5 steps to create an investment strategy

In part one and two of this article, I outlined the first four steps of the five-step process to create an investment strategy.

Read part one here.
Read part two here.

An investment strategy reduces behavioural risk – the risk of bad decisions – and helps to align a goal to the individual investments that are purchased and sold in your portfolio.

Creating an investment strategy requires some time and thought but makes managing a portfolio significantly easier. As a reminder the steps needed to create an investment strategy are the following:

Define your high level approach
Set your asset allocation
Determine your edge
Identify security selection criteria
Establish the basis for making changes to your portfolio

This article will cover step 5.

An example of an investment strategy

I’ve used my own investment strategy as an example to bring the process to life. My strategy is only applicable to my own circumstances. After going through the first four steps this is where I stand:

I will build passive income in my non-retirement accounts by 2035. 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 will invest in individual shares, ETFs and funds. I will avoid actively managed ETFs and funds and any that are likely to generate high levels of capital gains due to index construction and rebalancing policies.

I will invest in dividend paying shares and ETFs and funds that hold dividend paying shares.

I will focus on investments in high quality, non-cyclical companies with moats, strong finances, low business risk and acceptable payout ratios. My goal is for the yield of my overall portfolio to exceed the global market but more importantly I want growth in dividends so I will balance higher current dividend yields and income growth in individual holdings.

Step 5: Establish the basis for making changes to your portfolio

As previously stated, an Investment Strategy provides a framework to make investing decisions to ensure alignment with what an investor is ultimately trying to accomplish. The point of the exercise is to minimise mistakes.

The genesis of investment mistakes is a lack of understanding about what an investor is trying to accomplish and how to achieve a specific goal. The manifestation of those mistakes occurs in purchasing the wrong investments in the first place and constantly switching holdings in a portfolio.

Setting criteria for making changes to a portfolio provides an investor with structure to make rational decisions around portfolio turnover.

There are three broad categories that would cause an investor to make changes to a portfolio:

Rebalancing
An investment no longer meets the original thesis
A change in the investor’s circumstances

I will walk through each of those categories in detail. However, it is worth starting with a trap that many investors fall into and the main cause of chronic overtrading. That is the believe that there is a better opportunity than a current holding.

On surface this rationale seems logical. If an investor believes one investment will perform better in the future, then logic dictates it should be purchased with the proceeds from selling a current holding. When tempted to make this trade it is worth thinking long and hard about the merits of this decision.

Many investors are simply extrapolating the short-term outperformance of the new investment opportunity into the future. Some are seduced by a compelling narrative. Throughout time investors have chased performance. It often leads to poor outcomes.

The folly of this thinking is captured in Ben Graham’s parable of Mr. Market. Investors are overly fixated on price changes. This makes it easy to conflate price with value. Short-term price movements are often divorced from the long-term prospects of a company. They are emotional reactions to new data that is inconsequential over the long run. If an investor is focused on behavioural and / or structural edge it makes no sense to follow the herd.

If an investor is focused on informational or analytical edge it is worth remembering that what matters is after-tax outcomes and that transaction fees detract from returns. That means that the new investment must exceed what was sold by the transaction costs and taxes just to breakeven.

It is also likely that an investor will mis-judge the relative merits of a new investment in relation to a current holding. Morningstar has estimated in our annual Mind the Gap Study that investor returns are 1.7% less a year than the actual returns of the underlying investments – that shortfall is based on poor timing decisions.

This is far from the only study showing the downside of this approach. Between 1991 and 1996 the individual investors that traded the most earned an annual return that was 6.5% lower than the overall share market according to a paper by University of California professors Barber and Odean.

If you trade frequently in an attempt to be nimble and always own the ‘best’ investments I have news for you. Chances are you would have more money today if you traded less. Reducing the number of trades going forward means you will likely have more money in the future.

