The Art of Investing: Lessons from Legendary Investors
SAN DIEGO, CA - October 25rd, 2024
Author: Scott McClatchy
Senior Wealth Advisor, CFP®
Ever heard of Warren Buffett, John Templeton, Peter Lynch, David Swensen, George Soros, Carl Icahn, Ray Dalio, John Bogle, Jim Simons, or Benjamin Graham? Although they all took a different approach to investing, each staked out their place in the annals of the world’s greatest investors. Though you may not have the same resources as these storied investors, there are some takeaways you can apply to your own investment strategy.
Start by determining your investment objective and time horizon. From the simple examples below, you can see how diverse an investor’s goals or objectives can be, and thus how different their portfolios might need to be to meet those objectives.
Are you a young marketing professional investing for retirement a couple decades in the future? If so, you’re likely striving primarily for growth as a long-term investor.
Conversely, an 83-year-old grandmother who is well into retirement may be more interested in amassing income from her portfolio, and protecting against a large drop in value, making her focus capital preservation with income generation.
A married couple composed of a mid-career nurse and machine shop foreman who want to balance their portfolios to obtain growth while also earning income and investing for the down payment on a house in five years. The married couple’s objective might be growth, but their time horizon is much shorter than the young marketing professional saving for retirement.
Next, choose an investment strategy. There is no "one-size-fits-all" when it comes to investment strategies. Remember our list of billionaires? For the most part, they all pursued different strategies yet became wildly successful investors. As Neil R. Waxman, managing director of Capital Advisors said, "a holistic plan balances threats, opportunities, risks and rewards.” A good place to start is by deciding whether you want to be a passive or active investor, or create a mixture of the two, and then determine how to implement that via individual stocks and bonds, or some type of managed fund such as a mutual fund or ETF, private equity fund, private credit, venture capital, or hedge fund.
Passive investing is synonymous with indexing, which means buying all or a representative sample of stocks or bonds in an index in order to replicate the performance of that index. It has gained significant popularity since the introduction of passive index-based mutual funds in the 1970s and then similar ETFs in 1993. An S&P 500 index fund, for example, should track the S&P 500 index closely, although its performance will be a little worse than the index itself due to investing costs associated with the index fund.
Investors wishing to pursue a passive investing strategy can select from any number of index mutual funds or ETFs (exchange-traded funds). Indexing is a low-cost – and often tax-efficient – way to achieve market returns. Passive investors know going in that they won’t “beat the market,” but they may be fine with market returns and uncomfortable taking the extra risks necessary to attempt to consistently “beat the market.” The reality is, many individual and professional investors struggle to consistently “beat the market,” which is one reason why indexing has become more popular over the past 10-years or so.
Active investing means picking individual stocks or bonds in conjunction with market timing in an attempt to “beat the market.” Some individual investors select their own stock or bond portfolios, whereas others hire a manager(s) by investing in mutual funds. As a practical matter, it is difficult for smaller investors to efficiently build their own diversified portfolio of individual stocks or bonds.
For novice investors, it may be more beneficial to buy a mutual fund or ETF, or some other form of managed portfolio available from an advisor or investment firm. Diversifying and building a portfolio this way means every dollar goes toward a fund or portfolio consisting of many stocks or bonds, instead of only a few shares of stocks or a single bond. Diversification can be more readily achieved, and professional management is available for those who are uncomfortable managing their own portfolio.
Once you have figured out your investment strategy, you will need to determine an appropriate asset allocation before selecting your investment holdings. Asset allocation refers to what percentage of your portfolio will be in stocks, bonds, and cash, which are the primary asset classes, as well as other alternative investments. Long-term investors striving for growth may want to hold more in stocks than bonds, and very little in cash. But retirees taking income out of their investment portfolio to supplement Social Security may want to more heavily weight bonds and cash equivalents in their portfolios. Historically, stocks have higher returns than bonds, which have higher returns than cash; but risks are also highest with stocks as compared to bonds, and lower again with cash. More sophisticated and wealthy investors may want to consider alternative investments, as well, essentially forming another distinct asset class. Alternatives might include private equity, private credit, venture capital, hedge funds, commodities, futures or options trading, private credit, or private real estate.
Additionally, there are many sub-asset classes. For example, US small-cap stocks may behave very differently than US large-cap stocks at times, or Asian or European mid-cap stocks for that matter. Then there are emerging market (EM) stocks, which can grow rapidly at times but sell off quickly at other times; and EM stocks do not always correlate or move in conjunction with US stocks. Bonds are similar. There are many different sectors or categories of the bond market, and those different sectors do not necessarily move in lockstep with each other.
Regardless of whether you subscribe to the traditional 60/40 asset allocation model or use more sophisticated strategies to incorporate alternatives alongside your public market investments, according to Jim Gubitosi, the co-chief investment officer at Income Research + Management, the most important thing is to "have a target asset allocation framework and stick with it through market ups and downs".
Another layer of the portfolio strategy-allocation decision is investing style. The value style of investing, pioneered by Benjamin Graham but popularized by Warren Buffett, involves trying to identify companies with stock prices currently trading below their actual underlying value. Of course, this is easier said than done, since 10 different investors may have 10 different viewpoints on what a particular stock is worth but, in general, value investors seek companies with a low P/E ratio; a lower P/E ratio means you're paying less per $1 of current earnings for that particular stock.
Simply put, value investors look for bargains. Growth investing is different. These investors identify companies whose sales and earnings are growing faster than the market average. Often these companies operate in the faster growing sectors of the economy—such as information technology, biotech, social media, or streaming services—or are disruptive in nature. Google, Amazon, Netflix, NVIDIA, Gilead, and Facebook have in the past been considered growth stocks. The tricky part about growth investing is that you are not the only one who has figured out that some firms grow faster than others. The stock price associated with growth stocks tends to be higher than the price of value stocks, in relative terms. Peter Lynch was a growth investor, but he also paid more attention to the price of the stocks he purchased than most growth investors, so today his style might be labeled GARP for “Growth at a Reasonable Price.” According to a 2012 study from New York University's Stern School of Business, "While growth investing underperforms value investing, especially over long periods, it is also true that there are sub-periods, where growth investing dominates.".
Finally, now that you have determined your objective and time horizon, investment strategy and asset allocation, it is time to figure out the specific investments you need to purchase to implement your portfolio. If you are doing it yourself, this step involves some research and analysis. It is not rocket-science, but it does take some effort.
Companies like Morningstar and Lipper have huge databases of mutual funds and ETFs and their related relevant investment data. Many independent firms provide stock analysis for a price, as do most of the major brokerage houses.
Of course, putting all these pieces together can be a substantial amount of work as each investor's risk tolerance and objectives are unique, so consider using an advisor with decades of expertise in financial markets to build a portfolio that best fits your needs.
For more information, please email us at contact@ballastrockpw.com should you have an questions.