To build and maintain a durable and realistic investment program, some key concepts need to be heeded and implemented carefully:
Real investors buy real economic interests in companies or economies, not pieces of paper.
Avoid dilution of returns.
Identify clearly the investable portfolio.
Understand your strategy and stick to it.
Pay attention to costs.
Dilution of Returns
Investors typically capture only a portion of the returns of an asset class. This 'dilution' is due to a variety of factors, some of which are unavoidable and some of which can be managed more efficiently. The total amount of diluted return varies with the asset class and individual circumstance of the investor, but it is in any case sufficiently important to warrant careful consideration.
"Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in the corrections themselves." Peter Lynch
The main types of destructive dilution are:
Behavioral costs: Costs associated with the investor's ability – or lack thereof - to control emotional and psychological reactions during the normal evolution of any investment cycle.
Market timing: Investors' attempts to buy at the "bottom" and sell at the "top" of market ranges. Similar, and carrying equally destructive effects, to buying and selling mutual funds and other investment vehicles based on their past performance.
Transaction costs: Costs incurred in the execution of trades, including commissions and market impact. The more active an investor is, the more transaction costs will impact performance results.
Identifying the Investable Portfolio
This consists in dividing one's wealth according to its objectives and time horizon, and then sticking to that division. The investor's focus is directed to what is needed from each of the different pools of capital.
Know Your Strategy and Stick to It
Investment strategies can vary in the details, but in general they will have at least the following elements:
The essential element of the strategy, closely associated to the purpose of the pool of capital to which it applies. For Liquidity it's very short (cash), for Investable Assets it's very long, and for Self-Directed Investments anything goes (but here too one needs to define at least a theoretical target).
Determining it involves several elements, some of which are tied to behavioral characteristics of the specific investor. To be crossed-checked for consistency with the selected Time Horizon.
It consists of the methodology used to take investment decisions, and of the vehicles employed in implementing those decisions.
The main categories of costs to identify and evaluate are:
Structural costs, associated to the ownership structure of your assets (like holding companies, trusts, or insurance wrappers).
Management costs, for the managers and consultants that help you in the day-to-day running of your investment program.
Custody costs, charged by custodians (generally banks or broker-dealers) to hold your assets.
Transaction costs, incurred when making changes to your portfolio holdings or when custodians charge for receiving/making payments (coupons or dividends, or transfers) on cash transactions.
Vehicle costs, which are the costs of the funds, ETFs or other vehicles acquired and held in your portfolio.
Other costs, linked to administration and reporting requirements.