How to define an investment strategy

There are a few critical elements required to achieve an investing goal. The first element is taking the time to think about what you want to accomplish and writing down that goal. The second is to have a documented strategy to achieve your goal. That is a plan. You know where you are trying to end up and have an approach to get there.

It seems so simple. We plan our days, our vacations and our dinners. But most investors don’t have a plan. Investors without direction just drift along influenced by all the noise coming from changes in markets and the constant commentary from market ‘experts’. These investors struggle to evaluate how they are doing because there is no context to judge performance.

Helping investors craft a plan is one of the reasons that financial advisers add so much value. This advice comes with a cost. According to a 2022 University of Adelaide study fees for initial advice costs between $2,000 and $3,999. For some investors with higher levels of assets that may be a bargain. For some investors it makes no sense. The good news is that anyone can come up with their own plan.

This article focuses on crafting an investment strategy. The prerequisite to this step is to define your goals and understand the return needed to achieve your goals. We have multiple ways to help you with these steps.

There are four steps to create an investment strategy. They include:

Define your high level approach
Set your asset allocation
Determine your edge
Identify security selection criteria
Establish the basis for making changes to your portfolio

I will use myself as an example. Not because anyone should replicate my approach. I just think it is beneficial to have a real-life example.

Step 1: Define your overall approach

This step turns a goal into a high-level investment approach. A goal should specify the outcome an investor wants to achieve. For instance, an investor may want a portfolio that is worth $100k in 10 years or generate income of $20k a year in 10 years. And the goal should include what it takes to achieve that from a return perspective and from a saving perspective. After this exercise an investor may find they need to earn 8% a year and save $5000 a year to have a portfolio worth $100k in 10 years. This is a critical part of the planning exercise.

The investment approach should reflect the type of portfolio needed to achieve a specific goal. And there is no need to write War and Peace. If your goal is to earn 8% a year to have $100k in 10 years your investment approach may be to invest in growth assets to achieve capital growth with a 10-year time horizon.

Clarity is key. More details will be layered into the investment strategy in the future. The investment approach lays the foundation for the rest of the strategy.

My approach

My goal is to build passive income in my non-retirement accounts. I have a specific target I would like to achieve in 11 years. To achieve my goal I want to purchase income producing assets that provide a stable and growing income stream.

Step 2: Set your asset allocation

Studies have shown that asset allocation is the single largest driver of long-term returns. At a high level this involves an allocation between growth and defensive assets. In theory - and on a historical basis - growth assets like shares have higher returns than defensive assets like cash or bonds.

If a higher return is needed to meet an investment goal a larger portion of a portfolio needs to be allocated to growth assets. Simple as that.

Asset allocation can get more complex the further an investor drills down. Some investors are making decisions on how much to allocate to emerging market equities vs. small cap equities. I have nothing against this approach.

However, it is worth nothing that the largest driver of future expected returns of a portfolio comes from the high-level decision between growth and defensive assets. If you are more comfortable stopping at that level things will just be fine.

Complexity brings certain benefits but there are also downsides. Complexity requires more monitoring and more rebalancing which has tax implications and requires more effort and time to monitor a portfolio. I am not saying don’t do this. Just be mindful of the implications.

We will address diversification in the security selection portion of the investment strategy. Asset allocation and diversification are different. Asset allocation is about designing a portfolio that suits an investor given return and volatility objectives. The purpose of diversification is to remove single security, sector and asset class risk from a portfolio.

Whichever approach is taken write down your asset allocation.

My asset allocation

Mine is pretty simple – I want 90% of my assets in growth assets and 10% in defensive assets. I’m not personally overly concerned about allocations below the high level grouping of defensive and growth assets but there are specific reasons for this based on my goal of generating passive income. More to come.

Step 3: Determine your edge

At this point the foundation of an investment strategy is complete. The approach and asset allocation target will guide the criteria to select investment. But there is one important step that needs to be completed first.

The debate between active vs. passive is ongoing. The active camp believes that certain investment professionals can beat the index by picking individual investments. The passive camp believes that when fees and tax efficiency are considered it is rare to outperform the index.

It is an interesting debate and may have implications on your investment approach. But it is not the debate an individual investor needs to have. Our job is not to beat an index. Even if it was which index would we pick that represents a widely diversified portfolio? Our job is to achieve our goals. And those goals differ.

The question an individual investor should consider is what source of investing edge will help to achieve a specific goal. An investing edge can be thought of as your competitive advantage as an investor. There are four sources of edge an investor can have:

Informational edge: Informational edge is knowing more information about a particular investment than most other investors. Having unique information enables better investing decisions. This is very different than being an informed investor. There are lots of informed investors. This edge is very hard to obtain legally without getting into insider trading. It is very unlikely that anyone reading this has an informational advantage.

Analytical edge: In this case an investor has the same information as other investors but does a better job drawing conclusions from that information. This is very hard to do. Remember that you are not competing against your halfwit neighbour. You are competing against teams of highly educated and well paid professional investors who spend all day analysing investments.

Behavioural edge: Successful investing is not just an intellectual exercise. It also involves holding emotions at bay when making decisions on when to buy and sell different investments. There are countless behavioural impediments to successful investing. Despite the challenges in overcoming our ingrained biases this is a source of edge that any investor can have. Providing structure around decision making is a good start – hence the need to document your investment strategy.

Structural edge: Structural edge refers to external factors that influence the way an investor acts. This is largely an issue for professional investors. There are lots of factors that influence professionals – career considerations, dealing with investor inflows and outflows and pressure to not let short-term performance dip below an index. Not of these issues impact an individual investor. This allows us to focus on the long-term and our individual objectives. Despite a lack of external factors influencing investment decisions most individual investors remain short-term focused. This another source of edge that any non-professional investors can and should use to their advantage.

Identify and write down the sources of edge that you believe you have and what you need to do to take advantage of that edge. If you’ve read through the list of sources of edge and you don’t believe any of them apply that is perfectly fine. In that case it would be best to invest passively. Buying an index and regularly contributing to your portfolio is a great way to build long-term wealth. The key here is consistency. If the market goes up or it goes down continue to dollar cost average into your portfolio. Just stick to your plan.

My edge

I personally believe that I have behavioural and structural edge. I believe I can take advantage of those sources of edge by finding great companies with long-term competitive advantages and buying them when valuations are attractive. I want to hold them for long-periods of time which provides the opportunity for dividend growth which will increase my passive income. In order to achieve my edge I need a structured approach to my investment process to minimise the role my emotions play when I invest.

Step 4: Identify your security selection criteria

Investors are confronted with a vast array of choice. There are thousands of global publicly listed shares and ETFs. Australian investors can choose from 12k managed funds. Publicly listed companies range from giant multinationals to small locally focused businesses. ETFs and funds cover broad indexes and niche thematics. They follow countless investment strategies and can be actively and passively managed.

The abundance of choice creates challenges for investors. Some investors suffer from analysis paralysis and struggle to pull the trigger on an investment.

Ironically, knowing more about investing does not make this process any easier. People that are new to investing may feel overwhelmed by the seeming complexity of investment options. Experienced investors can feel equally overwhelmed by the potential flaws in each option. My colleague James Gruber wrote about these challenges when he tried to construct a simple 3 ETF portfolio.

Investors that make the leap and buy something can suffer buyer’s remorse and get tempted by alternate choices. This temptation is exacerbated by the fear of missing when faced with constant commentary on the merits of different strategies, markets and individual securities. This contributes to the constant churning of investor portfolios.

Defining your security selection criteria narrows the field and creates a more concentrated list of options. It also lessens the temptation to change investment approaches by maintaining the connection between a goal aligned investment strategy and portfolio holdings.

An investor may have different security selection criteria for different asset classes. This can be based on several factors. An example is that an investor may want to invest in individual companies for Australian shares given familiarity with the local market and the ease of trading. For emerging markets the same investor may want to use an ETF or fund because the markets are less familiar and it is very difficult to buy direct shares.

For new investors this step in an investment strategy may be challenging. It takes time and some knowledge to align a goal to the criteria used to select investments. More than anything it requires thinking. My suggestion is to get something on paper and refine it over time as you gain more experience and have a chance to clarify your thoughts.

Start with the types of investment vehicles given your sources of edge

Step three of defining an investment strategy involved identifying a source of edge or competitive advantage. If you found it challenging to articulate how you expected to do better than the average investor it might be a sign that you should get some help in managing your portfolio or stick to passive investing.

No edge means no individual shares. It means no thematic or factor ETFs. Just make sure you get exposure to the market or the part of the market that adheres to your investment approach and earn the average or index return. There is no shame in this approach. Focus on saving money and let the index do its job. This is a very effective approach to build wealth.

If you believe that you have informational or analytical edge it is worth considering where this plays out. Do you believe it will allow you to pick the right companies that provide you with the best opportunity to achieve your goals? The focus should be on purchasing individual shares.

Do you believe it allows you to identify asset classes or pockets of the market that are undervalued? That opens up the investment universe to individual shares and index tracking funds or ETFs. The key is simply directly funds into the attractive opportunities and avoiding unattractive parts of the market.

Do you believe you can pick the right managers that will enable you to achieve your goal? That means finding active fund and ETFs with talented managers.

It is worth noting once again that it is extremely difficult for any investor to maintain long-term informational and analytical edge.

If you believe you have behavioural or structural edge the key is discipline. Any type of investment can be used but making good decisions is paramount. Ensure that structures are in place to enable rational assessments of opportunities while eliminating or minimising emotional reactions to volatility.

My approach

Given the two sources of edge I identified I will invest in funds, ETFs and individual shares. However, I will avoid active funds and ETFs. My decision is to avoid active management in the portion of my portfolio aligned to my goal of generating passive income. To buy an active product is to outsource decision making without knowing what the manager is buying or selling or why thanks to Australia’s antiquated – and ridiculous – regulations that don’t force full disclosure of holdings.

Structural edge is something that impacts the average active manager which is one reason for high turnover. This is a generalisation. However, active managers also charge higher fees which detract from the income generated and generate poor tax outcomes when compared to passive products. This is also a generalisation. But without full disclosure of holdings it is very hard for me to find the managers that are adhering to my standards.

When combined with the fact that most active managers underperform it is enough for me to exclude active management. People may disagree with this decision. I’m ok with that as I don’t believe this decision impacts my ability to achieve my goals.

What personal circumstances influence investment selection

Personal circumstances play a role in transaction costs and tax implications. Everyone’s goal should be to minimise their impact on returns.

For super investors in the pension phase taxes can be ignored. Investors in lower marginal tax brackets or in super during the accumulation phase should be moderately concerned with minimising taxes. For investors with money outside of super in high marginal tax brackets minimising taxes is paramount.

Investor behaviour has an influence on returns. Holding investments for longer than a year is better than short-term holding periods. We will cover this in step 5.

The type of investment also matters. Both ETFs and Funds distribute capital gains to investors when they occur. In general, an actively managed ETF or fund will generate more capital gains than passive products. Some thematic or factor ETFs have high turnover due to rebalancing. It is important to understand how this works.

The advantage of holding individual shares is that the investor gets to choose when capital gains are realised. If you don’t sell you won’t pay capital gains taxes.

Transaction costs are dependent on an investor’s broker. Some brokers have low or no transaction costs. Transaction costs are also impacted by investor behaviour. Less trading means less transaction costs.

For an investor that is saving and investing continually with a high-cost broker transaction cost may play a role in the type of investment picked. Funds do not have transaction costs and savings plans may have lower investment limits.

My approach

I trade infrequently and have a low-cost broker. However, my income goal is for accounts that sit outside of super and I have to pay the marginal tax rate on capital gains and dividends. I can’t avoid taxes on income. But I do spend my income so this is just a cost of earning money. I want to avoid capital gains. This is another reason I want to avoid actively managed funds and ETFs and make sure that rebalancing policies are sensible. My individual share investments rarely generate capital gains given the low turnover of my portfolio.

The fact that I don’t trade a lot and have a low-cost broker means that transaction costs do not play a role in the vehicles I select.

Layer in the investment approach outlined in step one

This is where we start to incorporate your goals. If you are interested in generating and growing income than take an income tilt to whatever investment vehicle was previously identified. If you are looking for lower volatility than find investments that don’t tend to excessively fluctuate in price.

The more complicated part of this step is to identify the attributes that meet your approach.

This may take a bit of research. There are three common approaches that investors will have:

Meeting a specific return objective
Lower volatility
Income

I will outline the return objective approach and then use the income approach as my example.

Meeting a specific return objective is primarily an asset allocation decision. Higher returns require more of an allocation to growth assets. The asset allocation step went through this process. The key during the goal definition process is to make sure the return is achievable. If not, re-define your goal.

Don’t fall into the trap where you believe a specific investment approach will generate higher returns. There have been periods when growth has outperformed value. There have been periods when value has outperformed growth. Same thing with small caps vs. large caps, dividend paying shares vs. non-dividend paying shares and any other attribute.

At Morningstar we believe that the key attributes for long-term success are finding great companies with sustainable competitive advantages and companies trading below their intrinsic value. This matters a great day if you are picking individual shares. If not, you can either outsource the decision making to an active manager or simply dollar cost average into some form of ETF or fund that tracks an index.

