It’s easier when you know ‘How?’


October 17, 2017

It’s important not only to have an investment philosophy, but also to be able to rely on it.

Success in advising clients should start with the key questions why, what, where, when and how. Why are you investing? What are your priorities? Where is your destination? When do you hope to get there? How are you going to do it?

But in my experience with numerous advisers, the how is often overlooked.

I have asked hundreds of firms and advisers if they have an investment philosophy, and if they do, would they and their team be able to articulate it? The overwhelming majority don’t have one, and even when they do, they typically admit they and their team cannot articulate it.

‘How’ relates to process and philosophy. It’s not just what you invest in, but the approach you take to investing. This means adopting an investment philosophy of guidelines or beliefs to deal with whatever markets, and life generally, might throw at you and your clients. Of course, to achieve their goals, it’s important that they stay the course.

We are not just financial advisers, we are in the business of financial advice. The importance of business process is summed up best by this quote from Michael Gerber’s The E-Myth: “It’s not the unique things of a business that make it successful, it’s the business’s ability to do the ordinary things in an extraordinary way, and to do those things consistently, predictably, effectively, day after day after day.”

As one of my first mentors used to say in reference to having systems, processes and philosophies, “There is no point having original thought in a routine situation.” The right investment philosophy helps you save brain power while doing the routine, so you can apply original thought where it’s more useful.

Simply put, an investment philosophy:

  • Increases clarity over your investment process
  • Ensures portfolios you construct are structured around core beliefs
  • Ensures team consistency
  • Differentiates what you do from your competitors.

Expanding on this, if you have an investment philosophy built around supportable evidence, then you and your clients have the added advantages that it:

  • Won’t blow up and you’ll never need to say ‘sorry’
  • Helps keep clients focused and disciplined in volatile markets
  • Increases the probably of clients achieving their goals.

Ultimately, process provides structure for your clients. The world will always be complex and uncertain, and there will always be a host of potential distractions. But just having a structure can deliver clients a level of reassurance.

With a process, you are less likely to pursue the uncontrollable or unrepeatable by wasting time and money trying to second-guess markets or chasing last year’s winners or switching your investment strategy based on whatever is fashionable. Instead of trying to ride your luck or intuition, you’ll be methodically and steadily following a repeatable and defensible process that you and your team have researched and implemented. Ultimately, paying attention to process will make your clients’ goals more achievable.

So, what might an investment philosophy look like and how might you build it? Well, start by asking yourself and your team questions, and road-testing common defendable views. For example, ask, ‘Do we have an investment philosophy? Is it sustainable and based on evidence? Can we articulate it? Do we believe in investment or speculation? Do we believe in concentrated portfolios, or in broader diversification? Do we believe in taking short-term or long-term views? Do we have a view on tactical asset allocation, or do we believe in strategic asset allocation?’ etc.

In this age of disruption, it’s critical that any decision be supported not just by opinion but by evidence. In a business I was previous involved in, we used to use a saying from sport – play the ball, not the man. In other words, argue the point and support it with evidence, don’t just provide personal views, thoughts and opinions. A robust investment philosophy needs to remove ‘I reckon’ or ‘I think’-type comments.

Using that approach, the basic beliefs can be simple bullet-points. As an example, a business might say its philosophy is built around the following tenets:

  • Investing not speculating
  • Evidence based
  • Risk and return are related
  • Diversification is essential
  • Structure (asset allocation) explains performance
  • Costs and taxes matter
  • Discipline and controlling investor behaviour are important.

Expand on these points and the investment philosophy may start to look like this:

Investing not speculating: The futility of speculation is good news for the investor. It means prices for public securities are fair and that persistent differences in average portfolio returns are explained by differences in average risk. It is certainly possible to outperform markets, but not without accepting increased risk.

When you reject costly speculation and guesswork, investing becomes a matter of identifying the risks that bear compensation and choosing how much of these risks to take. Financial science has identified the sources of investment returns.

Evidence-based – markets work: Prices for financial assets find equilibrium quickly and it is difficult to predict and profit from any perceived inefficiencies in these prices consistently. The capital market rate of return is available to every investor at a reasonable price and over the long term, that rate has proved to be attractive.

Markets throughout the world have a history of rewarding investors for the capital they supply. Companies compete for investment capital, and millions of investors compete to find the most attractive returns. This competition quickly drives prices to fair value, ensuring that no investor can expect greater returns without bearing greater risk.

Risk and return are related: The higher the risk, the higher the potential return. It is certainly possible to outperform markets, but only by accepting increased risk. However, not all risks are worth taking. Certain risk factors can be controlled to minimise risk and aid long-term return. Remaining invested is a key risk-management tool.

