A Suggested Investment Framework

Introduction

Investing is committing your money to a business operation now, with the expectation to take out more money later. It has three core principles. The first and the most important is to protect the investment capital (the principal). Secondly, no investment is possible without thorough research which has many dimensions and takes time. Lastly, you have to be content with an adequate return. There should be a way of determining how much is adequate. This succinct framework of investing was propounded by Benjamin Graham in his book: The Intelligent Investor.

Investing merits some forethought lest it is mixed up with speculation which is more akin to gambling rather than investing.

The aim of writing this article is to propose a simple and logical way of thinking about investing, how to execute it and what should be a fair expectation from it. Moreover, I will also discuss why an investor should think in terms of capital allocation of which opportunity cost is the cornerstone.

Investment Framework

Safety of the Principal

Safety of the principal is of utmost importance. It is alright to settle for less return but you should have zero tolerance for permanent loss of capital. Just be patient and slow. Be a reluctant buyer and even more reluctant seller. It is far better to inch forward and be safe instead of attempting to take a big leap and break something.

Thorough Research

Have a method in place to weigh and assess anything that comes your way in the name of an investment option. Most of these products catch your attention because of the strong marketing and sales effort behind them. What can be that method or the way of looking at these investment options? Some suggestions are given here:

If the product is not regrularly earning something on monthly, quarterly or yearly basis, it is very difficult to assess its quality and how much you should pay for it.
If the business sector to which it belongs is not properly regulated, refrain from it.
If the product claims to return high profits in a short span of time, take it with a pinch of salt.
If something is “hot” and everyone is talking about it, chances are that it is not as good as it is being made out to be or at the least it is already over-priced.

If something checks all the boxes mentioned above, you can start analyzing it. For that, learn valuation and how to compare various options to decide in favor of one vis-a-vis others. As a bottom line, your bias should be towards saying “No” rather than saying “Yes”. Being a skeptic always pays in investing. Overcome FOMO.

Adequate Return

In order to be safe, don’t chase the promise of high returns. Target a bracket of expected returns where the lower limit is around 2% above the returns from debt products (fixed-income funds etc) and the upper limit is 20-22%, per annum. If you want to target higher, you should be extra careful and more thorough, and professional in your research. The higher return you are expecting should be a function of superior quality of the business franchise rather than market volatility. According to the simple logic of capitalism, there is no big money out there that can be earned effortlessly. It is an illusion. What converts this illusion into a common perception is our own greed and some shrewd marketing.

Goal-Based Investing

Another important way of thinking is to resort to goal-based investing rather than open-ended investing. Open-ended here means to say that I am investing because I want to make a lot of money. This way of thinking can subsequently create problems with regard to decision-making.

On the other side, a better way of thinking is that I have some financial resources and I have some goals. What could be the best way of achieving my financial goals with the resources I have. Moreover, I cannot afford to lose any money.

Capital Allocation

Now if we have determined a broad framework of investing and also have some clear financial goals to achieve, we can start discussing the soul of investing i.e. smart capital allocation. Actually, capital allocation is also an important element of the investment framework.

In investing, you want your resources to work optimally towards the attainment of your financial goals. There is nothing very technical about capital allocation. All it implies is that while you design your investment portfolio, every unit of money you own should be put to the best use.

For the sake of further clarity, consider following examples of wrong capital allocation:

Some individual investor saying that he will earn some money from trading in stock market and then will use that money to buy some good quality shares for long-term holding. Actually, if he thinks that trading is so good then he should persist with it. In the other case, he should buy all his shares on long-term basis right at the outset as an investor.
Owners of a company making money from the business and investing this money in some other business which is not very well known to them, but otherwise looks quite attractive. What they should do, instead, is to re-invest it back in the core business to expand it furhter to earn more money.
An individual bought some shares of a company. The price dropped significantly and he also realized that the business is not of a high quality. Now he is waiting for the share price to increase so that he is able to sell it at about his buying price to cover his losses and get out. This is called “sunk cost fallacy“. Actually, whenever you realize your mistake, you should correct it immediately instead of hoping against the hope.
A lot of cash is lying idle in the balace sheet of a company or an individual is keeping cash either in his bank account or at home and he doen’t require it in the forseeable future or at least for next 5 years.

Companies and individuals commit these and so many other types of capital allocation mistakes all the time which pull the efficiency of their business or investment down considerably.

Valuation and Comparison of Various Investment Options

Since capital allocation is all about deciding in favor of one option vis-a-vis all other options for a certain portion of your investment portfolio, it is extremely important to learn valuation of businesses and also be able to compare various investment options. These two are interrelated because unless you are able to correctly value various investment options, you will not be able to compare them properly and you will end up misallocating your capital.

Opportunity Cost

After valuation, the fundamental principle of capital allocation is opportunity cost.

For example, when you decide to spend some of your time on an activity, let’s say studying or watching TV, you may say that you are not spending that time on any other activity. So you are availing one opportunity and losing all other opportunities. Every opportunity has a cost. Therefore, the best way of looking at your time allocation to various activities is in terms of opportunity cost. Pay the least cost to get the maximum result.

With regard to capital allocation also, think in terms of opportunity cost. Every opportunity is not created equal. Therefore, identify and prepare a shortlist of some good opportunities, prioritize them and make capital allocation accordingly. The best opportunity should get maximum capital and so on.

Need to Diversify

If you strictly follow the principle of opportunity cost, you should allocate your entire capital to just one option i.e. the top one. However, that is not advisable due to the vagaries of the market. Therefore, you need to diversify your portfolio. Diversification should be well throughout and be carried out in a balanced way. Spreading yourself too thin will run counter to the opportunity cost principle.

No Rewards for Degree of Difficulty

One thing unique and interesting about investing is that there are no rewards for the degree of difficulty in execution.

In competitive sports, if you can jump higher or run faster, you are duly rewarded. In the same way, if you are a specialist in a particular field you are expected to have an all-round knowledge of that subject. On the contrary, in investing your success depends on how well you are able to execute your plan. It is not essential to know about every business or company or investment option out there. You may have a very narrow field of expertise and still end up quite rich. What is more important, however, is to know clearly what you don’t know and remain away from it.

Conclusion

It is crucial for a company as well as an individual to have an investment framework. This will ensure that every penny has been put to good work and there are no dead woods in your portfolio. You should keep reviewing your portfolio periodically. Once or twice a year should be enough. If you don’t have a system in place, you will be reacting to whatever is marketed to you, and the likelihood of making wrong choices will increase. This will result in capital allocation errors and your investment portfolio will suffer.

How did you find this content? Please comment and give suggestions, if you have any.

My other articles you may find useful are:

How to Make a Personal Financial Plan – Basic Considerations

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A Brief History of Money

Why I Started a Blog on Personal Finance

Anatomy of Financial Risk

Debt, Equity, and Real Estate: An Overview

Retirement Planning

How to Compare Equity and Real Estate as Investment Options

How Stock Market Works and How to Work in Stock Market?