My approach

I am interested in generating a sustainable and growing income stream. We can break down each of these components of my investment approach:

Income: This is simple. I want investments that generate income. This eliminates anything that doesn’t generate income. The yield of my portfolio should be higher than the overall market. If not I would just buy the index.
Sustainable: Sustainability of income is more complicated. But we can walk through some specific attributes. I don’t want a company whose earnings could fall significantly because they may not be able to maintain a dividend. That eliminates cyclical companies and companies that do not have moats and may succumb to competition over time. I want companies with medium or low Uncertainty Ratings. The Morningstar Uncertainty Rating assesses financial strength and business risk. Strong finances and low business risk are both positively correlated with a company’s ability to maintain dividends over time. I also want a lower payout rate which represents the amount of earnings paid out in dividends. I avoid excessively high payout rates that approach 100%. A high payout rate means that a drop in earnings could put the dividend in jeopardy as earnings may not be able to cover the payments to investors. I tend to buy larger companies that are well established with a diverse set of products and services. That provides more predictability of future outcomes.
Growth: Companies with growing dividends also need to grow earnings. It is impossible to predict the future but moats or sustainable competitive advantages play a role here. Holding competition at bay gives the company the ability to protect market share.

Some of these attributes are conflicting. For example, it is hard to generate income at a higher rate than the market and also grow that income significantly. That isn’t a problem. I can create a mix of different investments in a portfolio. Some with high current income and some with higher potential for growth.

For fund and ETFs I’m avoiding actively managed products but fortunately my strategy is not unique. There are many factor ETFs and funds that track indexes that use rules to try and identify sustainable and growing dividends. Comparing the rules to my criteria allows me to assess the ETF or fund. I recently did this in an article looking at Australian dividend ETFs.

Step 5: Establish the basis for making changes to your portfolio

As previously stated, an Investment Strategy provides a framework to make investing decisions to ensure alignment with what an investor is ultimately trying to accomplish. The point of the exercise is to minimise mistakes.

The genesis of investment mistakes is a lack of understanding about what an investor is trying to accomplish and how to achieve a specific goal. The manifestation of those mistakes occurs in purchasing the wrong investments in the first place and constantly switching holdings in a portfolio.

Setting criteria for making changes to a portfolio provides an investor with structure to make rational decisions around portfolio turnover.

There are three broad categories that would cause an investor to make changes to a portfolio:

Rebalancing
An investment no longer meets the original thesis
A change in the investor’s circumstances

I will walk through each of those categories in detail. However, it is worth starting with a trap that many investors fall into and the main cause of chronic overtrading. That is the believe that there is a better opportunity than a current holding.

On surface this rationale seems logical. If an investor believes one investment will perform better in the future, then logic dictates it should be purchased with the proceeds from selling a current holding. When tempted to make this trade it is worth thinking long and hard about the merits of this decision.

Many investors are simply extrapolating the short-term outperformance of the new investment opportunity into the future. Some are seduced by a compelling narrative. Throughout time investors have chased performance. It often leads to poor outcomes.

The folly of this thinking is captured in Ben Graham’s parable of Mr. Market. Investors are overly fixated on price changes. This makes it easy to conflate price with value. Short-term price movements are often divorced from the long-term prospects of a company. They are emotional reactions to new data that is inconsequential over the long run. If an investor is focused on behavioural and / or structural edge it makes no sense to follow the herd.

If an investor is focused on informational or analytical edge it is worth remembering that what matters is after-tax outcomes and that transaction fees detract from returns. That means that the new investment must exceed what was sold by the transaction costs and taxes just to breakeven.

It is also likely that an investor will mis-judge the relative merits of a new investment in relation to a current holding. Morningstar has estimated in our annual Mind the Gap Study that investor returns are 1.7% less a year than the actual returns of the underlying investments – that shortfall is based on poor timing decisions.

This is far from the only study showing the downside of this approach. Between 1991 and 1996 the individual investors that traded the most earned an annual return that was 6.5% lower than the overall share market according to a paper by University of California professors Barber and Odean.

If you trade frequently in an attempt to be nimble and always own the ‘best’ investments I have news for you. Chances are you would have more money today if you traded less. Reducing the number of trades going forward means you will likely have more money in the future.

Reasons to make changes to a portfolio

Rebalancing

There are times when a portfolio needs to be adjusted. If the allocation to an asset class grows or shrinks on a relative basis the overall asset allocation may not align with the target. Large differences can make it harder to achieve a specific goal. A portfolio may also need to be adjusted if a single position becomes prohibitively large. If that position falls significantly, it could prevent you from achieving your goal.

We’ve already documented our asset allocation target in step 2 of the strategy. At this stage we need to document how large a single position can grow before a change is made.

We diversify to reduce security specific risk in our portfolio. That is the risk that something goes wrong with a particular company we own. How much we diversify away that security specific risk is up to each investor.

