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Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark LaMonica: Okay. So today, Shani, we are going to talk about putting together an investment strategy.

Jayamanne: And we both think that creating an investment strategy is a key component of being a successful investor. And we're going through a three-step process today, Mark.

LaMonica: And this is right up your alley, right, Shani? You love multi-step processes.

Jayamanne: I know. I love ticking the boxes.

LaMonica: Exactly. You're very organized. You're very structured. So, this will be a good one for you. I am not very organized and certainly not structured. But when it comes to investing, I do think it's critically important. We want to make rational decisions as investors. And while being completely rational is impossible, the more structure that we add, the more rational we can be.

Jayamanne: And striving for rationality is to try to limit the impact that emotions have on our investing decisions. Emotions like fear and greed cause investors to make poor decisions that hurt our chances of achieving our goals.

LaMonica: And an investment strategy is simply the plan to achieve your goals. A goal, of course, is where each of us wants to end up. And we did an episode on achieving goals, which we will publish a replay of right after this episode for anyone that wants to reference it. In that episode, we used Shani as an example and walked through her goals for retirement.

Jayamanne: Yeah. So, it is an episode about my retirement goals and what I wanted to have in my superannuation.

LaMonica: Exactly. And personally, I think it was one of our best episodes. We did it a couple of years ago. So maybe we peaked a couple of years ago. But interestingly enough, I was having a conversation with someone the other day that listens to the podcast who said that it was her favorite episode too. So, I'm not the only one with that opinion.

Jayamanne: Well, there you go. So, I guess we're posting it after this episode. It's called "Constructing a Portfolio."

LaMonica: So, there is a reason that we're talking about goal setting and referencing that episode, and that's because goal setting and an investment strategy go hand in hand. A goal is where you end up and a strategy is how you get there. So, they're intertwined. So, before you sit down and define your investment strategy, make sure you have a goal – that is how much money you need, when you need it and what return you need and how much you need to save in order to achieve it.

Jayamanne: So, assuming you have a goal, an overall investment plan and asset allocation target, we're going to go through a three-step process to determine your edge, identify a security selection criteria and establish the basis for making changes to your portfolio. And as a special treat, we're going to bring this to life using Mark as an example.

LaMonica: Well, lucky me. So, let's not dwell on that. And why don't we just jump into the first step, Shani?

Jayamanne: Okay. So first, we need to hear your goal to frame the conversation.

LaMonica: Okay. Well, it's pretty straightforward and something people have probably heard before on this podcast. My goal is to build passive income in my non-retirement accounts. I do have a specific target in mind that I would like to achieve in 11 years. So, to achieve my goal, I want to purchase income-producing assets that provide a stable and growing income stream. I want 90% of my assets in growth and 10% in defensive assets. I'm not personally overly concerned about allocations below that high level grouping of defensive and growth assets. But there are some specific reasons for this based on my goal of generating passive income. So more to come on that as we go through this process.

Jayamanne: All right. So that's good. Now we can move on to determining your edge.

LaMonica: An edge is definitely a bit of finance jargon, which I think it's fair to say we both hate Shani, but it is an important step. 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. So, there are four sources of edge an investor can have.

Jayamanne: And the first is 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's very unlikely that anyone listening to this has an informational edge.

LaMonica: The second is analytical edge. In this case, an investor has the same information as other investors but does a better job drawing conclusions from that information. So, this is very hard to do. Remember that you are not competing against your half-wit neighbor. You're competing against teams of highly educated and well-paid professional investors who spend all day analyzing investments.

Jayamanne: Then we have behavioral 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 behavioral impediments to successful investing. Despite the challenges in overcoming our ingrained biases, this is a source of edge that an investor can have. Providing structure around decision-making is a good start, hence the need to document your investment strategy.

LaMonica: And finally, we have 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 performance dip below an index. None 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 is another source of edge that any non-professional investor can and should use to their advantage.

Jayamanne: So, 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 listened through the list of sources of edge and you don't believe any of them apply, that's also fine. In that case, it would be best to invest passively. Buy an index and regularly contribute to your portfolio, and that's 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, but just stick to your plan.

