful by paying unnecessarily without receiving a value added benefit.
For example, most loaded mutual funds can be avoided by finding a no-load equivalent and investing the fees saved. Rarely do loaded funds justify the fees. Research shows they don't add value in excess of costs.
Similarly, many high priced hedge funds are now being usurped by specialized mutual funds and ETFs offering a competitive risk/reward profile at a lower cost.
Be smart by willingly paying for value added investment services. Likewise, always seek to get the greatest value from your investment dollar by not paying for services that don't add value. Again, balance is the key.
10th Investment Strategy Commandment: Thou Shalt Invest in Thyself
Nothing is more financially dangerous than a million dollar portfolio managed with a thousand dollars worth of financial intelligence. Your investment skills and knowledge will be reflected in your investment results.
If you want to improve your return on investment, then you must first improve your financial intelligence. That's where Financial Mentor can help.
The best investment you can make is in yourself because nobody can ever take it away from you, and it will pay you dividends for the rest of your life. The goal of Financial Mentor's coaching and educational products is to grow your financial intelligence so you can grow your portfolio.
Let us know how we can help you make your financial dreams come true beginning right now. Whether you're going from zero to wealth or better managing the wealth you've already accumulated, Financial Mentor is here to support you.
“An investment in knowledge always pays the best interest.” – Benjamin Franklin
Invest Like Todd!
A better investment strategy than buy and hold - Makes more by risking less
Discover the scientific investment process Todd developed during his hedge fund days that he still uses to manage his own money today. It’s all simplified for you in this turn-key system that takes just 30 minutes per month.
Once again, a rocking article, Todd!
JeannaGabellini Great to hear from you again, Jeanna! Hope you are doing well. Thanks!
Being in the financial services industry I read a ton of articles and blogs. RARELY do I come across information I completely agree on…UNTIL NOW! Thanks Todd, very well written and factual information!
JudiJosephSnyder Thanks Judi. I appreciate your support!
Financialmentor are you doing any more podcasts?
@psharrisYM Financialmentor Yep, I got more in the wings. They are just a lot of work to publish with transcripts and show notes and all. Only so many hours in a day. Hope to resume podcast pubishing shortly.
Amazing write up, Thanks Todd, am richly blessed by your investment insight.
Richard Art Glad you got value from it. Thanks for your feedback.
This is a very enriching article. Oh, how qualitative the information embedded there in. Thank you.
This is an intriguing read. Thank You