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A Philosophical Approach To Investing

By Jim Miller, CFP, Senior Trust Officer

When we sit down with prospective new clients, we ask a number of questions that are focused on understanding what guides them in their investment decision-making. Do they have general beliefs about the investment markets that provide guidance and structure to their decisions? Do they have expectations about what their investment returns will be, and are these expectations reasonable?

Once we have an understanding of any guiding beliefs, we ask questions about their investment process. Do they have a systematic method or process for making investment decisions? Do they make their own decisions or rely on the advice of others? If they look to others, whom do they turn to for assistance and how do they select advisors?

Our experience has shown that many individuals haven’t given much thought to these questions and may not appreciate their importance. We believe it is critical for us to understand prospective clients’ investment philosophies and their decision-making process—and, it’s equally important that they understand ours. Why is this so important?

• It assists both parties to identify whether or not Merchants Trust Company is the right choice. If we aren’t the right fit, we will recommend others.
• It helps us determine if we can meet the expectations of the client. If we feel client expectations are unreasonable, we will discuss our perspective and what we believe are more likely outcomes. If there isn’t general agreement on a range of expected outcomes, then we most likely aren’t the right advisor.
• It serves as a foundation that provides guidance, understanding and confidence during periods of market volatility.

How to determine your investment philosophy

There are two questions that must be answered to identify key aspects of your investment philosophy. Both address whether or not you believe you can do better than the investment market averages.

1) Is it possible for you, or investment managers that you identify, to exceed the returns of a market index by selecting investments that differ from the index?

No: If your answer is ‘No’, then you believe in “Passive” investing. A passive investor holds every security from the market, with each represented in the same manner as in the market. This is done through index or exchange traded funds.

Yes: If your answer is ‘Yes’, then you believe in “Active” investing. An active investor is one who is not passive. His or her portfolio will differ from that of the passive managers at some or all times. Because active managers usually act on perceptions of mispricing, and because such perceptions change relatively frequently, such managers tend to trade fairly frequently—hence the term “Active.”

2) Is it possible to exceed the returns of the overall market by overweighting and underweighting different asset classes as perceived opportunities arise?

No: If your answer is ‘No’, then you believe in “Strategic Asset Allocation” —setting a long-term asset allocation and maintaining it.

Yes: If your answer is ‘Yes’, then you believe in “Tactical Asset Allocation” setting a long-term asset allocation but, making periodic adjustments.

The answer to question 1 for the large majority of investors will be ‘Yes’. After all, who doesn’t want to do better than average? The answer to question 2 is likely to be more divided. Therefore, the majority of investors will fall into either Box #1 or #2. You may question why anyone would even consider Box #4 where you are guaranteed only market average returns.

The short answer is that investment performance for the majority of investors falls short of those in #4. The majority of active investors under-perform the overall market, primarily due to the following factors:

• Most of the information about a given investment is available to all investors, and is therefore, already factored into the price.
• While there may be temporary inefficiencies in market pricing, it is difficult to identify and exploit them, and add value after the costs involved.
• It is very difficult to identify those relatively few managers who will outperform the market in advance of their doing so. Past performance isn’t a strong indicator of future performance.

When an investment manager claims they can do better than the market, we recommend that investors take a skeptical stance. Ask what their investment process is and how it adds value. Ask for evidence that it has worked in the past and understand the reasoning as to why it should continue to work in the future.

At Merchants Trust, we have great respect for the investment performance generated by the market indices, represented in Box #4. We define successful investment performance on our part as meeting or exceeding the market returns, after our fees. We believe the only way to accomplish this objective over the long-term is to have a sophisticated, disciplined and well-defined investment process.

Merchants Trust Company’s Investment Philosophy

Prior to 2002 Merchants Trust Company’s investment philosophy was closest to Box #2—seeking to add value with individual security selection but following a strategic long-term asset allocation. During 2002 we re-evaluated our investment philosophy and determined that there were opportunities to both improve returns, and reduce risk, by incorporating tactical asset allocation.

We believe that the investment markets are generally “efficient”—meaning that current prices accurately reflect the value of the underlying securities. However, we also believe that many investors make decisions based on emotions, rather than careful analysis. The emotional nature of investing opens up opportunities. For example, when greed is the dominant emotion, buying frenzies can result in prices much higher than rational analysis can justify. In contrast, when fear is dominant, prices often decline below justifiable levels.

These situations provide opportunities to reduce exposure to overvalued assets during the greed phase and increase exposure to undervalued assets during the fear phase. Our investment program carefully monitors individual securities and the different asset classes to take advantage of these opportunities.

How our philosophy differs from many others

1. We believe in multiple levels of diversification: among individual companies, industry sectors and maturities, as well as among different asset classes and money managers.
2. We believe that active management means not only extensive research and analysis of individual securities, but an equivalent focus on the valuations of several asset classes.
3. We believe that long-term investment returns can be enhanced and risk reduced through the use of tactical asset allocation (making changes in the amounts invested within the different asset classes, based on relative valuations).
4. We believe that no one organization has a monopoly on the best research capabilities or the most talented money managers. After extensive research and due diligence, we hire the most successful mutual fund managers to identify and take advantage of investment opportunities within each asset class. We have no affiliations with specific mutual fund companies and are able to independently choose the best managers.

We are pleased to report that our clients have benefited from our change in investment philosophy. Our research-based tactical asset allocation has generated returns in excess of a passive and/or strategic approach in each of the past three years.

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