Letter on investing

In 2007 I wrote a blog post on investing. During the last five years, my view evolved a bit. People often ask me how to get a financial education. This is the latest email I sent on the topic.

From: Bolognese, Luca
Sent: 04 April 2012 16:52
Subject: RE: A financial education

Disclaimer: this are just my personal opinions drawn from my 10+ years of investing, reading books and academic papers about it. I can justify most statements below with some academic reference, but that would make this email too long.

Also someone else might read the same material and come up with a different opinion. It is a field that is probabilistic in nature and doesn’t lend itself to certainties. For example, you can make a lot of money out of an investment and still be wrong to have made it. And conversely.

Our brains don’t work well in such fields.

  • The most important thing in investing is not investing, it is saving the money to invest. If you save enough and are mildly reasonable in your investments (aka you diversify), you are going to be ok. Saving is not mechanically difficult, it is motivationally difficult. The best book I found on the topic is this one. I read earlier editions, this is a new one. I don’t like the investment chapters.
  • After that, you need to make sure that your financial matters are in order (i.e. you are ensured against catastrophes, you maximize your tax deductions, etc..). This is the field of personal finance. I’ve been suggesting this book to American audiences. It is on Amazon.co.uk, so it might be the UK version.
  • Now that you have saved money and your finances are in order, you can start thinking about investing. The most important things in investing are: deciding what you believe in, what your risk tolerance is, how important is for your performance to track the market, what your time horizon is and how much time you want to dedicate to investing.
    • My risk tolerance is high. I’ve spent a lot of time learning about investing. I’m willing to see the value of my portfolio go down without experiencing emotional distress (I’ve tried it)
    • I don’t care about my investment performance tracking the market. I don’t watch financial programs.
    • My time horizon is long. These are money I invest for my retirement.
    • I’m willing to invest time to keep myself up to date on investment topics and manage my portfolio
    • I believe the following (these are the biases that colour my view):
    • Diversification among different sources of returns is to be sought aggressively
    • Most asset classes are not efficient because of:
      • Predictable flaws in human brain’s processing machinery
      • Institutional constraints on most professional investor (aka they have to track the market they invest in closely)
      • Short term performance incentive for professional investors
    • Some asset classes are intrinsically more inefficient than others (i.e. emerging markets micro stocks compared to US large stock) because that’s where the causes of inefficiencies are strongest
    • The biggest inefficiencies are among asset classes (i.e. stocks vs bonds vs commodities)
    • Most people (myself included) don’t have the time to do the research necessary to invest in individual stocks using the two ways that I believe are ‘right’: quant models or/and fundamental value analysis.
  • Some books to get you started:
    • A good perspective on how to think about the market and the work you need to do if you want to invest in stocks. The intelligent investor.
    • Why diversification is important. The intelligent asset allocator. I don’t believe in static asset allocation, but you need to know what it is to believe (or not) in it.
    • Moving beyond a static asset allocation with a quant based highly diversified, but simple to implement system. The Ivy Portfolio. I am very tempted to use this one myself
    • Why asset classes are often mispriced. Probably the premier quant shop around. Read most quarterly letters.
    • Systems to take advantage of such mispricing are described here. I have obtained copies of all the newsletters sent by the author going back to 1991 and backtested some of the systems. These are the system I use. But the newsletter is relatively expensive and complex to follow.
    • If you decide to branch out into value analysis of companies. Essays of warren buffett. You would also need to read an introductory and an advanced accounting text. I don’t know UK accounting, so cannot suggest good candidates.
    • If you are very conservative and want to just invest in Inflation Linked Bonds (or fearful of markets in general), there is a book for that: here.
  • With all of that out of the way, here is some practical counsel
    • if you have less than 20,000 pounds to invest try to find a fund or etf that invest in a diversified array of asset classes for a small price. I don’t know the UK market, so cannot suggest one.
    • If you have more than that and are willing to dedicate a few hours a month, you can start implementing some of the systems in the Ivy Portfolio book. Maybe you integrate it with the GMO 7 years asset class forecasts to push a bit of value bias in your system.
    • For most people that’s it. If it becomes a lifelong interest / mania as it is for me, there is a bit more that can be done, but it is unclear to me that the results are necessarily better than the simple systems described above.




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