On the process of investing
I have been thinking a lot about the process of investing. Partly because my sister, a doctor by qualification, recently began to dabble. But also because its now been over a year living through a tumultuous world - an incredibly challenging year for any active manager. When things go this crazy, the only way to remain steady is by understanding your own process, and sticking to it.
Why do I say understanding your own process? Because, surprisingly, it is easy to have a process without fully understanding what it is and the choices you've made along the way. When things are quiet, this is not really a stumbling block. But when there is turbulence around, it helps to have clarity about your process - because you are jolted around by macro news, massive price moves, socio-political upheaval, completely novel theories of value and valuation, and whatnot.
How complex can a process be you ask. On reflection, it turns out there are quite a few important pieces of an investment process. And each of these pieces in turn demands choices and decisions. Decisions that can be made deliberately, or completely by accident. What are those pieces?
The components of a process
The life-cycle of an investment starts with idea generation. The choices here are very wide. And of course, you don't have to choose just one. You could simply generate your ideas by cloning - choosing your most respected investors and taking cues from what they're buying. You could use screens. The choices even within screens as an idea source are very wide. You could generate ideas top-down, based on your analysis of industries, or even of broad macroeconomics trends. However you do it, it is good to be conscious of where your ideas come from. And also to understand where your best ideas have come from in the past.
The next step is analysis. An incredibly open area. At the very top level, you could be a technicals person or a fundamentals person. You could be a mix of both. You might eschew analysis altogether if you're simply cloning Mr. Buffett's portfolio. Whatever you do, are you consciously aware of doing it. Do you have a fixed order of doing those things? Its not a necessity, but in times of turbulence, or when working with a team, it helps tremendously.
While the previous two steps can be shared across a team, portfolio construction falls squarely within the ambit of a portfolio manager. Of course, if you are managing your own portfolio, it's all your own responsibility. However, this is a surprisingly misunderstood step. It is easy to think that this is only about position sizing and sector balancing. It is also about your goals and your style. For example, portfolio theory recommends that you look at your whole portfolio as a single entity. But in practice, it might make sense to break it into buckets, say something like a core-satellite structure. You could decide to have some room for "punts" while keeping most of it invested in long term positions. Thinking this through and having clarity of thought here can have an outsized impact on long term performance.
Now that you've made your investment, how do you track it? Do you track it at all? Too many retail investors swing between two extremes. They might look at the stock price everyday. Or they might forget that they ever bought something. The first is obviously bad (unless you're really trading, in which case, sure). But the other isn't ideal either. Forgetting about stock in a company that continues to do well for a decade can be great. But that's at least partly just luck. You need to find a balance.
In an institutional setting, monitoring is sine qua non. But there is still a lot of variation possible. Do you only look at quarterly results? Do you also interact with managements regularly? What questions do you ask and what metrics do you track? All these are obviously intertwined deeply with your investment philosophy and goals. But it is easy to ad-hoc your way through this. You shouldn't.
And finally, the big one. Exits. This is one area that even seasoned investors will often admit to not having perfected. This is partly driven by style. If you are a technical trader, this can be quite straightforward. If you are a long-term investor, however, this can be tricky. Good companies often trade up to crazy prices. Do you sell then? All of it? If you come across a new idea, how do you choose which existing position to replace? Not everyone has the luxury of new cash flows to invest into new ideas. Not having a clear exit process often means you exit good investments prematurely, while hanging on to bad ones too long.
The takeaway
In a few brief paragraphs, I have listed out what the big pieces of an investment process are. But there are worlds within each piece. Almost every investment process you can think of can be built by making specific choices in each of these categories. Choices in one step are not independent of choices in others. And putting together the right ones, ones that align with each other, and with your investment goals and personality, is an exercise that can pay rich dividends. Literally.