Risk comes from not knowing what you’re doing” Warren Buffet, an outstanding long-term investor.
An investment philosophy is a roadmap for your fund. Imagine you are driving without a map or a GPS. All you have are signs that appear from time to time telling you what towns or villages are coming up and how far away they are. You can also use the sun during the day and perhaps some other landmarks to give you a general guide, or you can guess where to go, but most likely you will get lost and end up in the wrong place, or at best, in the right place but late. You really needed a map. That’s essentially what an investment philosophy gives any investor – a map of where you are going and how you plan to get there.
In the same way a map doesn’t predict for unforeseen events, like road closures or bad weather that might take you away from your planned route, an investment philosophy doesn’t predict financial crises, member behaviour, or funding issues, but it can help you develop a response plan if those events occur.
A clearly prepared, well supported investment philosophy can help investors stay on track against a long-term goal, especially when short-term events conspire against you.
Individual investors versus groups of decision makers
Most institutional investors make decisions in some form of group. Boards or investment committees are generally responsible for setting the “big picture” requirements, including investment philosophy and beliefs, asset allocation and related parameters, and so on. Having an investment philosophy when a group makes decisions is particularly important as it creates a centralised point that can be referred to at any time. Of course, long-standing directors are valuable if they can remind others of what was agreed and why, especially when things go “wrong”. However, a clearly written investment philosophy is even more tangible and can act like a true “port in the storm” reminding members why decisions were made and providing them with the direction they need to see a difficult position through. This is not to say any underperforming investment should not be reviewed, or the investment philosophy used as a defence without doing the work, but if the investment case and the future prospects remain sound, then a reference to the investment philosophy is appropriate i.e. it explains “why did we do this in the first place?”
What should an investment philosophy statement look like?
An investment philosophy statement should reflect the kind of investor you are, what you believe in, and how you think you (or those who invest on your behalf) can make money, including the timeframe you believe you need to make that money, and how you believe you will meet your goals. It should be in writing, held somewhere where it is easy to find, and regularly consulted.
It is important an investment philosophy statement is clear and able to be understood by a range of stakeholders. It should contain statements about how you think you will earn returns, how you will manage risk, and the market conditions that do, and just as importantly, do not suit your approach. You may also like to include comments on your philosophy on fees and costs (all eat away at gross returns), your willingness to look at new ideas, and how you will make decisions.
While you can take guidance from other investment philosophy statements, it is critically important to take a bespoke approach, resulting in a tailored philosophy that is right for your fund.
What is the risk of not having a clear investment philosophy?
Without a coherent investment philosophy you face the risk of lacking direction at the times you most need it. Chopping and changing strategies mid-flight in an effort to react on the fly risks locking in poor performance.
It will also expose you to the risks of making investments that don’t really suit your goals, or even falling prey to those in the market who just want to sell you something.
A clear investment philosophy makes you very aware of what you really want to buy and helps you avoid the latest fad or distraction of passing unaligned opportunities.
Fiona Trafford-Walker is director of consulting at Frontier Advisors.