Investment beliefs are assumptions about the way in which financial markets function and the way in which an investor thinks that he or she can add value (or prevent value from being destroyed). Investment beliefs are often applied implicitly and not formalized. Formalization of this fingerspitzengefühl ensures transparency and better consistency. They set the direction for investment policy, investment practice and organisational culture.
1. Investing is about taking risk
Investments have a higher expected return than savings. Risk-taking is often rewarded in the long term. Investments have market risk (also known as systemic or non-diversifiable risk or beta) and specific risk (not systematic or diversifiable risk). For the first risk investors should be in the long run compensated for in the returns (the higher the risk, the higher the return), that is not the case for specific risk. The compensation above the risk-free rate is a compensation for the sensitivity of the assets to macroeconomic factors such as interest rates, economic growth, inflation and unemployment, and thus for the uncertain development of these assets. This fee is called risk premium. There is no risk premium for taking specific risks, as these risks can be 'eliminated' by diversification.
2. Strategic choices determines the majority of returns
Most beta decisions have more impact on returns than alpha decisions (pure alpha is only possible through timing). Investors can better focus on the strategic policy instead of tactical allocation. Estimating future returns, risks and correlations is difficult and you have to recognize the limitations of your assumptions. Correlations between asset classes are also unstable and not always discounted efficiently in market prices. This can be partially compensated by diversifying over different strategies that distinguish themselves qualitatively and are dependent on different economic factors. Investing is also a matter of patience. Man's natural tendency is to act, but people often underestimate the costs involved and trade on irrational convictions. Do not underestimate the power of compound returns (Einstein: compound interest is the eighth wonder of the world). It is not about 'timing' the market, but about 'time' in the market.
3. Investing is about the harvesting of risk premiums
There are five main risk sources of return over the risk-free return: a premium for taking equity risk, credit risk, liquidity risk, manager risk and insurance risk. Other important sources of risk such as duration, inflation and currencies do not offer consistent returns. The term structure for liquidity premiums is generally steep, allowing long-term investors to achieve higher returns than investors with a shorter horizon. Risk premiums vary over time. Sometimes certain asset classes are cheap based on realistic valuation measures and therefore offer an above-average expected return and sometimes certain investment categories are expensive and offer below-average expected returns. The current valuation is an important starting point for forecasting returns in the medium term.
4. Investments follow long-term fundamentals and short-term supply and demand
In the long run, the return of an asset category is determined by fundamental factors. In the short term, the return is determined by the forces of supply and demand (liquidity, momentum and speculation and other more psychologically determined behaviour of market participants). As a result, short-term returns are often volatile, more volatile than justified by changes to the fundamentals. The relationship between sentiment and return is often inverse. Long-term investors can benefit from this by not making extra costs for short-term trading, but by collecting these time-dependent premiums. The two best ways to beat the market are a long-term fundamental policy based on the over- or undervaluation of future cash flows, or a shorter-term approach based on psychological behaviour of market participants. Using benchmark indices in these policies often works counterproductively. Valuations fall back to the average over time.
It is difficult, but not impossible to recognize extreme valuations. Such periods can last longer than the patience of the investor or is allowed based on business risk. Short-term thinking is generally damaging due to the costs of excessive trading, but also by giving away the liquidity premium and by paying less attention to corporate governance. Innovative new markets are interesting because in the early stages they often do not work efficiently. Those who invest early can eventually benefit.
The behaviour of financial markets can be explained by the chaos theory combined with strong psychological elements that can strengthen decisions, nullify them or result in a completely contradictory outcome. This is a chaotic system of the second type. Chaos systems of the first type does not respond to predictions (for example the weather), chaos of the second type does respond to predictions and can therefore never be accurately predicted. Markets are generally - but not perfectly - efficient over a longer time horizon. Investors, however, make mistakes. In other words: the market is rational, humans are not. If these errors start to correlate (for example through legislation, supervision), this results in extreme market valuations and systemic risks. The final effect depends on the size of the market and the transaction costs. Scientific knowledge is particularly relevant for investors, especially when multiple disciplines are combined, such as in the area of behavioural finance (economics, sociology and psychology) or in the field of narrative economics (in addition to behavioural finance, marketing, journalism and even theology). The economy is only a small part of society, also for investors.
For the market as a whole, alpha is negative after deduction of costs. Alpha is a competitive advantage. In a less competitive market or in a market with participants that are not motivated by profit, more alpha can be obtained. However, beware: markets can be controlled for a longer period of time by irrational factors. In efficient markets with a low dispersion, virtually no alpha can be achieved. Then the preference soon goes to a passive allocations in the portfolio. Passive means that there is no need to act in the interim, the portfolio weights move with the market. The search for alpha is sensitive to conflicts of interest. Managing this risk is an important task in selecting managers. Stay cost-conscious and look for added value. The majority of investors would achieve better results if less active managers were included in the portfolio. The high costs of many alternative investments (private equity, hedge funds) ensure that the vast majority of the alpha and even part of the beta is lost. Only investors with a competitive advantage in selecting active managers are compensated for this. Alpha is also cyclical in nature and is determined by changes in correlation, volatility and cash flows. The influence of diversification is considerable, particularly within alpha managers, which is why good diversification across fund managers is necessary. Given the aforementioned difficulties, a (partly) passive interpretation of the portfolio can be preferred.
Investments are made based on function, not on form. For each market a different instrument may be required or is suitable to approach that specific market. This can change over time. Implementation is as important as the investment idea. This involves finding the right balance between risk, return and / or costs. Transparency about costs is therefore essential. Higher costs can only be justified if this leads to a material contribution to lower risks and/or higher returns. Strive for asymmetrically favourable opportunity / risk distributions as much as possible. A good investor does not only look up, but also down. Risk management is an essential part of investing. Even the safest investments carry risks which can hurt quite badly.
In the long run, savings is in terms of purchasing power riskier than investing. In the long run, the purchasing power of assets on a savings account will erode due to inflation and taxes. The biggest risk with savings and investment is the permanent loss of capital (purchasing power). In case of investment decisions, use a safety margin and require sufficient compensation for risks to be taken. Assets and liabilities must be matched. Risks are difficult to estimate in advance, the snake you do not see always bites you. This again emphasizes the importance of a good diversification, de facto a protection against ignorance. The value of standard deviation (volatility) as a risk concept is seriously overestimated. Acting based on volatility is both a risk (namely permanent loss of capital) and an opportunity (timing and therefore alpha). Be very cautious with risk models. Often it is not much more than 'garbage in, garbage out', but it is presented as the new Holy Grail in the field of investing. In most models, the adaptability of man is also seriously underestimated. The broad acceptance of risk models (volatility, VaR etc) is a (systemic) risk in itself.
10. The only thing that counts is a correct analysis
Choose an independent approach, it is not about getting the approval of others. Keep asking questions. Try to avoid blind spots as much as possible. A good company is not a good stock. The relationship between sentiment and performance is often inverse. Good companies use the funds entrusted wisely to create more wealth. Ultimately, it is the return (ROE, ROI) on capital that counts. Never pay too much and think as a contrarian. Recognize that about 90% of the time nobody knows what financial markets will do, but be decisive when you do. Think off the beaten path, creativity and pro-activity is essential to recognize opportunities and risks at an early stage. Good governance and corporate social responsibility are important for every investor; The only return is a healthy financial return. Finally: keep it simple.. Make sure you always understand what is being invested in.