Monday, January 02, 2012

Investment Principles

A few days ago, a friend emailed me with some questions about an investment he planned to make.  During the discussion, I wrote down for the first time, some of the principles I use to guide my personal investments.  I decided to create this document as a more thorough reference for myself and a point of discussion so others can offer correction where I'm wrong.

I'll start with a list of high-level principles, follow with my rough algorithm for asset allocation and conclude by explaining how the latter relates to the former.


The following five principles guide my investment decisions.  I try to evaluate each of them before buying a security.

  1. Hard work and frugality are the foundation of prosperity
  2. I'm not as smart as I think I am
  3. Greed and impatience will ruin the best laid schemes
  4. Emotional attachment prevents sound decisions
  5. Gold is the best cash
Incidentally, these correlate fairly well with some of the seven heavenly virtues, respectively diligence, temperance, humility, charity, patience.  If I can make up principles corresponding to chastity and kindness, I'll have a best selling book on my hands, Seven Virtues of Highly Effective Investors?


When I have some money to invest, I typically follow this algorithm to decide where it should be invested.  I invest in a security corresponding to the first question to which I answer yes.
  1. Could I be working or reducing my personal expenses right now?
  2. Have you found an undervalued stock by spending hours reading annual reports, assessing asset values and calculating cash flows?
  3. Is the stock market relatively undervalued?
  4. Is the bond market relatively undervalued?
  5. Is real estate relatively undervalued?
  6. Did Rumpelstilzchen turn straw into gold?
Deriving an Algorithm from Principles

The first principle is the most important.  Fundamentally, wealth represents someone's previous hard work.  Investment is not a way to get rich.  It's a way to modestly grow wealth that has been obtained through honest labor and sacrifice.  As usual, XKCD applies: "compound interest isn't some magical force"  Thus algorithm step 1 is to try working harder and giving up luxuries.  Investing is like electricity conservation, the most effective method is to decrease consumption.

The first principle has also lead me to value investing.  There are dozens of systems for making investment decisions.  Some people swear by various day trading methods or by technical analysis.  At the end of the day, those techniques are far too easy to be successful in the long run.  If an investment claims to offer wealth without effort, it's a lie; the piper must be paid.  The best exposition I've found on value investing is the book Value Investing: From Graham to Buffett and Beyond or in Buffett's words, "other guys read Playboy. I read annual reports"  The first principle suggests that only that sort of work can bring substantial returns; as embodied in algorithm step 2.

When I get tired of the hard work required by principle one, I'm tempted to substitute vain confidence in my truly dizzying intellect.  The second principle is there to save me from myself.  No matter how much I deceive myself, I'm not smart enough to discern a single winning company based on a few contemporary trends.  The goal of algorithm steps 3, 4 and 5 is to trade substantial investment gains requiring my hard work for small gains requiring hard work from others.  Since I'm not smart enough to pick a single winning company, I restrict myself to choosing from one of three asset classes (stocks, bonds, real estate).  Index funds with very low expense ratios are a cheap way to invest in an entire asset class.  It's also hard to become emotionally attached to an index fund (principle 4).

Of course, deciding whether an asset class is undervalued also requires a fair amount of work.  Since the US Dollar is a highly inflationary measuring stick, I'm partial to long term (100+ years) ratios as a start: 10 year trailing P/E, DJIA in gold, historic bond yields, Shiller's home price index in gold, etc.

Algorithm step 6 is a fall through decision to hold cash, in the form of gold, waiting for better investments to arise.  Gold provides no yield and is only the best among a losing team of currencies.  About all it has going for it is a long history and a predictable supply; neither of which other currencies possess.

It's at this point that principle 3 becomes important.  For the last two decades, I think the general stock market has been overpriced.  For the last two years, bonds have been overpriced.  For much of the last two decades, a lot of real estate has been overpriced. It's not much fun to be holding gold, earning nothing in real terms (although 0 is better than negative!).  It's like sitting on the bench at the big game.  "Come on coach, I want to play!"  In these lulls, the only way to invest profitably is to revisit the principles of hard work, frugality and patience.

In honor of principle 2, please enlighten me in the comments below.