Seven Steps That’ll Have You Investing Like A Pro

Seven Steps That’ll Have You Investing Like A Pro
Stéphane Renevier, CFA

about 1 year ago7 mins

  • The best fund managers have a tried-and-tested investment process, and you can have one too. Start by carefully articulating what your investing objectives and your constraints are.

  • Then, set a clear process on how to generate investment ideas, how to analyze them, and how to implement them.

  • Finally, decide how you’ll manage your portfolio, how you’ll track and analyze your performance, and how you’ll improve your process.

The best fund managers have a tried-and-tested investment process, and you can have one too. Start by carefully articulating what your investing objectives and your constraints are.

Then, set a clear process on how to generate investment ideas, how to analyze them, and how to implement them.

Finally, decide how you’ll manage your portfolio, how you’ll track and analyze your performance, and how you’ll improve your process.

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When you manage a fund, the first thing prospective investors want to know is how you generate your returns. Historical performance is important, sure, but even more vital is your investment process: how you go from idea to implementation, and how you manage it all. See, luck can influence short-term performance, but it’s the strength of the investment process that determines long-term investing success. That’s true with your own investments too. So here are seven things to think about as you create or refine your process.

Overview of an investment process. Sources: Finimize, InvestInU Academy.
Overview of an investment process. Sources: Finimize, InvestInU Academy.

1. What are your objectives and constraints?

Being crystal clear on your objectives and constraints is the first defense against your own psychology and the market’s volatility. So take a beat and answer the following questions:

Objectives:

  • What is your real time horizon?
  • What reasonable range of returns are you targeting?
  • Will you invest passively, actively, or both?

Constraints:

  • What assets and products should you just leave out?
  • Realistically, what’s the maximum loss you can tolerate?
  • Can you feasibly beat the market over the long term (i.e. do you have a proven edge?)
  • How much time can you actually dedicate to investing?

If you’ve got more than one objective – say you want to invest for the long-term but also want to practice investing more actively – then make sure you treat each approach separately. For instance, you may aim to achieve 7% returns per year over the next two decades by investing passively in your primary portfolio, and aim to generate 15% this year alone by actively picking stocks in a second, smaller portfolio. The latter is more difficult and riskier, so you should expect larger potential losses and plan to devote more time to it.

2. How will you generate investment ideas?

Where will most of your ideas come from? Your personal observations? Finimize? A screening tool? The clearer you are about how you’ll generate ideas, the more ideas you’ll be able to generate, and the higher their quality.

If you’re unsure where to start, here are two different approaches (I covered this in more detail here):

  • Top-down: You kick off with a high-level theme and identify which assets or stocks it might benefit most. For example, you may think that inflation will remain higher than usual over the next few years. In that case, you might consider assets that typically thrive in higher inflation environments, like real estate, commodities, or energy stocks.
  • Bottom-up: You identify the attributes of a successful opportunity by zooming into each investment. For instance, if you’re a value investor, you might look at price-to-earnings, or assess the quality of a company’s earnings. It doesn’t have to be based solely on fundamentals: you can also generate ideas by looking at technical factors like a strong uptick in insider buying, extremely low investor positioning, or even chart patterns like a “cup-and-handle” formation. A tool like Finviz is a great starting point to test out this approach.

Don’t be afraid to experiment with both approaches. But don’t forget your #1: make sure your ideas are in line with your objectives and constraints.

3. How will you analyze your ideas?

Now that you’ve got a few interesting ideas, how will you decide which ones warrant a deeper look – and a place in your portfolio?

As I explained here, you might want to check things like:

  • The price action over the past five years
  • The narrative around the investment
  • The key characteristics of the industry (or asset class, style, or region if it’s not a stock)
  • The growth, value, and quality characteristics of your investment
  • The technicals (positioning, technical indicators, etc.)
  • The main macroeconomic drivers

What you decide to focus on depends on your skills, interests, and investment style. Whatever you choose, you’ll know you’re on the right track if you can explain your thesis in three key points, and understand the counter-arguments and risks.

4. How will you implement your ideas?

This is perhaps the most underrated part of the process. Two things really drive your profits and losses: how often you’re right (i.e. your “hit rate”) and how much money you make when you’re right versus how much you lose when you’re wrong (your gain/loss asymmetry). To be successful, you don’t need to achieve a really high hit rate. If your average gain is twice as big as your average loss, you can be right slightly less than 50% of the time and still generate high returns. How you implement your trades will drive much of your gain/loss asymmetry, so pay close attention to this part.

In practice, it means you should figure out:

  • What’s the best expression of your idea? (Should you invest in a sector ETF, for example, or buy your highest conviction stock? Or is a call option on the stock a better play?)
  • How can you minimize your costs? Here, you’ll want to consider your direct costs, but also indirect ones, like paying the dividend yield and the financing cost if you short the S&P 500.
  • When should you buy? Will you wait for a certain price or technical indicator?
  • When will you increase or decrease your position, and when will you sell?

By defining a few guidelines around all these elements – and maybe even creating a checklist – you’ll be in a better position to boost the size of your gains and reduce the size of your losses. The best investors have a process to constantly maximize their risk/reward.

5. How will you construct and manage your portfolio?

One of the most important decisions you’ll face is how much to allocate to each position. For instance, should you allocate more to a trade if you have a higher conviction on it? Should you allocate more when you’ve got a tight stop-loss? What about if the trade adds diversification benefits to the rest of your portfolio? There are no right or wrong answers. You can try different methods and see what works best for you. If you want to learn more, I wrote about position sizing and asset allocation here and here.

Once you’ve built your portfolio, set some guidelines for when you’ll reassess your positions, when you’ll rebalance them, how you’ll assess the big risks, and how you’ll manage those risks. The clearer your process, the less likely you are to deviate from it at the worst possible time.

6. How will you track your performance?

When you’ve had a gain, was it because you picked the right stocks, or did all stocks go up? If you want to assess how you’re really doing and see what you can do better, you need to look at what’s really driving your returns. You should also be able to calculate your performance in risk-adjusted terms, and have an idea of how well you fared versus your own benchmark. I explained those in more detail here.

If you’re serious about tracking your performance and improving, the best way is to maintain an investment journal, where you write down your thoughts on markets, and on your investment choices (including ideas you considered but decided against).

7. How will you improve your process?

This is perhaps the part that can add the most value over time. You want to constantly analyze how well you’re doing, focusing more on the process than the outcome. By identifying your strengths and weaknesses, you’ll quickly be able to pinpoint what you can do better. If you’ve got the right process, performance will eventually come.

That may seem like a lot to digest, but you can start small. You could isolate just one aspect of the process, give it some thought, and try it in real life, trying to learn from your mistakes. Or you can start with a simple guideline for each step. It might not be simple, but I can guarantee you this: the biggest driver of your long-term investing performance will be the strength of your process, and how well you respect it. I’d say that’s probably worth the cost.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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