LaMonica: And this is an area where an example really brings this concept to life. I personally believe that I have behavioral 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 minimize the role my emotions play when I invest. And that will of course inform what kind of securities I pick for my portfolio.

Jayamanne: And that brings us to identifying security selection criteria. And this is likely the most time-consuming step of crafting a strategy, but also one where you can add a lot of value.

LaMonica: And investors are confronted with a vast array of choice. There are thousands of global publicly listed shares and ETFs. Australian investors can choose from 12,000 managed funds. Publicly listed companies range from giant multinationals to small locally focused businesses. ETFs and funds cover broad indexes, niche thematics. They follow countless investment strategies and can be actively and passively managed.

Jayamanne: And this abundance of choice creates challenges for investors. Some investors suffer from analysis paralysis and struggle to pull the trigger on an investment.

LaMonica: And ironically, knowing more about investing does not make this process any easier. People that are new to investing may feel overwhelmed by the seeming complexity of investment options. Experienced investors can feel equally overwhelmed by the potential flaws in each option.

Jayamanne: Investors that make the leap and buy something can suffer buyer's remorse and get tempted by alternate choices. This temptation is exacerbated by the fear of missing out when faced with constant commentary on the merits of different strategies, markets and individual securities. This contributes to the constant churning of investor portfolios.

LaMonica: And defining your security selection criteria narrows the field and creates a more concentrated list of options. It also lessens the temptation to change investment approaches by maintaining the connection between a goal-aligned investment strategy and portfolio holdings.

Jayamanne: An investor may have different security selection criteria for different asset classes. This can be based on several factors. An example is that an investor may want to invest in individual companies for Australian shares given familiarity with the local market and the ease of trading. For emerging markets, the same investor may want to use an ETF or fund because the markets are less familiar and it's very difficult to buy direct shares.

LaMonica: If you are new to investing, this may be challenging. It takes time and some knowledge to align a goal to the criteria used to select investments. More than anything, it requires thinking. So, my suggestion is to get something on paper and refine it over time as you gain more experience and have a chance to clarify your thoughts.

Jayamanne: When defining your investment selection criteria, start with the types of investment vehicles given your sources of edge. If you found it challenging to articulate how you expected to do better than the average investor, it might be a sign that you should just get some help in managing your portfolio or stick to passive investing. No edge means no individual shares. It means no thematics or factor ETFs. Just make sure you get exposure to the market or the part of the market that adheres to your investment approach and earn the average or index return. There's no shame in this approach. Focus on saving money and let the index do its job. This is a very effective approach to build wealth, as we mentioned previously.

LaMonica: If you believe that you have informational or analytical edge, it's worth considering where this plays out. Do you believe it will allow you to pick the right companies that provide you with the best opportunity to achieve your goals? Then the focus should be on purchasing individual shares. Do you believe it allows you to identify asset classes or pockets of the market that are undervalued? That opens up the investment universe to individual shares and index tracking funds or ETFs. The key is simply directing funds into the attractive opportunities and avoiding unattractive parts of the market.

Jayamanne: Do you believe you can pick the right managers that will enable you to achieve your goal? That means finding active fund or ETFs with talented managers.

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LaMonica: It is worth noting once again that it is extremely difficult for any individual investor to maintain long-term informational and analytical edge. So, let's turn to the two sources of edge that I believe all individual investors can take advantage of. If you believe you have behavioral or structural edge, the key is discipline. Any type of investment can be used, but making good decisions is paramount. Ensure that structures are in place to enable rational assessments of opportunities while eliminating or minimizing emotional reactions to volatility. Part of that is what we are talking about today. Have a goal and have a strategy to achieve that goal.

Jayamanne: That's the first step of defining your investment selection criteria, identifying the types of investments that you will use. So, Mark, where do you stand on this point?

