There are a few critical elements required to achieve an investing goal. The first element is taking the time to think about what you want to accomplish and writing down that goal. The second is to have a documented strategy to achieve your goal. That is a plan. You know where you are trying to end up and have an approach to get there.

It seems so simple. We plan our days, our vacations and our dinners. But most investors don’t have a plan. Investors without direction just drift along influenced by all the noise coming from changes in markets and the constant commentary from market ‘experts’. These investors struggle to evaluate how they are doing because there is no context to judge performance.

Helping investors craft a plan is one of the reasons that financial advisers add so much value. This advice comes with a cost. According to a 2022 University of Adelaide study fees for initial advice costs between $2,000 and $3,999. For some investors with higher levels of assets that may be a bargain. For some investors it makes no sense. The good news is that anyone can come up with their own plan.

This article focuses on crafting an investment strategy. The prerequisite to this step is to define your goals and understand the return needed to achieve your goals. We have multiple ways to help you with these steps.

Our portfolio construction episode of Investing Compass. 

Our recent webinar on setting goals:

There are four steps to create an investment strategy. They include:

  1. Define your high level approach
  2. Set your asset allocation
  3. Determine your edge
  4. Identify security selection criteria
  5. Establish the basis for making changes to your portfolio

 

Part 1 of this article will cover the first three steps.

Part two can be found here

Part three can be found here

I will use myself as an example. Not because anyone should replicate my approach. I just think it is beneficial to have a real-life example.

Define your overall approach

This step turns a goal into a high-level investment approach. A goal should specify the outcome an investor wants to achieve. For instance, an investor may want a portfolio that is worth $100k in 10 years or generate income of $20k a year in 10 years. And the goal should include what it takes to achieve that from a return perspective and from a saving perspective. After this exercise an investor may find they need to earn 8% a year and save $5000 a year to have a portfolio worth $100k in 10 years. This is a critical part of the planning exercise.

The investment approach should reflect the type of portfolio needed to achieve a specific goal. And there is no need to write War and Peace. If your goal is to earn 8% a year to have $100k in 10 years your investment approach may be to invest in growth assets to achieve capital growth with a 10-year time horizon.

Clarity is key. More details will be layered into the investment strategy in the future. The investment approach lays the foundation for the rest of the strategy.

My approach

My goal is to build passive income in my non-retirement accounts. I have a specific target I would like to achieve in 11 years. To achieve my goal I want to purchase income producing assets that provide a stable and growing income stream.

Set your asset allocation

Studies have shown that asset allocation is the single largest driver of long-term returns. At a high level this involves an allocation between growth and defensive assets. In theory - and on a historical basis - growth assets like shares have higher returns than defensive assets like cash or bonds.

If a higher return is needed to meet an investment goal a larger portion of a portfolio needs to be allocated to growth assets. Simple as that.

Asset allocation can get more complex the further an investor drills down. Some investors are making decisions on how much to allocate to emerging market equities vs. small cap equities. I have nothing against this approach.

However, it is worth nothing that the largest driver of future expected returns of a portfolio comes from the high-level decision between growth and defensive assets. If you are more comfortable stopping at that level things will just be fine.

Complexity brings certain benefits but there are also downsides. Complexity requires more monitoring and more rebalancing which has tax implications and requires more effort and time to monitor a portfolio. I am not saying don’t do this. Just be mindful of the implications.

We will address diversification in the security selection portion of the investment strategy. Asset allocation and diversification are different. Asset allocation is about designing a portfolio that suits an investor given return and volatility objectives. The purpose of diversification is to remove single security, sector and asset class risk from a portfolio.

Whichever approach is taken write down your asset allocation.

My asset allocation 

Mine is pretty simple – I want 90% of my assets in growth assets and 10% in defensive assets. I’m not personally overly concerned about allocations below the high level grouping of defensive and growth assets but there are specific reasons for this based on my goal of generating passive income. More to come.

Determine your edge

At this point the foundation of an investment strategy is complete. The approach and asset allocation target will guide the criteria to select investment. But there is one important step that needs to be completed first.

The debate between active vs. passive is ongoing. The active camp believes that certain investment professionals can beat the index by picking individual investments. The passive camp believes that when fees and tax efficiency are considered it is rare to outperform the index.

It is an interesting debate and may have implications on your investment approach. But it is not the debate an individual investor needs to have. Our job is not to beat an index. Even if it was which index would we pick that represents a widely diversified portfolio? Our job is to achieve our goals. And those goals differ.

The question an individual investor should consider is what source of investing edge will help to achieve a specific goal. An investing edge can be thought of as your competitive advantage as an investor. There are four sources of edge an investor can have:

Informational edge: Informational edge is knowing more information about a particular investment than most other investors. Having unique information enables better investing decisions. This is very different than being an informed investor. There are lots of informed investors. This edge is very hard to obtain legally without getting into insider trading. It is very unlikely that anyone reading this has an informational advantage.

Analytical edge: In this case an investor has the same information as other investors but does a better job drawing conclusions from that information. This is very hard to do. Remember that you are not competing against your halfwit neighbour. You are competing against teams of highly educated and well paid professional investors who spend all day analysing investments.

Behavioural edge: Successful investing is not just an intellectual exercise. It also involves holding emotions at bay when making decisions on when to buy and sell different investments. There are countless behavioural impediments to successful investing. Despite the challenges in overcoming our ingrained biases this is a source of edge that any investor can have. Providing structure around decision making is a good start – hence the need to document your investment strategy.

Structural edge: Structural edge refers to external factors that influence the way an investor acts. This is largely an issue for professional investors. There are lots of factors that influence professionals – career considerations, dealing with investor inflows and outflows and pressure to not let short-term performance dip below an index. Not of these issues impact an individual investor. This allows us to focus on the long-term and our individual objectives. Despite a lack of external factors influencing investment decisions most individual investors remain short-term focused. This another source of edge that any non-professional investors can and should use to their advantage.

Identify and write down the sources of edge that you believe you have and what you need to do to take advantage of that edge. If you’ve read through the list of sources of edge and you don’t believe any of them apply that is perfectly fine. In that case it would be best to invest passively. Buying an index and regularly contributing to your portfolio is a great way to build long-term wealth. The key here is consistency. If the market goes up or it goes down continue to dollar cost average into your portfolio. Just stick to your plan.

My edge

I personally believe that I have behavioural and structural edge. I believe I can take advantage of those sources of edge by finding great companies with long-term competitive advantages and buying them when valuations are attractive. I want to hold them for long-periods of time which provides the opportunity for dividend growth which will increase my passive income. In order to achieve my edge I need a structured approach to my investment process to minimise the role my emotions play when I invest.

Conclusion

The first three steps of my investment strategy are complete. I have established a foundation to define my security selection criteria and to establish a set of rules governing when and under what circumstances I will make changes to my portfolio. I will cover those steps in part 2 of this article.

In summary:

I will build passive income in my non-retirement accounts over the next 11 years. To achieve my goal I will purchase income producing assets that provide a stable and growing income stream.

I will allocate 90% of my portfolio to growth assets and 10% to defensive assets.

My competitive advantage stems from behavioural and structural edge. Taking advantage of these sources of edge requires a focus on finding great dividend paying companies with long-term competitive advantages. I will purchase investments at attractive valuations and hold them for the long-term to take advantage of dividend growth. Structured decision making is the key to my success and to take advantage of my sources of edge.


I want to know about your investment strategy. If you are willing to share please email mark.lamonica1@morningstar.com