It’s a Monday, and this week we’re getting personal. In this post, I’ll be revealing my own investing philosophy and explaining why it works for me.
Some of you will agree with my reasoning. Others may not. And if you’re one of those people, good! I want you to leave a comment telling me where I’ve gone wrong.
If this post can provoke some meaningful discussion, I shall count it as a victory.
Without further ado, let’s dive right in.
The 3 Golden Rules
My investment philosophy is based on three very basic principles. I call these the ‘Golden Rules’.
They help guide my investing decisions and give me something to fall back on if I’m ever unsure whether to invest or not. We’ll take each rule one by one and explain how they work.
Golden Rule #1: I’m In This Game For Life
My investment horizon is long. And I mean way, way long. I’m talking a minimum of 15 years into the future, and probably longer.
Why does this matter?
Knowing how long you’re going to invest for is one of the key components to a successful investment strategy. The longer your investment horizon, the more likely you are to ride out any short term volatility in the value of your investments.
In addition, by holding your investments for a long time, you allow yourself to extract maximum value from compounding growth. I’ve explained how compound growth works previously, but for our purposes we can simply refer to it as earning interest on your interest.
The longer you keep your investments, the more your capital will grow. And the more your capital grows, the more interest you’ll earn on that capital.
Over the long term, the snowballing effect of compounding growth can transform pennies into millions.
If you’d invested just £100 into an index fund tracking the Composite Index (which is now the S&P 500 Index) back in 1923, your £100 would be worth a whopping £3,413,505 before inflation. That’s over £3.4 million in compounded growth alone.
Time is your friend
You need a long runway to allow the teeth of compounding growth to bite properly. By their very nature, short-term investors forgo the effects of compounding growth by selling their investments prematurely.
I’m not saying this is a bad strategy, particularly if your circumstances don’t allow you to have a longer financial outlook. However, if you’re looking to 10x your money overnight, you better be prepared to take on a considerable amount of risk.
Not only do you stand to lose more money, but taking on risk has negative consequences of its own. Even if the worst doesn’t happen and the trade pulls through, you still had to experience the additional stress while you waited for events to play out.
And in the world we live in, who needs more stress? I know I certainly don’t.
We all have a different risk tolerance, that much is true. But by taking the long term position, your downside is reduced automatically. You don’t have to chase speculative trades, because you’re not seeking to become a millionaire overnight.
This means you can dabble in safer and more diversified investments. These have a higher probability of sustained returns in the long run and carry less risk. You therefore remove a large part of the emotional turbulence you would experience with more speculative alternatives.
For the vast majority of people, a longer investment horizon is statistically a safer and more viable method of long term wealth creation.
Can you know the future?
Of course, time is never guaranteed. I could get hit by a bus tomorrow, or a flying car in 2036.
However, in the absence of contradicting evidence, I don’t believe that living my life as if I am going to die imminently is a smart strategy. I like to plan for the future as best I can, and I have to assume that my body won’t fail me before that future arrives.
At the very least, if I’m wrong and a flying car does get me, I won’t be around to care. But my future wife and family will care, and hopefully they’ll be around to reap the rewards of the seeds I planted.
Bottom line: Take the long view. As the saying goes, the stock market transfers money from the impatient to the patient.
Golden Rule #2: I Don’t Have An Edge
As a general rule, I refrain from investing in individual company stocks or shares. Why?
Because the truth is this: unless you are a financial expert, have years of experience in investing or have some other specialised knowledge of a particular industry, it is extremely difficult to beat the market in the long run by picking your own stocks and shares.
How unlikely you ask?
Over a 15 year period, only 8% of actively managed funds manage to beat the market. 8%. That means you have to be in the top 8% of investors for 15 years to get a higher return than the market is offering you.
I don’t fancy those odds any day of the week.
Of course, these statistics don’t stop some people from trying. Some individuals genuinely think they can beat the market by cherry picking the companies that they invest in.
We call these people ‘active traders’, and the reason they think they can beat the market is because they believe they have an ‘edge’ over their competitors.
What is an ‘edge’ in investing?
An edge is a technique, method or approach that gives an investor an advantage over other investors in the market.
Who are the other investors in the market? Well, let’s take a look at your competition.
David vs Goliath
Like you, institutional investors and fund managers are constantly striving for greater and faster returns on their investments. Unlike you, these players have a few tricks up their sleeve to give themselves a competitive advantage.
For example, it could be a hedge fund paying for premium subscriptions to access investor databases or use AI software. Or maybe it’s the thousands spent by a mutual fund on research development and forensic accounting, to construct predictive models of future performance.
It could be the senior analyst attending exclusive conferences or press releases regarding upcoming company announcements. Maybe it’s the fund manager having dinner with C-suite executives from the company’s board.
Or perhaps it’s the researcher, liaising with industry-leading professionals and experts in an emerging field. Maybe some employees at the fund used to work at the target company themselves, and they have the inside scoop on the business’s strategy for the next year or quarter.
Perhaps it’s just the finance professionals themselves, who received the best educations, from the highest ranking universities, with the top grades in the country. The Doctorates, the PhDs and the MBAs.
And it doesn’t stop there. Not only do your competitors have quicker and better access to more accurate information than you, but they may be engaged in underhand methods of getting ahead.
Maybe their old university roommate is now a high ranking official who has the power to enact new legislation in an up and coming sector. Perhaps they have a source within the company who leaks insider information.
I’m not saying any of this to scare you. And I’m not suggesting that you’re not smart or capable of acquiring an edge yourself. I’m just saying the harsh reality is that the odds are stacked against you before you even begin.
