How to invest like a pro
The critical reason that professional investors make more money than most other investors is that they engage with the financial markets (of all sorts) full-time. This does not imply they are more intelligent than other non-professional investors but does imply that they invest with clear-cut agendas. They design specific strategies to meet these agendas and execute them systematically.
As advisers, we strive to provide our clients with the same edge as professional investors. To achieve this edge we studied what is unique about seasoned investors and institutions to replicate it for our clients.
Seasoned Mindset
Investors who have spent time in the markets are typically survivors of many ups and downs in their PnL.
Every seasoned investor has had at least one harrowing experience of nearly wiping more than 50% of their portfolio at some stage of their investing career.
Surviving this experience (with luck) and continuing (with grit) is what makes them seasoned.
The conclusion that each seasoned investor draws, surviving a wipeout, is discipline. Seasoned investors have hardcore discipline built into their investing activities. This discipline is made up of two parts:
- Overcoming biases and
- A strategy-based approach.
Overcoming biases
Biases are patterns that deviate our thought process from rationality. Our brains are hard-programmed with biases because they help us make sense of the world with ease (and the least amount of energy). Biases are conclusions to complex situations that evolution has programmed into us to protect us from threats in the physical natural world. For example, when we sense danger we tend to act immediately to avoid it, even without processing completely what the source is.
Seasoned investors know this shortcoming of biases (after facing its consequences several times) and understand that the conclusions of biases do not operate well in the financial world.
They know that sheer willpower will not prevent them from falling into the trap of biases. Therefore they design strategies to bypass biases and have second-order thinking built into their investing.
Strategy-based Approach
Professional seasoned investors define investment strategies to overcome biases. They reduce the number of decision variables and form an algorithm to work systematically (whether executed by machines or manually by men). Strategy-based investing removes emotions and biases from investing and makes it a business-like activity. There is no role of willpower in strategy-based investing, it is purely a process that can be repeated over and over again with ease.
Whether the mood of the investors is happy, sad, or angry on a particular day, it does not reflect in their investment strategy.
Strategy-based investing also gives investors the patience to wait for specific opportunities. Value investing strategies for example have a long waiting cycle. The markets have to crash and good securities have to be available as dirt-cheap valuations for value investors to make money. Value investors cannot afford to feel FOMO and jump on the next shiny thing. Their patience is fueled by predictability.
Taking Calculated Risks
When investors know how often their strategy will work (given the right set of conditions) they can keep going on taking bet after bet without the worry of loss in a particular position.
Investment strategies have a probability built into them. Over a period of time and many positions, they have a defined ratio of the percentage of winning positions to the percentage of losing positions.
Strategy-based investing also provides the edge of a calculated risk-reward system. Strategies help investors measure the amount of reward that an opportunity offers given the amount of risk. This means they can press the gas pedal more at certain times than others by sizing up their positions.
A strategy-based investment opportunity will tell what is the average size of wins in comparison to the average size of losses.
If the value is high, seasoned investors can bet more amount of their capital in that position (without violating global risk management rules) and win bigger rewards sooner.
Combining probabilities and average sizes, the following equation holds for a winning strategy:
Percentage of winners * Average size of winner > Percentage of losers * Average size of loser
Defined Investment Styles
Seasoned investors know that there are many ways to make money in the markets. The possibilities and opportunities are endless. However, professional investing requires doing something consistent. So they narrow in on an investment style.
Benjamin Graham, Mohnish Pabrai, and Seth Kalrman are value investors. They stick to only value investing (their circle of competence) and stay off anything else. It is their investment style. While they know there are other ways of making money, they keep their focus on the specific investment style that works for them and keep doing the same things over and over again. Over a period of time, their investment styles evolve into a more customized form with specialized knowledge. That is how they achieve excellence.
Institutional Edge
The second set of professional investors is institutions. Institutional investors include funds, incubators, family offices, foundations, endowments, sovereign funds, banks, insurance companies, etc. For these investors investing is their primary business activity just like production may be for a heavy machinery business or distribution for an FMCG business. Like every business, institutional investors know why they are doing the specific activity (to make money). They have clearly defined investment objectives.
Every institutional investor is serving some client’s specific needs.
An endowment would be serving the needs for cash flow for a university’s operations. A mutual fund would meet the investment objectives of the scheme. A family office may be preserving familial wealth and generating cash for the lifestyle of its benefactors. A foundation would ensure the financing of a grant to a specific cause. In each case, institutional investing serves a particular client with a specific need. All institutional investors do not invest in the same fashion. Instead, they adapt to meet the needs of their benefactors (who may be individuals, families, companies, non-profit organizations, etc) and make decisions through investment committees.
