Tuesday, January 27, 2015

What are the first principles in Investing ?

The awesome thing about the finance blogosphere in Singapore is that bloggers can build on each other's ideas.

BigFatPurse has put up a really good article on first principles and why it can often be better than just employing analogies. 

While it does not apply to every domain I know, analogies are not particularly good in investing. Many investors like to talk about Warren Buffett but forget that he can takeover entire companies and fire managers which destroy value, this has the effect of unlocking value from the stocks that he buys.

Retail investors like us will not be that lucky. A value stock can be undervalued for decades tying our money down for years before they can be put to better use elsewhere.

Of course the other problem of analogizing success is that we often come across successful relatives who brag about their investments becoming multi-baggers. This is a terrible fallacy which is often committed after Chinese New Year - If a cousin or uncle sports a fine piece of luxury watch or drives a Maserati, we automatically think that we can copy what they are trying to do. There is no framework which guides how we look at finances.

While I do not have the answers as to what all the First Principles of Investing are, I can share what can be conveniently written in one blog article.

a) Compounding is greatest thing known to mankind.

The first principle is simply that compounding allows you to create wealth exponentially. The theory is obvious even though the practice is not. If compounding is the 8th Wonder of the world, the savings you make in your 20s are a whole lot more important than the savings you make in your 40s, so why are so many young Singaporeans fabulous and broke ?

Similarly, return of 8% are astronomical compared with returns of 6%.

b) Your profits are your raw returns from your investments minus costs.

Another obvious theory which is seldom seen in practice. If profits are raw returns minus costs, you should be aggressively managing your investment costs by pruning out investment vehicles which pay too large a commission to the salesman or fund manager.

The superiority of ETFs over actively managed funds over the long term should be something to concerned about. You should be trimming your personal expenses as well, if only to channel more money into your savings.

c) Asset allocation can be a free lunch if you re-balance your portfolio.

This is more complicated. Asset classes do not move in tandem and complicated mathematics shows that by mixing up these key asset classes, you can improve your risk-adjusted returns. Another words, diversify your investments to cover different market situations. Buy a mix of equities ( STI ETF), bonds ( CPF-SA ) and commodities ( Commodity ETF from SGX ).

Rebalance your asset mix every year. Your human capital or unearned income is also an asset and should taken into consideration.

d) Performance of an asset class is a question of statistics and probability.

Generally speaking the best asset class over the long term are equities with a return 8% and a standard deviation of about 20%. While proponents can argue about the fallacious assumption about markets being normally distributed. We know with a simple understanding of statistics that promising returns over 7% a risky proposition for anyone selling an investment product. This allows an investor to immediately filter out deals which guarantee 12% a year - the deal is too good to be true.

In summary, there is a broader reason why we need to turn to first principles instead of merely analogizing from the investment success of others. First principles sets the boundaries between common sense and salesman bullshit, allowing you to avoid paying hefty commission and scams. With the right foundation, a person can craft a plan to make his first million without looking for a guru or role-model.

An obstacle towards understanding these first principle is that the study of finance is inherently difficult which costs may years of a person's life. It is difficult to get started in investing using first principles without a strong grounding in statistics, economics and accounting.

Which alludes to an bigger question : Is theory that worthless in a society that is now trying to turn to competence and skill ?

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