Reasons to make changes to a portfolio

Rebalancing

There are times when a portfolio needs to be adjusted. If the allocation to an asset class grows or shrinks on a relative basis the overall asset allocation may not align with the target. Large differences can make it harder to achieve a specific goal. A portfolio may also need to be adjusted if a single position becomes prohibitively large. If that position falls significantly, it could prevent you from achieving your goal.

We’ve already documented our asset allocation target in step 2 of the strategy. At this stage we need to document how large a single position can grow before a change is made.

We diversify to reduce security specific risk in our portfolio. That is the risk that something goes wrong with a particular company we own. How much we diversify away that security specific risk is up to each investor.

We could diversify it all away by owning an index fund that includes every share. We could diversify some of it by owning two companies. Each individual share you add to your portfolio will move your security specific risk along the spectrum from putting all your eggs in one basket and owning the entire market. Owning the whole market or every share available means you are just exposed to market risk. And you will get the market return. You are now a passive investor.

For more on diversification see this article.

In my case I don’t want a single share to exceed 5% of the market value in my portfolio and I don’t want a single share to exceed 5% of my total income. For a well-diversified ETF, I will tolerate a much larger position size and percent of income. This is a judgement call on how large an ETF position can grow before it is too big and is based on the specific ETF. I’m more comfortable with larger positions in a broadly diversified ETF than a narrowly focused ETF.

It is important to determine the rules about position sizing and what to do if a position gets too big. I try not to sell if I can help it. My first step is to turn off the dividend reinvestment if a single security or asset class is approaching my limit. I also re-direct new savings into under represented asset classes and holdings. Only as a last resort will I sell off part of a position. My hesitancy in selling is based on my goal of avoiding taxes and transaction fees.

An investment no longer meets the original thesis

In part 4 of the strategy we outlined the selection criteria used to pick individual holdings for a portfolio. The reasons why a particular holding meets those criteria and is purchased is your thesis. In my case I will focus on investments in high quality, non-cyclical companies with moats, strong finances, low business risk and acceptable payout ratios.

I hope that every investment I pick meets those characteristics at the time of purchase and well into the future. That is unrealistic. Conditions change and companies change. This occurs far less frequently than popularly portrayed. But it does happen.

If a company no longer meets my criteria it may be time to consider replacing it with something that does. However, just as I would never buy a company that only had a single good quarter or year, I would never sell a company that goes through a rough patch. Patience is key.

Investor circumstances change

Over time an investor’s circumstances may change. This is natural as an investor ages and / or approaches a goal. This may be a time that an investor would reconsider holdings in a portfolio. When this happens the best thing to do is go back to the beginning are refine the strategy. That way each part of an investment strategy remains aligned.

My approach

I do not want a single share to represent more than 5% of my portfolio from both a market value and percent of income basis. For an ETF I will set limits based on how broadly the ETF is diversified.

I will examine my allocation to growth and defensive assets on an annual basis and will consider making a change if the allocation is 5% above or below my target. I will allocated more to defensive assets if I cannot find investments that meet my criteria.

I will try to avoid rebalancing by selling a position and will only do so once if I cannot adjust my portfolio by redirecting dividends and new savings.

I will change individual holdings if they have demonstrated conclusively they no longer fit my original thesis and my security selection criteria.

Conclusion

This brings our long journey to an end. We’ve now defined an investment strategy. I’ve used a personal example because it brings the process to life. I hope that has helped. The strategy is relatively short but there are lots of points I considered as I made each decision and tried to capture those trade-offs in this series of articles.

If you are defining your own investment strategy please remember this doesn’t need to be an exercise that is completed in one sitting. There are lots of things to think about. This is also a living and breathing document which can refined over time as you gain more experience and knowledge. Make sure you review your strategy periodically.

And if this seems like too much effort you can always take-up day trading. Stare at charts until the future direction of the price line becomes obvious. Admonish yourself that the trend is your friend. And don’t forget to tell me I’m wrong about overtrading as you sip cocktails on the deck of your yacht. You can write me at mark.lamonica1@morningstar.com

Below is my complete investment strategy: