The Importance of Having Your Own Investment Strategy Consider a dairy farmer. What is noticeable about their life?
Farmer’s lives are dictated by routine. When I was in high school, I worked on a beef farm and my uncle owned a large dairy farm nearby. The lives of the employees were incredibly repetitive – but it’s no coincidence that their lives are mired in routine. It’s actually one of the things that enabled them to be successful. Imagine if they didn’t have a routine, and woke up every morning wondering “How am I going to farm today?” Certainly their business would be in shambles in no time.
In this regard, investing is like farming – in order to be successful, you need to have a simple, repeatable strategy that you can execute over and over without worrying about the strategy itself. Today I’ll be writing about the important of having your own investing strategy.
Choosing your end goal
Ideally the way we invest will be different depending on what our goals are. For example, the Yale University Endowment Fund managed by David F. Swensen is likely dramatically different in composition than the Canada Pension Plan’s ~$275 billion fund managed by the CPPIB, which in turn is different than the insurance float of Warren Buffett’s Berkshire Hathaway. Yale needs to pay for the university’s operations; the CPP needs to pay for the pensions of millions of Canadian; and Berkshire’s insurance float needs to pay for future insurance claims. Their portfolios are different based on their needs.
Your personal portfolio is the same way. Without knowing precisely what you need from your investments, there’s no way to develop a repeatable investment strategy.
To develop your own strategy, there’s two things you need to consider – where you are now, and where you want to be in the future. Many people are surprised when I advocate for thinking about their current state, but a lot of what matters right now is actually non-financial. You need to consider your current investment knowledge, your level of wealth (i.e. no hedge funds are going to invest the $500 in your piggy bank), your risk tolerance, and a lot of other factors as well.
Probably the most important factor to consider is your time horizon – how long you can invest your money before you will need to spend it. Time horizon is key because the longer your time horizon, the riskier the investments you can comfortably make. Risky investments like stocks often have boatloads of short-term volatility but always outperform less-risky assets (like bonds) over the long-term.
To understand what I mean, consider this. There’s been lots of 1-year periods where bonds have outperformed stocks, but definitely very few 7-year periods where stocks haven’t outperformed bonds. So having a long time horizon allows you to allocate more capital to higher-risk, higher-return asset classes without worrying about short-term price fluctuations.
Make sure to take a holistic few of time horizon when developing your investment strategy. It’s common to assume that young people automatically have long time horizons since they are far from retirement, but this is not necessarily the case. For example, a 25-year old only has a 5-year time horizon if he’s expecting to spend all of his money on the down payment of a mortgage when he’s 30.
After considering you current state, you also need to create a goal – that’s the other piece of the puzzle. For many, this involves the abstract concept of “financial independence,” which is often associated with the level of wealth required to enjoy a healthy retirement. Make sure that you create an end goal that is both a reach (meaning you’ll have to work hard for it) but is also still attainable.
Having your own investment thesis allows you to be independent
Once you’ve considered both the present and the future to create your own personal investment strategy, you’ll start to reap the benefits. One of the main benefits of following your own strategy is the independence that it naturally provides.
If you’re following external advice for the security selection of your portfolio, you’re doing it all wrong. You have no independence. By acting on advice, you remove yourself from the decision-making process. This also means that you will be the last person out of any investment in the event that it is no longer attractive – which usually means you have the most to lose.
I also have to recognize that being an independent investor is hard. There are so many media outlets that exist (including this one, paradoxically) to give financial advice that stepping back to form your own opinions can be difficult. That’s why I try and back all my claims with real evidence – not only does it show my readers that I have reasons behind my claims, but it also helps with my own personal analysis. There’s been times when I start a blog post arguing a point, only to realize my claim was false after looking at the data. Further, I believe analysis is important because one of the tasks that most investors struggle with is the collection of data – decision-making is much easier once you have the clean data in front of you.
My investment strategy
So what does this mean for me? Personally, I have a goal of earning $80,000 of passive income when I retire. Though people typically retire in their 60s, I believe that with careful planning and aggressive saving I will be able to retire significantly earlier. I’ve decided that the best strategy to help me reach this goal is a combination of value investing and dividend growth investing. I’ll explain both of those strategies briefly here so you get a sense of my methodology.