Diversification is essential: Concentrated, non-systematic risk is unrewarded in investment portfolios over time. Diversification is the antidote to many avoidable risks. Therefore, investment portfolios should be diversified comprehensively, across and within asset classes and sub-asset classes.

Portfolio structure (asset allocation) explains performance: The dominant contributor to portfolio performance is the relative exposure of capital to the various asset classes and sub-asset classes. Use of strategic asset allocation, together with careful rebalancing, is likely to be more rewarding than speculative strategies such as market timing or tactical asset allocation.

Costs and taxes matter: Investment portfolios should be constructed and maintained with costs and taxes in mind. Costs and taxes may be implicit or explicit in an investment portfolio. Clients cannot consume gross returns. Their goals and aspirations are funded by cash flow from net returns after taxes and other costs.

Discipline and controlling investor behaviour are important: “The investor’s chief problem – and even his worst enemy – is likely to be himself,” Benjamin Graham wrote.

Having a philosophy will help clients stay the course and not make irrational decisions, enabling them to achieve returns to which they are entitled for the risk they are prepared to undertake. It will also enable you to build in education as a key part of your proposition.

One tool for understanding the importance of discipline is Dalbar’s ( Quantitative Analysis of Investor Behaviour, which has been measuring the effects of investors’ decisions to buy, sell and switch into and out of mutual funds over both short- and long-term time frames. The results consistently shows a behaviour gap – the average investor earns less, in many cases much less, than fund performance reports would suggest. Why? Because without advice, human beings are hardwired to make emotional decisions like buying high and selling low. This behaviour gap that Dalbar refers to can range from 3 per cent to 7 per cent a year over long time periods.


One area where behavioural finance becomes an issue is portfolio rebalancing.

From time to time, investment portfolios move away from their strategic asset allocation benchmarks. This occurs because asset classes and sub-asset classes behave in different ways at different times. Their returns differ periodically (as intended), so the portfolio will skew over short- to medium-term time periods.

In order to deal with this phenomenon, portfolios need to be rebalanced back to their strategic benchmarks at an appropriate time, as the original benchmark is that which the investor agreed was appropriate for their long-term tolerance of risk.

In simple terms, rebalancing often involves buying (or topping up) asset classes that have underperformed, and selling down what has outperformed. It can be counterintuitive at first.

There are many approaches to portfolio rebalancing, but it’s important to remember that when assets are bought and sold from portfolios, costs and taxes are usually generated, and these need to be factored into any rebalancing decision. Rather than employing automated or rigid policies, it may be preferable, where possible, to rebalance from cash in an investor’s portfolio. This could be done by ensuring that the underlying assets distribute their earnings to a cash account, from which capital will then be available to top-up asset classes and sub-asset classes as the need arises.

Forecasting and non-forecasting managers

As part of your investment philosophy, you will need to take a position in the active vs. passive debate. I am not a fan of the terms active and passive, they can be misleading. I prefer the terms forecasting or non-forecasting. In any case, when formulating a position, take a look at the evidence, such as the Standard & Poors Active versus Index (SPIVA).

Many planners would be familiar with SPIVA, and those who aren’t need to be. SPIVA states that it’s the de facto scorekeeper in the ongoing active vs. passive debate. The first SPIVA scorecard was in 2002. It is done in markets such as the US, Canada, Europe, India, Japan and, fortunately for us, Australia. You can subscribe to it for no cost and receive reports direct to your inbox. Results continue to be staggering, showing just how many traditional forecasting managers underperform the benchmark returns to which they are entitled over one, three and five years – up to 80 per cent underperform.


All this information is critical for building your investment philosophy. Running a business requires process. Investment is just part of that. Investing successfully requires a properly constructed, logical, rigorous and robust investment philosophy. With this, client education becomes a core part of your value proposition.

What would need to happen for you to build an investment philosophy and avoid applying original thought to routine situations, enabling you to have solid processes like a good business? Start with the evidence and build on that. The end result should be evidence-based material, such as PowerPoints, white papers, and educational videos.

Like many things, it’s straightforward but not easy. But if you push through, build a framework and refine it, you and your team may be freed up to focus on what’s important – helping more clients achieve their life goals.

David Haintz is the principal of Global Adviser Alpha.

TOPICS:  Dalbar's Quantitative Analysis of Investor BehaviourGlobal Adviser Alphainvestor behaviourPortfolio ConstructionrebalancingStandard & Poors Active versus Index