Some advisors are great with investments. Others? Not so much. There can be several reasons why, but if you dig hard enough, you'll find that underneath them all, there's one common factor that makes the great ones great: Process. Financial advisors who know investments share the common trait of having a robust investment process that lets them systematically select investments that are positioned well for success.
Wonder if your advisor is an investment expert? Here are 7 signs your advisor might NOT be great with investments.
Why is an investing process so important?
Investing without a process isn't investing. It's gambling.
The Oxford Dictionary defines gambling as "play[ing] games of chance for money." Some of those who participate in the stock market are playing games of chance. They don't have well-reasoned beliefs behind their buy and sell decisions, but rather make choices based on their emotions or gut reactions. Their hopes of getting a return are more based on luck than any tangible reasoning. Sadly, this is exactly what we saw during the COVID-19 pandemic. Sports betting in the United States had been put on hold due to shutdowns. Flush with cash from government handouts, many sports bettors scratched their gambling itch in the stock market, causing waves of irrational stock behavior as some stocks surged while others fell for seemingly no reason at all.
In contrast, investing is defined as "expend[ing] money with the expectation of achieving a profit." The key word in this definition is "expectation." On what basis do we have an expectation that we'll see a profit? Some investors spend hours poring over financial reports, trying to determine the inherent value of a stock. Others study movements in the price, volume, and volatility of an investment with a watchful eye, attempting to discern the precise moment to make a move. There are many approaches to investing, some of which may have more merit than others, but the more thorough and well-thought-out our reasons are for expecting a profit, the more our decisions resemble true investment.
True investing requires detailed and precise reasoning for why choices are being made. There has to be a strong reason for including an investment in a portfolio, some reason to believe that an opportunity will either boost returns or reduce risk. The less reasoned an investment decision becomes, the more it resembles a trip to Vegas or the local horse track. Maybe it works out, but the odds of stringing together multiple years' worth of quality investment decisions become increasingly small.
This is why it's so dangerous when advisors or everyday investors pick investments based on their gut feeling. Our emotions can be influenced by any of a thousand different factors, from nostalgia to fear to hubris. You wouldn't want your advisor choosing a stock just because it's a name brand he remembers from his childhood, so it gives him the warm-and-fuzzies. You'd want hard-hitting, data-driven analysis so you feel rock-solid that his or her choice was the best one. When an advisor spends time perfecting a system for selecting investments, they set themselves up for long-term investing success.
But how exactly does an investment process help?
A solid investment process does three things for an advisor.
First, it allows them to be less biased in investment choices.
There are many approaches to investing, and many reasons to include a stock or bond in an investment portfolio. Maybe a stock has a great P/E ratio or fantastic free cash flow, or it's above its 50 day moving average. Perhaps a bond looks like it may improve its credit quality or matches the duration an investor is looking for. Not only are there limitless choices in investing philosophy, but there are also investing fads that come and go with the breeze. Perhaps Ray Dalio or Warren Buffet explains the rationale behind a successful move they recently made, and suddenly the investing world is in an uproar over the strategy they used.
An investing process keeps advisors from jumping on the most recent bandwagon until they've had time to research and determine the merits of investing that way. Not every strategy works in every situation, and if an advisor is going to take on a new element to their investing framework, they need time to think through how they're going to handle the drawbacks and potential for mistaken analysis with their new approach. They need the complete picture for that strategy, including what may cause it to succeed or fail, before they start making decisions based on it.
Secondly, a robust investment process allows advisors to construct portfolios, not just select investments.
Let me explain using a sports analogy. We've all seen star athletes who are amazing performers on their own but don't work well with the team they're on. For those who know American Football, Terrell Owens, who played wide receiver primarily for the 49ers, Eagles and Cowboys, had a reputation for causing discord with his teammates everywhere he went. Even though an athlete like this might be incredible on the field, their interactions with the players around them drags the team performance down. A lesser athlete can, at times, be an upgrade because of the impact they have on the people around them.
Investment portfolios can be a lot like that. Every asset in a portfolio has a role to play, either to boost returns or to decrease risk, and what ultimately matters most is the performance of the whole portfolio. Sound investors pay attention not just to the features of an individual investment, but the way it interacts with the other investments in the portfolio.
One of the dangers of investing without a process is that it's nearly impossible to analyze how well the investments in a portfolio are playing together. Each choice is made in a vacuum, without regard for how that choice fits together in the bigger picture of the portfolio. What may seem like a fine choice based on whatever recent investment trend has an advisor's attention at the moment could actually be a worse decision when viewed in context.
A systematized process keeps investors consistent across all of their investment choices, so that they're actively seeking out investments that fit well with each other. Each investment in the portfolio is selected with a particular role in mind, whether that be potential for gains, likelihood of reducing risk, or bringing down the correlation of the assets in the portfolio.
Thirdly, an investing process allows advisors to learn from their investing choices.
I hate to be the bearer of bad news, but not all investing decisions will work. Even great investors will, at times, make a choice that doesn't turn out well. But one trait of great investors is that they're constantly learning.
Becoming proficient in any investment strategy is going to take time, both in deep research and analysis to determine approaches that might work and in real-world experience implementing those approaches. An advisor who isn't thoughtful about his or her investment approach likely doesn't stick with a single method of analysis long enough to learn from their successes (good) or their mistakes (even better). Or worse, they may draw outsized conclusions from a single experience or small handful of events, believing they understand what drives investment returns when the real driver remains hidden.
Furthermore, even if an advisor wanted to learn from their mistakes, without a defined framework there's nothing there to learn from. How can someone decide if something works or not if they don't apply it consistently? There would be no way of knowing what exactly was causing the portfolio's underperformance, and thus no way of growing from the experience. Keeping a consistent process can inform which investment strategies are working and which ones aren't, as well as what changes could be made to make the process better.
How To Develop An Investment Process
An investment process requires developing a structure for three things: selecting, evaluating, and monitoring investments. Finding your process isn't a quick task. It will likely take a significant amount of work to get started and then years to perfect. If you're just getting started, here are a few quick tips:
Start with research. There are countless approaches to investing, and you need to pick one that resonates with you. Read as much as you can about various approaches until you find one that fits, and then keep researching until you really understand it inside and out.
Know the pitfalls. Every investment strategy has dangers that could cause underperformance. Don't just research what makes a strategy work; figure out what could make it go wrong.
Understand your unique circumstances. What is an appropriate strategy for one investor may be completely inappropriate for another. You'll need to identify your own investment goals and objectives, timeline, risk tolerance, and liquidity needs so you can tailor your investment strategy to match your own situation and requirements.
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