We could diversify it all away by owning an index fund that includes every share. We could diversify some of it by owning two companies. Each individual share you add to your portfolio will move your security specific risk along the spectrum from putting all your eggs in one basket and owning the entire market. Owning the whole market or every share available means you are just exposed to market risk. And you will get the market return. You are now a passive investor.

For more on diversification see this article.

In my case I don’t want a single share to exceed 5% of the market value in my portfolio and I don’t want a single share to exceed 5% of my total income. For a well-diversified ETF, I will tolerate a much larger position size and percent of income. This is a judgement call on how large an ETF position can grow before it is too big and is based on the specific ETF. I’m more comfortable with larger positions in a broadly diversified ETF than a narrowly focused ETF.

It is important to determine the rules about position sizing and what to do if a position gets too big. I try not to sell if I can help it. My first step is to turn off the dividend reinvestment if a single security or asset class is approaching my limit. I also re-direct new savings into under represented asset classes and holdings. Only as a last resort will I sell off part of a position. My hesitancy in selling is based on my goal of avoiding taxes and transaction fees.

An investment no longer meets the original thesis

In part 4 of the strategy we outlined the selection criteria used to pick individual holdings for a portfolio. The reasons why a particular holding meets those criteria and is purchased is your thesis. In my case I will focus on investments in high quality, non-cyclical companies with moats, strong finances, low business risk and acceptable payout ratios.

I hope that every investment I pick meets those characteristics at the time of purchase and well into the future. That is unrealistic. Conditions change and companies change. This occurs far less frequently than popularly portrayed. But it does happen.

If a company no longer meets my criteria it may be time to consider replacing it with something that does. However, just as I would never buy a company that only had a single good quarter or year, I would never sell a company that goes through a rough patch. Patience is key.

Investor circumstances change

Over time an investor’s circumstances may change. This is natural as an investor ages and / or approaches a goal. This may be a time that an investor would reconsider holdings in a portfolio. When this happens the best thing to do is go back to the beginning are refine the strategy. That way each part of an investment strategy remains aligned.

My approach

I do not want a single share to represent more than 5% of my portfolio from both a market value and percent of income basis. For an ETF I will set limits based on how broadly the ETF is diversified.

I will examine my allocation to growth and defensive assets on an annual basis and will consider making a change if the allocation is 5% above or below my target. I will allocated more to defensive assets if I cannot find investments that meet my criteria.

I will try to avoid rebalancing by selling a position and will only do so once if I cannot adjust my portfolio by redirecting dividends and new savings.

I will change individual holdings if they have demonstrated conclusively they no longer fit my original thesis and my security selection criteria.

Conclusion

This brings our long journey to an end. We’ve now defined an investment strategy. I’ve used a personal example because it brings the process to life. I hope that has helped. The strategy is relatively short but there are lots of points I considered as I made each decision and tried to capture those trade-offs in this series of articles.

If you are defining your own investment strategy please remember this doesn’t need to be an exercise that is completed in one sitting. There are lots of things to think about. This is also a living and breathing document which can refined over time as you gain more experience and knowledge. Make sure you review your strategy periodically.

And if this seems like too much effort you can always take-up day trading. Stare at charts until the future direction of the price line becomes obvious. Admonish yourself that the trend is your friend. And don’t forget to tell me I’m wrong about overtrading as you sip cocktails on the deck of your yacht. You can write me at mark.lamonica1@morningstar.com

Below is my complete investment strategy:

I will build passive income in my non-retirement accounts by 2035. To achieve my goal I will purchase income producing assets that provide a stable and growing income stream.

I will allocate 90% of my portfolio to growth assets and 10% to defensive assets.

My competitive advantage stems from behavioural and structural edge. Taking advantage of these sources of edge requires a focus on finding great dividend paying companies with long-term competitive advantages. I will purchase investments at attractive valuations and hold them for the long-term to take advantage of dividend growth. Structured decision making is the key to my success and to take advantage of my sources of edge.

I will invest in individual shares, ETFs and funds. I will avoid actively managed ETFs and funds and any that are likely to generate high levels of capital gains due to index construction and rebalancing policies.

I will invest in dividend paying shares and ETFs and funds that hold dividend paying shares.

I will focus on investments in high quality, non-cyclical companies with moats, strong finances, low business risk and acceptable payout ratios. My goal is for the yield of my overall portfolio to exceed the global market but more importantly I want growth in dividends so I will balance higher current dividend yields and income growth in individual holdings.

I will try to avoid rebalancing by selling a position and will only do so once if I cannot adjust my portfolio by redirecting dividends and new savings.

I will change individual holdings if they have demonstrated conclusively they no longer fit my original thesis and my security selection criteria.