You must have a robust methodology for selecting the right share, property or bond to invest in. If you select the right asset, your investment returns are likely to be very healthy in the long run.
However, if you make a mistake, it is likely to cost you money – in terms of opportunity cost and/or in real terms.
The best way to prevent making a mistake is to use a methodology for selecting the right asset that is proven to work. In this blog I outline the four different methodologies and the two that I think are best to use in combination, where possible.
There are four different asset selection methodologies
There are many different asset selection approaches which can have their own subtleties and idiosyncrasies. However, every methodology can be broadly allocated into four different categories:
1. Value investing
This involves identifying assets or sectors that are intrinsically undervalued. Markets are not always perfectly efficient and sometimes assets transact for amounts less than fair market value. This could be due to factors such as a motivated seller, misinformation, market sentiment (fear) and so on.
2. Growth investing
This involves identifying assets or sectors that have high growth prospects. This approach is less concerned with the price paid for the asset compared to its appraised value – it’s all about the idea that you can buy this asset today for $x and that price will look cheap in the future after the expected growth has materialised. This methodology requires you to form a view as to what the future growth opportunities could be which is often highly subjective.
3. Fundamental investing
This approach involves identifying the assets or sectors that have the strongest underlying fundamentals such that the asset quality is extremely high. This approach is less concerned about the price paid and usually the assets growth prospects might be already reflected in the current price. The thesis underlying this strategy is that investment returns are directly linked to asset quality i.e. you can only expect above average returns from above average quality assets.
4. Technical analysis
This approach involves looking for trends in data and statistics (such as price movements and volume) to identify assets and sectors that are expected to deliver above average returns in the short or longer term
Fundamental with a value tilt, if possible
The lowest risk approach by far is fundamental investing. Asset quality will typically persist longer than market mispricing or unrecognised growth prospects. As Warren Buffett says, he would rather buy a wonderful stock at a fair price than a fair stock at a wonderful price.
However, sometimes it is possible to employ both a fundamental and value approach. That is, for example, sometimes you can buy a wonderful property or stock for a wonderful price. But, you must never pursue a value approach at the cost of the investment’s fundamentals. That is, never compromise on asset quality.
You can reduce your risk by using an evidenced-based approach
An evidenced-based approach involves only adopting an asset selection methodology where there is overwhelming evidence that it will produce the desired investment returns. Too many people adopt investment methodologies and approaches without considering whether the evidence stacks up and that is just too risky – it is totally unnecessary to take that risk. Therefore, if you want to find a fundamental approach to adopt when selecting the right residential property to invest in, make sure there’s an overwhelming amount of evidence that demonstrates the methodology works.
Specifically, there are several things to consider when assessing the historical evidence:
Is there a list of pre-determined rules that you follow to implement the methodology? For example, if looking to invest in an apartment, it must have carparking on title. One of the major benefits of a rules-based approach is that it is repeatable without highly specialised (expensive) human resources.
You must understand historic returns
It is important to understand what has driven investment returns. Can the returns be attributed to the investment methodology alone or were they influenced by other factors? Are returns likely to persist over the long run through various market cycles? Observing returns is only half the picture. It is equally important to understand the factors that have driven the returns because that will demonstrate whether your rules-based approach will continue to work.
Methodologies can be openly critiqued and stress-tested
Evidenced-based approaches are often peer-reviewed and critiqued. This allows methodologies to be scrutinised and tested by peers and industry participants to ensure they are robust.
They tend to be low-cost
Evidenced-based and rules-based approaches tend to be low cost because the methodology itself is responsible for generating the returns, not an investment manager who are often paid large sums of money.
I’d like to share our fundamental approach with a value tilt
I invite you to join me for a 45-minute livestream seminar on Tuesday 13 November 2018 after work at 7:30pm where I will share with you where I think the best value opportunities exist in the share market and residential property markets at the moment.