So, investing is an art form much like any of the other “things” we do in life. If you are a musician you must practice until you become proficient, and then to become a master takes many years of dedication. Even then there will be people above and below you in terms of proficiency and skill, but that doesn’t mean you aren’t great.
As each day passes I look to myself trying to figure out what investment style will suit me best, and I’m coming to the conclusion that an intermediate to long-term perspective will probably be best for me at least for now. That doesn’t mean that short-term trading won’t be a part of what I do, but it will be minimal.
Why? Well, the longer-term trends make more sense. Say for example with our current credit crisis at hand. The USD is being devaluated at an alarming rate. As the Fed continues to pump money into the system (mind you it is created out of thin air) thus each dollar is worth less due to there being more of them in circulation. Well in that case what do you do if the dollar continues to fall? Well, purchase other currencies that you think will be stronger against the dollar and / or purchase commodities as they are valued in the dollar. As the dollar weakens the commodities go up in value. However, you have to be careful as you are also dealing with supply/demand issues when it comes to raw materials. To say there are hard and fast rules is dangerous. For example while it may be supposed that an increase in gold is a indicator that inflation is coming, to abide by that rule in every situation may get you in trouble.
Okay so I’m almost finished with Harry Browne’s Investment Strategy and wanted to write about the questions we need to ask about our investments and the questions we normally ask, which lead us astray.
1) RISK: Is there any risk?
Well there is always risk in any investment. The only risk-free investment or the closest thing to it is T-Bills, which is considered the risk-free rate.
If risk is inherant in any investment then what?
1) What economic conditions will cause the investment to decline in value?
2) Are any other investments inversely correlated with this investment to compensate for its decline?
3) What is the most you can lose? (Generally this is 100% of what you put in, but remember that if you are using leverage you can go beyond 100%. Imagine futures for example and you are locked limit down if you are long. You can’t get out and may end up having to pay your broker even after your sell.)
Safety: Is this investment safe?
Well, safety is somewhat misleading. The cash in your bank account is safe as long as your bank doesn’t collapse, and if it does hopefully the FDIC will have enough capital to guarantee your account. But say inflation is at 10% and you are earning 3% interest your capital is depreciating at 7% per year. Yikes!
1) Under what circumstances would I lose a substantial portion of my capital — say 20% or more?
2) What would cause my entire investment to be worth nothing?
3) Can I lose more than my investment. (See #3 under Risk)
INCOME AND CAPITAL APPRECIATION: What is the investment yield?
Your investment can appreciate in 3 ways (sometimes a combination of a, b, c):
a) Price appreciation
b) Interest earned
c) Dividends
Also, there is a tradeoff between income and appreciation with regard to taxes. b and c provide immediate income with a tax liability, while a also provides income, but taxes are deferred until you sell thus generating income.
Chasing high yields means chasing a risker investment as the general rule is that the higher the yield the greater the risk. So, if a T-Bill is yielding 3% and a corp AAA bond is yielding 6% the corp bond has a greater risk of default. I’m not saying that the corp will default, but the possibility is greater. Also, with high inflation purchasing a bond at 6%, while inflation is at 12% means as I stated earlier that you are losing money.
1) Under what circumstances, if any is the investment likely to appreciate?
2) Under what circumstances, if any is the investment likely to depreciate?
3) In good circumstances for the investment, will the overall return — yield plus capital appreciation — help your portfolio?
Note about mutual funds: You want the fund paying the lowest yield. Any dividend paid simply reduces the price of the fund by a comparable amount. You also have to pay taxes on the dividend, whereas it could have stayed in the fund invested being compounded.
TRACK RECORD: How did this investment perform in recent years?
Investments go up and down, the economy expands and contracts. There is no written rule that says if it has been going up for the past number of years that it will continue to do so in the future. You may be buying at the top and selling at the bottom. The same may hold for an investment advisor. They may be hot, and by the time you invest with them they went cold.
1) What kind of economic climate should cause this investment to prosper. (IE: Inflation and Gold)
2) When the climate HAS existed, DID the investment prosper?
3) If this investment is for a balanced portfolio will it give you too much exposure to one category of investments?
4) If this is a speculation, do you think we’re heading into an economic climate favorable to this investment?
SPONSORS: Who things this investment is about to rise?
Nobody can predict the future! I don’t care what anyone says, but they can’t. All we have a various indicators, past events based on similar circumstances, and the moon!
1) Why is this person recommending the investment? Do their arguments make sense?
2) What do they believe it will add to your portfolio?
3) What will have to happen for their forecast to come true?
4) Do you want to bet on that event with funds you can afford to lose?
TAKING THE PLUNGE: How much should I invest?
Nobody can tell you how much to invest because we all have different objectives, and risk tolerances. I will say however that for risk management Van K Tharpe has some helpful information. One book I would recommend in this area is Trade Your Way to Financial Freedom.
Balanced Portfolio:
1) How much of the investment do I need to provide the proper balance against my other investments?
2) How large of an investment would overexpose me to some potential event?
Speculation:
1) The entire investment could be lost. How much can you afford to lose?
TAKE OVER CANDIDATE: Is this company a potential takeover candidate?
If you are acting on the possibility of a takeover or some other event materializing such as a product being successful… if it doesn’t happen there will most likely be a drop in its price as it failed to meet expectations.
1) Do you interpret the widely known information different from what most people believe?
Investing with the crowd isn’t much of a profit maker. Generally the price of the asset already reflects what is widely known. Therefore if something is out of favor or not on the radar screen of everyone, if it performs you could make out quite well. ie: where will the next bubble be? Can we say the green movement?
Unpopularity isn’t a guarantee of profits, but it is a prerequisite.
POPULARITY: If this investment is so good, why don’t I see it recommended in newsletters or Money magazine?
1) If you are discussing an off the radar investment with someone are they trying to help you decide if it is right for you? Or are they simply guessing that the investment will go up in price?
If the latter ignore the price — remember the future is unknown.
TECHNICAL ANALYSIS: Do the technical factors favor the investment now?
Technical indicators have a chance of being right or wrong. There are a vast number of indicators people believe in. Some may be correct due to the self-fulfilling prophecy. If enough people believe in them and use them to trade or invest then they will exist.
1) Is there something more interesting on TV that in the charts?
SUMMARY:
You must be able to define what you are trying to achieve. HAVE A PLAN! Without a plan you will be riding a very large wave without anyway out, only to later be crushed. To have a plan will enable you to ask the right questions. A plan also will enable you to evaluate what you see and hear. Lastly, you will be able to decide if an investment is in line with your goals.
–Most of this was a paraphrase of Harry Browne with a few of my opinions added in. Most of it is common investment wisdom, but alas from what I can tell most of us are looking for the Holy Grail. Van K Tharpe talks about the Grail… It isn’t what you think. There is no magic answer, there isn’t a system that is fool proof, and again we can’t predict what will happen with certainty. Good Luck!