LaMonica: Okay. Well, given the two sources of edge I identified, I will invest in funds, ETFs, and individual shares. However, I will avoid active funds and ETFs. My decision is to avoid active management in the portion of my portfolio aligned to my goal of generating passive income. To buy an active product is to outsource decision-making without knowing what the manager is buying or selling or why, thanks to Australia's antiquated and ridiculous regulations that don't force full disclosure of holdings.

Structural edge is something that impacts the average active manager, which is one reason for high turnover in those funds. And this is a generalization. However, active managers also charge higher fees, which attract from the income generated and generate poor tax outcomes when compared to passive products, which is also a bit of a generalization. But without full disclosure of holdings, it is very hard for me to find the managers that are adhering to my standards. When combined with the fact that most active managers underperform, it's enough for me to exclude active management. And people may disagree with this decision, and I'm okay with that, as I don't believe this decision impacts my ability to achieve my goals.

Jayamanne: The next step in defining your investment selection criteria is how personal circumstances influence investment selection. Personal circumstances play a role in transaction cost and tax implications. Everyone's goals should be to minimize their impact on returns. For super investors in the pension phase, taxes can be ignored. Investors in lower marginal tax brackets or in super during the accumulation phase, they shouldn't be moderately concerned with minimizing taxes. For investors with money outside of super in high marginal tax brackets, minimizing taxes is paramount.

LaMonica: Investor behavior has an influence on returns. Holding investments for longer than a year is better than short-term holding periods. The type of investment also matters. Both ETFs and funds distribute capital gains to investors when they occur. In general, an actively managed ETF or fund will generate more capital gains than passive products. Some thematic or factor ETFs have high turnover due to rebalancing. It's important to understand how this works. The advantage of holding individual shares is that the investor gets to choose when capital gains are realized. You don't sell, you won't pay capital gains taxes.

Jayamanne: Transaction costs are dependent on an investor's broker. Some brokers have low or no transaction costs. Transaction costs are also impacted by investor behavior. Less trading means less transaction costs. For investor that is saving and investing continually with a high-cost broker, transaction costs may play a role in the type of investment picked. Funds do not have transaction costs and savings plans may have lower investment limits.

LaMonica: Personally, I trade infrequently and have a low-cost broker. However, my income goals for accounts that sit outside of super, I have to pay the marginal tax rate on capital gains and dividends. Can't avoid taxes on income, but I do spend my income, so that is just the cost of earning money. I want to avoid capital gains. This is another reason I want to avoid actively managed funds and ETFs and I make sure that rebalancing policies are sensible. My individual share investments rarely generate capital gains given the low turnover of my portfolio. Fact that I don't trade a lot and have a low-cost broker means that transaction costs do not play a role in the vehicles I select.

Jayamanne: Now we need the criteria to pick each investment. This aligns with your goal and in your case, as we've discussed, you're trying to generate income for your portfolio.

LaMonica: That's right. I'm interested in generating a sustainable and growing income stream, and we can break down each of these components of my investment approach. So, income part, that's pretty simple. I want investments that generate income. This eliminates anything that doesn't generate income. The yield of my portfolio should be higher than the overall market. If not, I would just buy the index.

Sustainability. So, sustainability of income is more complicated. We can walk through some specific attributes. I don't want a company whose earnings could fall significantly because they may not be able to maintain a dividend. That eliminates cyclical companies and companies that do not have moats and may succumb to competition over time. I want companies with medium or low uncertainty rating. The Morningstar uncertainty rating assesses financial strength and business risk. Strong finances and low business risk are both positively correlated with a company's ability to maintain dividends over time. I also want a lower payout rate, which represents the amount of earnings paid out in dividends. I avoid excessively high payout rates that approach 100%. A high payout rate means that a drop in earnings could put the dividend in jeopardy as earnings may not be able to cover the payments to investors. I tend to buy larger companies that are well established with a diverse set of products and services. This provides more predictability of future outcomes. And then finally, growth. Companies with growing dividends also need to grow earnings. It is impossible to predict the future, but moats or sustainable competitive advantages play a role here. Holding competition at bay gives the company the ability to protect market share.