Decentralizing Control
Investment committees decentralize control from one person to a team operating with a set of pre-defined rules for pre-determined scenarios. While institutional investors may have begun following a star manager, they manage to internalize their strategy and convert it into a process. This ensures that the same strategy can be run by a team (or algorithms) even without the individual manager.
At the same time, a committee makes investment management robust by weighing in the opinions of multiple experts (human or machine). The investment committee ensures that the interests of the benefactors of the institution are always protected. This requires investment committees to operate using:
- Mandates and
- A system-driven approach.
Mandates
Investment mandates are a set of instructions on how a pool of funds will be handled. It defines where the pool of funds can be invested, for how long, and with how much exposure to risk. Mandates also set guidelines within which the fund managers need to operate. This makes the investment activity a controlled affair and indifferent to the whims and fantasies of individual managers.
Carefully crafted and regularly upgraded mandates protect the interests of clients. However, it takes time and iterations to define them. Good mandates are often crisp and clear, for example:
- Keeping the value of the corpus maintained.
- Achieve a growth rate between 6 to 8% annually.
- Earn a steady income of USD 10,000 per month.
- Minimizing the tax outflow.
Continuously executing mandates requires processes to be set into place. This is done by adopting a system-driven approach.
System-driven Approach
Investment committees rely on systems to execute their mandates for meeting their client’s needs. Systems are periodic in nature and reliable in operation. Systematic investing means that whether it rains or shines an investment is reviewed periodically and actions are taken to keep it on course as per pre-defined rules.
A periodic review ensures that given the opportunities today, would the investor keep the same investments in the same ratio, or change them for possibly a better outcome.
Reviewing investments forces the systematic investor to keep in mind the constraints of execution and penalties (like tax, etc.). Reviewing also keeps the focus of the investor on the capital rather than marrying them to the position. Profit or loss becomes irrelevant when the primary agenda is capital efficiency. The systematic investor is always only on the lookout for the best means to deploy capital to preserve, accumulate and grow capital most cheaply and efficiently.
The second quality of systems is that they operate on predefined rules. Systematic investing requires the investor to consider if-then-else scenarios. This means the investor (through their experiences) defines how to act in case of the occurrence of an event in the market or security, bringing about reliability and accountability in the decision-making.
How to invest like a Pro
Seasoned investors are driven by a strategy-based approach to investing emotion-free, with patience, by taking calculated risks and narrowing down their investment style. At the same time, institutional investment committees are driven by mandates and execute them using a decentralized system-driven approach. On the other hand, individuals and families are driven by their needs and desires.
Needs & Desires
Needs are essential requirements for a decent living, while desires are optional choices for a fulfilling life. Investment decisions made by individuals and families that are driven by needs and desires are emotional, susceptible to biases, and individual-centric. This puts non-professional inventors at a disadvantage in comparison to professional investors.
On top of it, individual investors are often faced with competing choices of needs and desires. Very rarely do they have a precise clarity of the order of these needs and desires. This makes investing a tough decision.
…two problems that make it a tough decision.
1. You are unable to see the larger picture because either the known options are not clear-cut (or fuzzy), or the alternatives to these options are unknown to you.
2. We are unable to envisage the long-term outcome of the decisions we make now because there are too many variables that can happen between now and then.
In short,
(Fuzzy/ Unknown Options) * (Fuzzy/ Unknown Outcomes) = Tough Decision
Page 166, Chapter 18, “How We Make Tough Decisions”, “What My MBA Did Not Teach Me About Money”
At the same time, needs and desires are also the north stars of what the individual and family want. Investing should be motivated by needs and desires but not be driven by them. This means to be focused like seasoned and institutional investors, individual and family investors need to have a solution-oriented approach that is strategy-based and system-driven. The first step is identifying needs and desires to reduce some part of the fuzziness of the tough decision.
Solution-Oriented Approach
In the article “How to invest if you are a newbie” we identified the three themes of Wealth, Goals & Cash-flow that cover mostly everything in the lives of individuals & families. This gives us a starting point in identifying the needs and desires of our clients and refining them with dialogue.
By focusing on finding investment solutions for these three themes, individuals and families can invest like seasoned investors (using specific strategies) and institutions (using systematic execution). While some parts of these three themes correspond to the needs in life, others correspond to desires.
Needs include:
- Wealth – Covering contingencies & Retirement.
- Goals – Funding emotional goals.
- Cash-flow – Replacing income for basics and creating a buffer.
Desires cover:
- Wealth – Becoming rich, staying rich, and leaving a legacy.