Value investing means I am seeking to purchase stocks that are trading at a meaningful discount to my perception of their intrinsic value – finding the market price is easy, but estimating intrinsic value is not. Dividend growth investing means I am looking for companies that not only pay a nice dividend now, but have a history of meaningful dividend increases over time and are likely to continue this trend.
Now, I’ll briefly explain what metrics I use to judge whether investments fall into my “value” strategy, my “dividend growth” strategy, or, ideally, both!
On the value side, there are two main metrics I look for to assess whether an investment is attractive. The first is the Price to Book Value ratio, which is literally calculated as market price per common share divided by book value per common share. The market price is easy – look it up on Google Finance or Yahoo Finance. The book value per share is a little tougher to tease out, though still not hard with the modern technology that we have access to. Book value is simply the total equity attributed to common shareholders divided by the number of common shares. It’s important to exclude any of the company’s book value that is attributed to the preferred sharedholders. To calculate book value, you need to look at the company’s balance sheet, and I’ll walk you through how to do that here.
We’ll calculate book value for General Electric. First, go to Google Finance and pull up the company, and on the left side click “Financials”.
There’s three things we are looking for – total equity, preferred stock equity, and total common shares outstanding. These are all near the bottom of the page so are really easy to capture in a screenshot:
We use the following formula to determine book value per share:
[(Total Equity) – (Redeemable Preferred Stock, Total) – (Preferred Stock – Non Redeemable, Net)]/(Total Common Shares Outstanding)
Which gives a number of (98,273.00 – 0.00 – 6.00)/9379.29 = $10.48, the book value per share of General Electric according to this financial statement. Since their price is above $30, this gives them a price to book of ~3, which is quite high.
The second metric I look at as a value investor is Price to Earnings ratio (commonly called PE ratio). While price to book gives us a sense of whether the stock is trading cheaply based on their assets, price to earnings gives a sense of value based on the stock’s earnings. PE is really easy to calculate – simply stock price divided by earnings per share (EPS). There are tons of different PE ratios depending on whether you are using forward earnings, trailing earnings, or what have you. You can find PE ratio with a quick Google Finance stock ticker lookup. For example, consider General Electric’s PE.
For the dividend growth portion of my investing strategy, there’s three main metrics that I look at. These are dividend yield, annual dividend growth %, and dividend payout ratio. Dividend yield is calculate as the dividend per share divided by the stock’s market price. It fluctuates on a daily basis based on changes in the stock’s market price, and is typically included among an advanced stock quote.
Annual dividend growth percentage is exactly what it sounds like – the yearly growth of a company’s dividend. Note that we are concerned with the growth of the cash dividend of a stock, not the growth of it’s dividend yield – ideally the stock price will appreciate at rates similar to the cash dividend, which leaves the yield unchanged over time. Dividend growth is not typically provided in a stock quote, but you can calculate it by looking at a company’s income statement provided by Google Finance.
Make sure to consider dividends per share, not gross dividends, because if the number of shares outstanding is changing, this will not be reflected in the gross dividend number.
The third metric is dividend payout ratio. This number, expressed as a percentage, shows how much of a company’s earnings are paid out in dividends to common shareholders. You can calculate it based on the income statement on Google Finance – just divide “Dividends per Share – Common Stock Primary Issue” by “Diluted Normalized EPS”.
Looking at the numbers on the income statement, General Electric has a payout ratio of about 64%. Payout ratios vary based on company, industry, and economic times – for example, payout ratios spiked in the 2008 financial crisis as earnings dropped. The lower a payout ratio, the more secure a company’s dividend will be in the face of economic shocks because they have more free cash flow that can be used to pay the dividend if earnings drop.
Incorporating this into your own portfolio
Hopefully now you see why it’s so important to develop your own investment strategy. It’s the only way to achieve true financial independence. By sharing my strategy, I wanted to underline two main things:
- Make sure you have quantifiable metrics. Whenever possible, it’s nice to be able to work off of numbers rather than speculation. Numbers don’t lie.
- Make sure your metrics can be generalized across companies and industries. Don’t measure Apple’s success on iPhone sales – this is not comparable to other tech giants like Alphabet or Microsoft. Instead, measure them on profit margins, earnings growth, or other metrics that can also be used to judge competitors.
Best of luck, and feel free to share your personal strategy in the comments section!
Readers, do any of you already have a personal investment strategy? What are the secrets to your success? As more time passes and you gain experience, how has your investment philosophy changed over time? LEt me know in the comments section!