The 7 Benefits of an Investment Process
In his famous quote on Mental Models, Charlie Munger noted,
“Well, the first rule is that you can’t really know anything if you just remember isolated facts and try and bang ‘em back. If the facts don’t hang together on a latticework of theory, you don’t have them in a usable form.
You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You’ve got to hang experience on a latticework of models in your head.”
For investors, an Investment Process offers a framework to organise your investment knowledge on the way to profitable ideas. Like a football scoreboard that is the outcome of a disciplined training regime, consistently good investment ideas flow from having a well designed and consistently applied Investment Process.
(Investors can learn more about getting started in Why Most Investors Fail: Don’t Make The Same Mistake)
A well-designed and consistently applied investment process brings the following benefits:
1. Focus on what drives your investments
Building a process forces the investor to start asking explicit questions.
Importantly, this turns the investor from a passive recipient of information into an active seeker of knowledge. Company presentations and broker research are carefully framed to promote a certain view of a company. Having defined questions that represent what is important to you provides a way to circumvent this framing of information to find alternative explanations and viewpoints.
2. Form a balanced view of a company
The market is rarely so inefficient that everything about a company is either good or bad. Even where all the business attributes are excellent – valuation is likely to be less so. Despite this, most commentary aims to distill this complexity into simple buy/sell formulas. A better approach is to consider the positives and negatives holistically. The positive aspects can suggest what type of investment returns may be on offer, and the negatives can help infer how much risk you might be taking if you make that investment.
A good process helps investors develop what Scott Fitzgerald called a first rate intelligence:
“the ability to hold two opposing ideas in mind at the same time and still retain the ability to function.”
3. Incorporate change into your investment process
The one constant of financial markets is change. In our view, there are three main things that change – share prices, company fundamentals and investor preferences. Humans are notoriously bad at changing opinions, usually searching for information that confirms existing beliefs rather than challenging them.
A well designed process forces investors to focus on change. Good things turn bad (most commonly valuation) and bad things turn good (e.g. balance sheet repair post capital raise). A process that successfully monitors these changes provides the opportunity to respond to them ahead of the market.
4. It helps you turn over more rocks
Successful investing involves the paradox of working hard to find information whilst simultaneously doing nothing. In mostly efficient markets, most ideas will be average. A defined process can quickly screen out unproductive ideas. This frees up time to turn over more rocks in the hope of finding that rare gem.
5. A repository for knowledge
In investing, compounding knowledge provides both context for the next piece of information and the ability to connect seemingly unconnected dots.
A defined investment process provides structure for storing this knowledge. It frees up time by reducing repetition, and sows the seeds for cross fertilization of ideas. In this scenario information grows linearly, but knowledge compounds.
6. Counteract your emotions
All investors experience emotion. The exuberance of a winner, the anger of a loser, or most dangerous of all, the fear of uncertainty. Avoiding emotion is almost impossible – but with a sound process, you can limit your reaction to it.
Your process provides a neutral voice reminding you of your thoughts from a different emotional state. It can reduce fear when things are going against you, and elation when riding high. A good process can stop you making obvious mistakes.
7. Understand upside and downside
Buffet famously notes that “when it’s raining gold, reach for a bucket, not a thimble”. Your process should give some indications of what size bucket is required. Great valuation without support from other factors might warrant some caution. But if all your investment factors suggest it looks, sounds and feels like a gold bar falling, then grab a big bucket.
Whilst buckets of gold are good, we never know the future with precision. Enthusiasm for individual ideas must be tempered by portfolio considerations. Again, your process can help, by highlighting aggregate exposures to specific factors such as leverage.
An Investment process has clear benefits:
Focus on what drives an investment, make a balanced decision, incorporate change, turn over more rocks, store your knowledge, counteract your emotions, and understand upside and downside. We built Blocks to do all of these things – to make it easier for you to build your own Investment process and make better decisions.
In our next post we will talk about the key considerations in designing an effective investment process. Between now and then, make a start on your own investment process by signing up for a free Blocks account today.