You simply don’t have access to the same kind of firepower as these giants.
Even if you do have an edge, how will you maintain it? Circumstances change, industries adapt, the market evolves. Keeping your edge in an ever-changing environment is a 24 hour job.
So what’s the answer?
It’s simple. You embrace the fact that you don’t possess an edge. And as such, you don’t try to beat the market. Instead, you simply accept what the market is giving you.
As we know from previous posts, the S&P 500 Index has given an inflation-adjusted annualised return of 7.49% since its inception almost 100 years ago.
This means that the market is giving you nearly 7.5% of growth per year over the long run.1Technically, the S&P 500 Index isn’t ‘the market’, as it only represents US equities. However, even with a world or global index fund, you can still expect an inflation-adjusted return of around 4.5-5.5% per year on average. And that’s with the most minimal effort from your side.
This strategy is called ‘passive investing’, and I’m a big proponent of it.
The best part? After 15 years, passive investors will end up with better returns than roughly 92% of investors who try to cherry pick their stocks.
What’s more, if you’re using a cheap index fund with a low ongoing charge (less than 0.25%), you’ll keep your costs far lower than someone investing in an actively managed fund. This will increase your returns even more.
The longer you passively invest for, the more active investors you’ll beat.
It’s minimum effort for maximum returns. Now that’s what I call a strategy.
Can you beat the market?
What about those individuals who do beat the market, like Peter Lynch or Charlie Munger? Well, this can happen for one of two reasons:
Either (a) they do possess an edge, like the ones we mentioned above (e.g. a financial professional, an individual with specialised industry knowledge, the use of inside information) or (b) they simply get lucky.
So if you buy a stock looking for a short term gain and it goes up in value, ask yourself this: what was your edge?
If you didn’t have one, then you got lucky. And if you’re relying on luck, you might as well head to your nearest casino and stick your savings on red.
The bottom line: Know your edge. It’s incredibly difficult to consistently beat the market in the long run by actively investing. A passive investor will beat 92% of active traders over a 15 year period.
Golden Rule #3: The Efficient Markets Hypothesis
I subscribe to a theory called the Efficient Markets Hypothesis (“EMH”). The EMH states that the price of assets accurately reflects all publicly available information.
In practice, this means that the price of a share reflects its fair market value. The invisible hand of the market automatically determines this value based on the principles of supply and demand.
I’ll demonstrate how this works with an example.
When you buy shares in a specific company to try and make a gain in the short term, you are effectively declaring to the world:
“I believe these shares are currently undervalued. If I buy these shares now at this price, they will be worth more in the near future once the market realises their true value.“
By making this statement, you are asserting that the market price of these shares does not reflect their real value.
You are therefore implying that you know something the market doesn’t. Because if the market knew what you knew, the shares would be valued higher.
Finding your edge
This is where we come back to ‘edge’. In order to know something that the market doesn’t know, you need to have an edge. And as we mentioned above, the chances of you having a consistent edge in the long run are extremely slim.
The one thing we can assert about the market is that, on average, it increases in value over time. This means that if you buy a share at market value (which is the fair price, according to the EMH), it will make you a return in the long run.
Based on these factors, it does not make sense to discriminate between which shares you choose to buy. The market already reflects the true price of all shares based on the information available to it.
As such, one share cannot be better than the other. None are undervalued, and none are overvalued either. The market simply tells you the correct value based on all publicly available information.
Diversify then multiply
If the EMH is true, then your best possible strategy is to accumulate a diversified range of shares at their current market price. Over time, some will do badly and some will do well. But the overall value of your investments will appreciate in the long run.
This saves you from having to ‘time’ the market. There isn’t a good time or a bad time to purchase your shares because you will be charged a fair market price whenever you decide to buy.
The only constant is the slow upward march of the market overall. And if your investments are diversified enough and represent a large enough portion of the market, they will track the market’s performance too.
This is often why people praise the low cost effectiveness of index funds. They track the market at a fraction of the price of an actively managed fund. And they’re also much more likely to give you better returns in the long run. It’s a win-win scenario.
The bottom line: Unless you have an edge, trust the market. You need to know something that the market doesn’t if you think the price of a share doesn’t reflect its true value. Time in the market is better than timing the market.
Conclusion: Does being passive pay?
After learning my 3 golden rules, you may be feeling a bit disheartened.
How will you become the next Gordon Gekko if you can’t pick individual shares? And do you really have to hold your investments for the next 15 years?
The simple answer is that you should do whatever is right for you. This isn’t advice, it’s just what works for me.
Sometimes, even I flout the rules a little if my current position allows me to take on some extra risk. I just keep it sensible and have these principles as a cushion to fall back on.
For people with a higher risk tolerance or skill level, these rules will probably bore you to tears. And that’s fine too. Everybody is different. That’s part of what makes investing such a diverse and interesting field to be involved with.
Preaching to the converted
If my philosophy does resonate with you, then accepting the golden rules can actually feel pretty liberating.
Because when you accept that you probably don’t have an edge, you stop trying to find one. All the stress and effort of investing simply evaporates.
Instead, you get to focus on the other important things in your life, safe in the knowledge that you’re still earning a better return on your investments than the vast majority of active traders in the long run.
It is a simple and effective path to financial freedom, and I like it.
Let me know your thoughts by leaving me a comment below or sending me a message on Twitter @OfficialLOAM. You can even make suggestions for topics you’d like me to cover in future posts.
See you in the next one.