As investors, we would all like to beat the market handily, and we would all like to pick "great" investments on instinct. However, while intuition is undoubtedly a part of the process of investing, it is just part of the process. As investors, it is not surprising that we focus so much of our energy and efforts on investment philosophies and strategies, and so little on the investment process. It is far more interesting to read about how Peter Lynch picks stocks and what makes Warren Buffett a valuable investor, than it is to talk about the steps involved in creating a portfolio or in executing trades. Though it does not get sufficient attention, understanding the investment process is critical for every investor for several reasons:
The best way of describing this book is by noting what it does not do. It does not emphasize individual investors or push an investment philosophy. It does not focus heavily on coming up with strategies that beat the market, though there is reference to some of them in the course of the book. Instead, it talks about the process of investing and how this process is the same no matter what investment philosophy one might have.
The book is built around the investment process. The process always starts with the investor and understanding his or her needs and preferences. For a portfolio manager, the investor is a client, and the first and often most significant part of the investment process is understanding the client?s needs, the client?s tax status and most importantly, his or her risk preferences. For an individual investor constructing his or her own portfolio, this may seem simpler, but understanding one?s own needs and preferences is just as important a first step as it is for the portfolio manager.
The next part of the process is the actual construction of the portfolio, which we divide into three sub-parts. The first of these is the decision on how to allocate the portfolio across different asset classes defined broadly as equities, fixed income securities and real assets (such as real estate, commodities and other assets). This asset allocation decision can also be framed in terms of investments in domestic assets versus foreign assets, and the factors driving this decision. The second component is the asset selection decision, where individual assets are picked within each asset class to make up the portfolio. In practical terms, this is the step where the stocks that make up the equity component, the bonds that make up the fixed income component and the real assets that make up the real asset component are picked. The final component is execution, where the portfolio is actually put together, where investors have to trade off transactions cost against transactions speed. While the importance of execution will vary across investment strategies, there are many investors who have failed at this stage in the process.
The final part of the process, and often the most painful one for professional money managers, is the performance evaluation. Investing is after all focused on one objective and one objective alone, which is to make the most money you can, given the risk constraints you operate under. Investors are not forgiving of failure and unwilling to accept even the best of excuses, and loyalty to money managers is not a commonly found trait. By the same token, performance evaluation is just as important to the individual investor who constructs his or her own portfolio, since the feedback from it should largely determine how that investor approaches investing in the future.
These parts of the process are summarized in Figure 1, and we will return to this figure to emphasize the steps in the process as we move through the book. The book is built around the same structure. It begins with a chapter that provides an overview of investment management as a business. The first major section is on understanding client needs and preferences, where we look at not only how to think about risk in investing but also at how to measure an investor?s willingness to take risk. The second section looks at the asset allocation decision, while the third section examines different approaches to selecting assets. The fourth section takes a brief look at the execution decision, and the fifth section develops different approaches to evaluating performance.