Portfolio Construction: Choosing your Investment Philosophy

Choosing your Investment Philosophy involves examining your beliefs about the market. Our beliefs, whether conscious or subconscious, are the root of action. Beliefs about the market and how it works are largely responsible for dictating decisions made regarding investments. Formed for many reasons and based on numerous factors, beliefs may be changed instantaneously based on new information or a new understanding. For this reason, it is important to consciously examine your beliefs about the market.

Markets Work
First, let’s examine the efficient market belief.
What does it mean? Well, the name efficient market refers to the underlying premise of this view that the market, left to its own devices is efficient. It’s based on supply and demand. The free market is the best determinant of market prices. What this means is that all knowable and predictable information about future prices and movements is already factored into the current price. Therefore, only new and unknowable information and events change prices going forward. In this context, the randomness of the market makes it impossible for any individual or entity to consistently predict market movements and capture additional returns that are unrelated to risk. Markets that are overvalued, or underpriced, are not identifiable in advance.
Is there any proof? The debate about the efficiency of markets, has resulted in hundreds of empirical studies attempting to determine whether specific markets are, in fact, efficient. Many investors are surprised to learn that a tremendous amount of evidence supports the efficient market belief. Furthermore, academic research over the past fifty years in the field of economics, strongly supports the theory that markets work.
The 1990 Nobel Prize in Economics was awarded to Harry Markowitz, Merton Miller, and William Sharpe for their role in developing the concept of Modern Portfolio Theory, or (MPT). MPT is a long-term investment strategy that includes diversification and asset allocation.

Markets Fail
Now let’s look at the other side of the story, otherwise known as the market failure belief.
What does it mean? The basis for this belief is that the market fails to price goods and services accurately. Because there are flaws in the systems, it is possible for some individuals to identify in advance which prices are incorrect and, in effect, predict the future. Simply put, overvalued or under priced markets can be forecast and predicted. By systematically finding mispricing’s, either in stocks or market sectors, it is possible under this belief, to both increase returns and avoid losses in investments.
Is there any proof? Empirical evidence supporting an inefficient market is poor. Statistical studies show that professional money managers who use speculative techniques, designed to take advantage of mispricing’s in the market, are only able to provide higher returns than the market index, at a level with what would be expected to by blind random luck. On the other hand, it is easier to find anecdotal evidence to support this view. Individuals who have “beat the market,” are easily found on magazine covers and radio shows, TV talk shows or Internet chat rooms.
There is an allure to this method of investing that is compelling to our basic instincts as human beings.
Perhaps for the first time in your life, you know there is a choice to be made about how the market really works, and you have examined both belief systems. Many investors live in a haze of confusion, never understanding that there is an important choice to be made here. They are trapped in the Investors’ Dilemma, trying to rationalize beliefs on both sides of the continuum. While this may be comfortable and uncontested by media and advertisers anxious to sell products, it only leads to chaos for the investor.
If you want to escape the Investors’ Dilemma, it is crucial that you take a stand regarding your market belief. This is where the rubber meets the road for the investor. In order to develop your own Personal Investment Philosophy, you will need to choose between the belief systems of market efficiency or market failure.
Do you believe, as Adam Smith did, that free markets set prices better than any individual or group of people can? Or, do you believe that markets fail, and that there is an individual or group of individuals who best know what prices should be?
What do you believe? What makes most sense to you?

About Paul Nichols

Paul is the founder of Financial Abundance, a Registered Investor Advisory firm and EDI, an Estate Planning Firm with offices in State College and Lewisburg. He has been working with individuals, families and businesses for over twenty years, including many Fortune 500 companies. He has educated tens of thousands of people through seminars, workshops and various international speaking engagements where he shared the stage with many notable individuals such as Ronald Reagan, Robert Kiyosaki (author of Rich Dad, Poor Dad), Mike Ditka, General Schwarzkopf, and Newt Gingrich to name a few.

In 2000, after many years of traveling to consult companies and individuals, Paul decided to relocate from Colorado to State College, PA (his wife’s hometown) to develop a local advisory firm.

Paul operates under the core belief that education plus understanding leads to clarity and confidence; resulting in peace of mind. He is a proud father of three and devoted husband of 20 plus years.

Some of Paul’s accomplishments:
Regular contributor to the Centre Daily Times, via the “It’s Your Money” blog
Featured in the movie Navigating the Fog of Investing
Regular contributor to Town & Gown as the publications Investor Coach
Host of the weekly iTunes Podcast, It’s Your Money
Member of the Western PA Better Business Bureau
Member of the Centre County Chamber of Business and Industry