Methodology - A Successful Investment Philosophy

Introduction

How does one development a successful investment philosophy?  Year after year the majority of professionally managed funds fail to out perform the market averages.  Each uses different methods to optimize picks.  Popular with today's hedge funds is trading risk for better returns often with disastrous results..  One simple truth remains - unless you own a crystal ball there is no way of anticipating markets.

Mathematical models attempt to manage risk and increase returns.  Yet mathematical models will never understand human behavior.  Markets are about people and on aggregate about history.  Only from a deep understanding of history can we anticipate change.  Only by understanding the mood of crowds can we obtain an insight into the future.

At first glance it may seem counter intuitive to analyze hundreds of years of history to understand today's complex world.  What does the Battle of Hastings or the French Revolution tell us about the future of Amazon or IBM?  Beyond the repetitive nature of the Long Wave, Nicholai Kondratyev provides us a model of behavior.

Each one of us is a product of our thoughts. Often the difference between success and failure lies not ability but attitude.  Society is simply a refection of collective thought.  Kondratyev shows us how to order or arrange the popular mood while determining the extremes of behavior.  If market participants are driven by human thought, attitudes and desire then the best way to analyze markets is to understand the underlying thinking of the participants 

Long Term Perspective

Think of yourself standing on a platform overlooking a busy train station or plane terminal.  With only a few minutes of observation movement appears random and even chaotic.  However, observing for a longer period patterns emerge.  What was previously random activity becomes orderly and predictable.  The ordered activity is not that of random numbers forming fractals, but ordered activity with purpose. 

Yet as patterns emerge, there are also unexplained extraordinary events.  A holiday or weekend will feel and even sound different.  Patterns are broken.  There may even be panics or long periods of inactivity.  Longer study will reveal minor inconsistencies with a change in dress and even schedules.  No single day will be exactly like the previous day.  Record events long enough and subtle differences will become apparent.

Without the long term observation betting on the actions of participants is like playing three card Monte.  Yet without a deeper understanding of the people catching trains or planes, the only frame of reference is the movement of people.  Much like stock prices observing activity only tells half the story.  Without history there is no way to anticipate major trend changes or even extraordinary events affecting prices like war, famine and economic growth.

Systemic Risk

Investment is about balancing risk with gains.  Typically one expects to trade risk for higher gains.  The risk in the stock market is greater than Government backed securities, but potential gains are greater.  Diversity is intended to further limit risk by spreading investment across a number of unrelated holdings.

Generally missed in a discussion of risk is the concept of systemic risk.  Stocks and markets tend to move together.  One holding Dot Com stocks following the 2000 peak did poorly regardless of the merits of the company.  Years of over achieving will not recover the losses.  Systemic Risk is not limited to extraordinary situations like the Dot Com Crash, 9/11 or the 1929 Crash.  Those holding blue chip stocks like GM following the mid 1960s saw their assets sucked away by foreign competition, inflation and obsolescence.  Even government backed securities suffer from a depreciating dollar.

Diversity only insures one shares in the greater risk of major economic changes and events.  Often investors dismiss systemic risk either through the lack of understanding history or as fate affecting all.  The professional investor recognizes making money in markets is only half the picture.  Jessie Livermore and many other barons of Wall Street made and lost fortunes.  The smart investor is as concerned with keeping ones gains.  The retention and accumulation of wealth requires managing systemic risk.

Tying it Together

From the above we can begin to construct quite a different model of investment.  The key to wealth accumulation is to be ahead of trends.  Instead of timing, diversity and watching the ticker one can eliminate or limit risk by anticipating a trend and allowing it to carry your fortunes higher.  Ordering economic activity by popular mood one is able to partially eliminate systemic risk of things like War, Inflation, resource shortages and in many cases the impact from natural disasters.   While Kondratyev's economic theories allow us to construct an investment model we do not rely solely of long term trends.  History and economic harmonics are the foundation for selecting and measuring trends, execution becomes the other part of the model.