The investment strategy is the cornerstone of any asset management process. The name speaks for itself, every investment activity is a process: it is a set of activities assembled logically and coherently with the purpose of achieving a goal.
So, intuitively, the first step to make the investment strategy is to establish a goal, an investment objective. The easiest way is by answering the following question:
Why do I want to invest?
I might want to invest to buy a car in the future, to travel all around the world, to buy an asset, for my retirement, for my great-grandchildren… anything goes. It is vital to have a clear objective in mind during the investment process.
Once I have established an investment objective, I need to define a quantifiable method to measure our progress and to manage our risks:
What´s the return that I need and how long should it take me to achieve my goal; how much risk can I tolerate?
Risk is directly linked to return: with an increase in risk the potential return increases. Because risk is a measurement of dispersion of returns, to increase our potential return we have to increase the dispersion of them… there is no other way (if I want a return of 5% in one period but the dispersion of the returns is 1% or less 100% of the time on that period there is no way of achieving the desired return).
The investment restrictions are born from the investment goal and risk preferences. For example, if my investment objective is to save for my retirement and I am close to retire, investing heavily on stocks (which are a riskier kind of assets compared to bonds, for example) might not be a good idea. On the other hand, if my investment objective is to have enough money to buy a Ferrari 275 GTB/4 Berlinetta in 60 years and I have a decent job, I will need to invest on riskier assets to achieve a greater expected return on the long run.
We can make a more concrete example:
If my goal is to have $3,000,000 in 5 years (time: first restriction) and I can only invest $30,000 each month (monthly availability: second restriction), I would require an interest rate of 19%… that’s a lot. Compare it to the 5-year T-Bill that pays 1.8% (in USD), or the 5-year Mexican government bond with a rete of 6.77% (in MXN), or even the 6.67% the 10-year Greek bond (in EUR). Even comparing it with equities: the 5-year return of the S&P500 was 14.4% (in USD), of the Mexican Stock Exchange was 5.9% (in MXN), and of the EuroStoxx 50 return during the last 5 years was 9.82% (in EUR). If I don’t want to invest in an obscure asset, like the Pakistani Karachi100 (+29.8% in the last 5 years in Pakistani Rupee), what can I do to achieve my goal? One way is to change the objective… realize it’s not achievable under current circumstances. Another solution is to change my restrictions: I can invest more money, I can invest for a longer period of time, or both.
For example: if I decide to change my investment objective and increase in 40%, 2 more years from 5 to 7, the time I am willing to invest I only need a return of 4.91% to get the $3,000,000. If I can invest 50% more each month, from $30k to $45k, I only require a return of 4.22% to get the $3,000,000.
Now we can make a more realistic example:
I know something about REITS and I will like to live from my investment in those assets. I know the risks (my investment constrains) and characteristics of the REITS and I am willing to accept those parameters. Also, I have a stable job and I think I can stay here at least 5 more years. Then, I could live with 2 times the minimum wage of my region which is $5,274, adjusted for inflation. So my objective is to have $1,000,000 worth of REITS in 5 years that will give me a cash flow of $5,274 each month and the risks I am willing to take are those inherent to REITS.
Those are some simple examples that will help in the establishment of the investment strategy. In conclusion, I need to have a goal (why do I want to invest?) and some way to measure how am I going to accomplish it (how long should I invest? what return do II need? what risks am I willing to take?).
Whats next? We need to define our investment policies. If I know my performance and the risks I am exposed to, I can make changes in my investment strategy to achieve my goal in the most efficient way. The investment policies:
1) Will help me measure my performance. Am I doing well? How well or how bad? How often am I going to review my performance?
2) Are going to help me to keep track of the risks. How will I measure the risks? How often will I measure the risks?
3) Will have my investment strategy. My investment strategy will dictate where am I going to invest, what kind of assets am I going to buy, how long am I going to keep an asset, etc.
What characterizes a good asset manager is the discipline it has while following the investment policies.
So… how can we create those investment policies? Next Chapter >>