Some of these attributes are conflicting. For example, it's hard to generate income at a higher rate than the market and also grow that income significantly. That isn't a problem. I can create a mix of different investments in a portfolio, some with high current income and some with higher potential for growth. For funds and ETFs, I'm avoiding actively managed products, but fortunately my strategy is not unique. There are many factor ETFs and funds that track indexes that use rules to try and identify sustainable and growing dividends. Comparing the rules to my criteria allows me to assess an ETF or funds.

Jayamanne: Now that we have criteria for selecting investments, we can define the basis for making changes to your portfolio. 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 minimize mistakes. The reason we make investment mistakes is a lack of understanding about what we're trying to accomplish and how to achieve a specific goal. The manifestation of those mistakes is purchasing the wrong investments in the first place and constantly switching holdings in a portfolio.

LaMonica: And 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. That's rebalancing, an investment that no longer meets the original thesis, and a change in investor circumstances.

Jayamanne: We'll walk through those, but it's important to address a trap that many investors fall into. That's a belief that there is a better opportunity than a current holding. On surface, this rationale seems logical. If you believe one investment will perform better in the future, then logic dictates that it should be purchased with the proceeds from selling a current holding. When you're tempted to make this trade, it's worth thinking long and hard about the merits of this decision.

LaMonica: 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. When investors focus on informational or analytical edge, it's worth remembering that what matters is after-tax outcomes, and that transaction fees and taxes detract from returns. That means that the new investment must exceed what was sold by the transaction costs and taxes just to break even.

Jayamanne: If you trade frequently in an attempt to be nimble and always own the best investments, 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.

LaMonica: All right. So, Shani, let's go through the actual reasons to make changes to your portfolio. The two obvious ones are if your personal circumstances change or your goals change, and if an investment no longer meets your criteria. If your circumstances change, start this process over by redefining your goal.

Jayamanne: And if an investment no longer meets your criteria, it might be time to switch investments. But where we really want to spend time is on rebalancing. That, of course, can happen if an allocation to a specific asset class changes. But this is where we want to focus on diversification.

LaMonica: We diversify to reduce security-specific risk in our portfolio. That is a 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.

Jayamanne: 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're just exposed to market risk, and you'll get the market return. You're now a passive investor.

LaMonica: 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 the total income generated from my portfolio. For a well-diversified ETF, I'll tolerate a much larger position size and percentage of income. And this is a judgment call on how large an ETF position can grow before it's 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.

Jayamanne: It's important to determine the rules about position sizing and what to do if a position gets too big. Try not to sell if you can help it. Turn off the dividend reinvestment if a single security or asset class is approaching your limit. Redirect new savings into underrepresented asset classes and holdings. Only as a last resort should you sell off part of your position. Because selling means taxes and transaction fees. So, Mark, what is your approach?

LaMonica: Okay. So, as I said, I don't want a single share to represent more than 5% of my portfolio, both from a market value and income basis. And also, as I said, with an ETF, the limits will be based on how broadly that ETF is diversified. I will examine my allocation to growth in defensive assets on an annual basis and will consider making a change if the allocation is 5% above or below my target. So, I will allocate more to defensive assets if I can't find any investments that meet my criteria. As Shani just discussed, I try to avoid rebalancing by selling a position and will only do so if I can't adjust my portfolio by redirecting dividends in new savings. I will change individual holdings if they have demonstrated conclusively that they no longer fit my original thesis and my security selection criteria which I outlined above.

Jayamanne: All right. So, this brings our very long journey to an end. We've now defined an investment strategy, and hopefully Mark's example is helpful. A strategy is ultimately quite short, but there are a lot of points to consider and trade-offs to be made.

LaMonica: If you're 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 be refined over time as you gain more experience and knowledge. Just make sure that you review your strategy periodically.

All right. So, Shani, that was old school because it was very long.

Jayamanne: It was very long.

LaMonica: Like some of our original ones.

Jayamanne: I was finding it very hard towards the end.

LaMonica: Yeah, imagine the people listening to it. But if you've made it to the end, thank you very much. We really appreciate it. And as always, you can send any comments, questions to me. My email address is in the show notes, and we would love a rating in your podcast app.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)