How Professionals Select Investments
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This article is intended for the educated layman. It was written as part of a continuing series of articles on a variety of investment topics.
Nowadays people know the price of everything and the value of nothing.
Hamlet: Do you see yonder cloud thats almost in shape of a camel?
Polonius: By th mass and tis, like a camel indeed.
Hamlet: Methinks it is like a weasel.
As weve pursued our errand of increasing wealth, we have been stalking a magical prey. We have scrupulously observed it, and weve seen that the creatures that weve been stalking, that is, investments, have two essential but mutable attributes: the prospect of sustenance (return) and danger (risk). Even when we have captured our prey (selected our investments), these attributes persist, with our captive investments returns continuing to evanesce until, finally, we devour these creatures, that is, spend the wealth. Only in consuming them do we really, definitively, know what sustenance they could provide.
In considering the attributes of return and risk, however, we have neglected another attribute of our prey. Investments are social animals and interact with each other in complex ways that will determine our wealth even after we have corralled them. The return and risk of an assemblage of investments are determined as much by their interactions as by the returns and risks of the individual investments.
Other Articles by Adam Apt
Lessons from Madoff
How to Think about Investing
How to Think about Investment Returns
How to Think about Investment Risk
How to Think about Return and Risk at the Same Time
Not by Return Alone: Judging Investment Performance
I have not, so far, introduced you to strategies for capturing our prey. Whatever tactics we choose, our strategy will have two essential components: first, the selection of particular investments, and, second, a plan to take advantage of their social behavior by combining them best to serve our interests.
We refer to these components of an investment strategy as security selection and portfolio construction.
Most investment writing for the public is about the thrill of the hunt, that is, security selection. It is all about tactics, with little regard to strategy. Some writers try to convey the excitement of stalking the biggest and most elusive returns, sometimes with regard to the dangers, sometimes not. Other writers may feel the excitement, but only ploddingly lay down routine procedures that they advise you to follow. A few popular investment writers address portfolio construction, but such literature looks pallid beside writing about chasing the investments that seem to offer the most gorgeous returns.
In contrast, I have chosen a more considered, reasoned approach to investing, observing and analyzing first, before developing a strategy and tactics based upon what we have learned. To a degree, this contrast corresponds to the (rather simplistic) division I cited in my article on return and risk, between the sportsmen and the academics of investing.
Anyone can select securities. How many times have you heard something like, Apple is a great company and a great stock; or, Citibank stock has been beaten down so far that now its a good bet to go up, or, alternatively, Stocks cant keep going up like this? To select securities thoughtfully, however, requires an extensive education, either through home schooling or in the classroom, and there are many textbooks to teach you. Like all worthwhile endeavors, security selection requires hours of study and tedium. You have to learn accounting and mathematics and statistics and economics, and various intellectual tools and techniques. I will only outline how serious investors go about it, not teach you how to do it.
By securities, I mean stocks, bonds, shares in mutual funds, exchange-traded funds, and more abstruse investment vehicles, and also entire asset classes and sub-classes. That may be stretching the definition of securities, but it still fits if were talking about deciding which things to put into a portfolio.
Security selection is a broader term than security valuation, an expression with which it is often conflated. I, personally, would wish them to mean the same thing, but they dont, because securities are often chosen, not because of their value, but because of their behavior.There are, broadly speaking, two approaches to security selection: tactics based on valuing securities and comparing their values to their prices, and tactics based upon the behavior of the prices of the securities. The general terms that we professionals use for these two kinds of tactics are fundamental analysis and technical analysis.1 Fundamental analysis is pretty much the same thing as security valuation. But dont let the word technical confuse you. In this context, it doesnt imply scientific methods. Technical analysis is the use of series of past prices (or quantities of shares traded, called volume) to predict where prices will go, without reference to accounting values and economic analysis. One very common way of pursuing technical analysis is called charting, because it relies upon charts of prices. Some speakers use charting and technical analysis interchangeably.
1 Sometimes quantitative analysis is used to refer to a third kind of tactic, but computer-implemented methods along this line are generally some sort of mechanical, numbers-driven fundamental analysis with an occasional admixture of technical analysis.