- Goals – Financing material goals.
- Cash-flow – Generating profits for discretionary spending.
When individuals and families segregate needs and desires they can organize their investing agendas like professionals.
They can take lesser risks for needs and more risks for desires. This implies each investor can have multiple profiles of risk depending on the need or desire they are investing for. Conservative investors can be seeking risks for their desires, while aggressive investors can seek safety for their needs. This is done through Core & Satellite Investing.
Core & Satellite Investing
Core and Satellite investing is a well-established method of segregating risks. Investopedia defines it as follows:-
Core-satellite investing is a method of portfolio construction designed to minimize costs, tax liability, and volatility while providing an opportunity to outperform the broad stock market as a whole. The core of the portfolio consists of passive investments that track major market indices, such as the Standard and Poor’s 500 Index (S&P 500). Additional positions, known as satellites, are added to the portfolio in the form of actively managed investments.
A Guide to Core-Satellite Investing, Investopedia
Core and Satellite investing allows individual investors to take appropriate exposure to different levels of risks by systematically deploying different strategies. This is how they can invest like a pro.
At Modulor Capital, we go a step further by mapping Core portfolios as solutions for human needs and Satellite portfolios as solutions for human desires. This provides us with a perspective to give the appropriate exposure to client portfolios as per their primary and secondary investment objectives.
Core portfolios intend to gain as much as the market with lower-than-market risks, while Satellite portfolios intend to take market-like risks with the chance of generating better-than-market returns.
Core portfolios and satellite portfolios are driven by their respective investment objectives. These investment objectives act like mandates when investing in individuals and families. Human needs and desires are very personal. However, these need to be translated into standard investment objectives that can be uniformly applied when investing.
Investment Objectives
Investment objectives give a professional orientation to investing. Investors with clear investment objectives seek not just returns but the fulfillment of their needs and desires.
Human needs span from the very short term to the long term. We have identified 3 key needs and their corresponding investment objectives and use them to construct portfolios:
- The Need for Safety – The investment objective for preparing for rough patches in a timeframe of up to 1 year to meet the need for safety is Preservation.
- The Need for Survival – The second core investment objective that investors engage to be able to survive through protracted tough times that may happen in the short to long term is Accumulation.
- The Need to Thrive – The inherent drive to thrive like many others is the third quantamental core objective, called Growth.
You can read more about these need-oriented objectives in the article GAP – The Core Investment Objectives in our research publication – Quantamental Investing.
Once the needs are in the process of being met, human desires kick in. 3 key desires drive humans to invest. These desires and their corresponding investment objectives are as follows:
- The Desire to Grow Faster than Others – The investment objective to take suitable risks to appreciate capital faster than others is Capital-appreciation.
- The Desire to Enjoy the Fruits of Past Labor – The investment objective to create passive income from accumulated capital is Income-creation.
- The Desire to Enjoy Surpluses – The investment objective to generate surpluses from accumulated capital to spend on non-essential things/experiences is called Profit-generation.
The desire-oriented objectives are described in detail in the article – PIC — The Satellite Investment Objectives.
The next step is matching the investment strategies of professionals with human needs and desires. We do this by taking up specific Core and Satellite investment styles and mixing them to form different portfolios.
Investment Styles
While there are many styles of investment strategies that investors can employ, at Modulor Capital we follow three Core and three Satellite investment styles for the different needs and desires of individuals. These are:
- Core
- Dynamic – An investment style that modifies the asset allocation with respect to predetermined rules that are triggered in specific market conditions.
- Tactical – An investment style that intends to time different asset markets (such as equity, gold, etc) to generate better returns and lower risk.
- Blended – An investment style that uses strategic as well as tactical allocation in different ratios within a portfolio to achieve different investment outcomes.
- Satellite
- Value – An investment style that focuses on cheaper-than-ideal valuation stocks (or assets) and/or mean-reversion momentum.
- Growth – An investment style that seeks to gain through market-leading stocks, industries, or sectors and/ or momentum.
- Sentiment – An investment style that seeks to exploit news and events and/ or build-up of positions.
Investment styles driving different investment strategies are combined in portfolios to meet different investment objectives.
Individuals and families can invest like professionals by having clear-cut investment objectives (akin to mandates for institutional investors) and deploying specific investment styles for these objectives (as seasoned investors deploy strategies).
Looking to invest in solution-oriented Core & Satellite portfolios?
Learn more about our Model Core & Satellite portfolios or get to Know More about how we deploy them.
About Us
Modulor Advisory Services is a Securities and Exchange Board of India (SEBI) Registered Investment Adviser (RIA) with license number INA100015115.