What's your investment philosophy? Here's mine.
Developing a set of core beliefs can help keep your plan on track.
“Often financial authors, advisors and experts refer to investment philosophy. What do they mean by this and what are the principles of forming one?”
I recently received that email from a reader. I responded, but it was such a good question—and frankly, such a thought-provoking exercise for me to articulate my own investment philosophy--that I thought it made sense to share my response with readers more broadly.
Philosophy versus strategy
At the risk of overcomplicating things, an investment philosophy isn’t the same as an investment strategy. An investment philosophy is a set of core beliefs that you’ll use to guide your plan and your decisions; it underpins your strategy. An investment strategy, meanwhile, is where the rubber meets the road; it’s the approach you’ll take to executing your philosophy. Perhaps you’ll maintain a focus on smaller-cap and value stocks, for example, or keep things ultra-simple with broad-market index funds. You could take it a step further and articulate a process that you’ll use: for example, the screens you would run to identify worthy smaller-cap value companies, or how often you’d rebalance your asset-class exposures if you’re using broad-market index funds.
The reason it’s important to start with a philosophy is that it can help keep you on track and tune out distractions. For example, while SpaceX captured headlines over the past few weeks with its initial public offering, the investor operating with the philosophy that active security selection is futile could simply pay attention to whether the company was likely to be included in major indexes. (The passive investor wouldn’t even have to do that, really.)
Make it personal
As with investment strategy, your investment philosophy should be pretty straightforward. In fact, if you have more than five or so core principles, you’re probably making it more complicated than it needs to be. Think big-picture: What views do you have about investments that are unwavering and are so ingrained that they’re practically an extension of your personality? If your principles fit that description, it means you’re much more likely to stick with the philosophy through thick and thin.
As I thought through my own investment philosophy, here’s what I came up with. And remember: You don’t need to agree with me! The best investment philosophies are personal rather than handed down from someone else.
Principle 1: KISS. (Keep it simple, stupid!)
This is my core belief: A minimalist approach to investment selection and portfolio oversight beats a more complicated one any day. Prioritizing simplicity points toward a portfolio of broadly diversified mutual funds, especially low-cost index funds and exchange-traded funds. It’s straightforward to select such holdings and assemble them into a portfolio with your desired asset class exposures. Maintaining it is also simple: A thorough once-annual portfolio review, where you determine whether rebalancing is in order, will be plenty. This is the classic “good enough” approach that I’ve written about before.
A side benefit of keeping it simple is that it enables you to ignore a lot of the noise in the investment world. As I’ve written before, I have a large and growing “too hard pile”—investments that just aren’t worth the bother and might only had a marginal benefit to our plan even if we owned them. I also happily ignore a lot of the financial news flow. (Apologies, CNBC.) Whether it’s the latest inflation reading or a hot IPO, it’s unlikely to have a significant impact on my investments. I might pay attention because it affects the world we’re all living in, but I would never adjust my portfolio in response to the news flow.
Principle 2: Maintain ample liquidity.
I can’t help it: While I am comfortable with heavy equity exposure in my portfolio, I also like the peace of mind that having a large-ish cash cushion affords. Intellectually, I know that holding cash isn’t great from an investment standpoint: While interest rates are higher today than they were a few years ago, cash yields are pretty thin gruel once you factor in inflation. Nonetheless, I consider cash to be a core luxury good at this life stage, allowing us to cover big-ticket outlays at a moment’s notice while also feeling comfortable with our aggressively positioned long-term portfolio. We’ve been deliberately adding to our fixed income holdings as retirement approaches (all of my new contributions have been going into bonds for the past several years!), but I know we’ll also continue to carry an ample cash cushion because of the mental peace that it affords.
Principle 3: Time horizon rules.
In a related vein, another of my core beliefs is that it makes sense to use anticipated spending horizon to guide what to invest in and how much risk to take. If you have a long time horizon (say, over 10 years), you can reasonably hold equities because it’s been pretty rare for stocks to be down over that time frame: They’ve landed in the black in more than 90% of rolling 10-year periods. But for shorter spending horizons, stocks are risky: That’s where bonds and cash come in.
That’s the basic intuition behind the bucket approach to retirement portfolio planning, where you use anticipated spending horizon to guide your allocation to each of three main buckets: a “spend now” bucket that holds cash, a “spend soon” bucket that holds high-quality short- and intermediate-term bonds, and a “spend later” bucket that holds a globally diversified stock portfolio. The beauty of a bucket approach is that it’s extremely customizable: You’re using your planned spending for the foreseeable future to decide how much to drop into each of the buckets. It’s also a healthy form of healthy accounting that can help investors stick with their long-term investments because they know their near-term spending needs are safe.
Principle 4: Costs matter.
I’ve often said that it was one of the great privileges of my career to get to know and learn from Vanguard founder Jack Bogle. Among his many pearls of wisdom, he pointed out that the beauty of index funds isn’t so much that markets are consistently efficient: They’re often not. Rather, it’s simply that index funds have a cost advantage over active funds that, when compounded over a number of years, translates into a serious outperformance edge.
Bogle’s message has broader applicability for an investment program, too. That’s because costs are a rare element of investing that investors exert some level of control over. In addition to selecting low-cost investments, make sure you’re getting good value for your money if you’re paying for financial-planning and investment advice. Also pay attention to tax efficiency by prioritizing tax-sheltered investment accounts (assuming they’re low-cost!) and employing tax-efficient holdings in taxable accounts.
Principle 5: Get the big things right.
Finally, a core principle for me is to not allocate time toward small decisions that won’t have a meaningful impact on our plan’s success or failure. Over the years I’ve observed investors obsessing over topics like whether to carve out a separate allocation to real estate stocks or if it makes sense to hold foreign stocks in an IRA or taxable account. Of course, it’s fine to spend time delving into those issues if they’re of interest to you, but where you land on them is unlikely to significantly affect whether you achieve your financial goals.
Instead, I prefer to spend my time focusing on getting the big stuff right: staying employed and growing my income, living within my means and sticking to a steady savings program, and maintaining a sane asset allocation. If I stay focused on those sorts of activities and decisions, everything else should fall into place.
