How to Invest Like an Institution

For those investors who have survived one or more major market downturns, some lessons have been learned. Some firms not only survive those downturns, but profit handsomely from them. Why do certain investment companies fare better than others and survive market waves?

Successful companies have a long-term investment philosophy and they abide by that. They also have a strong investment strategy that they formalize within their products and understand that while taking some risk is part of the game, a steady, disciplined approach ensures long-term success. Once the key tools of successful investment firms are understood, they can easily be adopted by individual investors to become successful. By adopting some of their strategies, you can invest like the pros.

Determine a strong investment philosophy before you consider any investment strategy. An investment philosophy is the basis for investment policies and procedures and, ultimately, long-term plans. In a nutshell, an investment philosophy is a set of core beliefs from which all investment strategies are developed. In order for an investment philosophy to be sound, it must be based on reasonable expectations and assumptions of how historical information can serve as a tool for proper investment guidance.

For example, the investment philosophy "to beat the market every year" is a positive goal, but it is too vague and does not incorporate sound principles. It's also important for a sound investment philosophy to define investment time horizons, asset classes in which to invest and guidance on how to respond to market volatility while adhering to your investment principles. A sound long-term investment philosophy also keeps successful firms on track with those guidelines, rather than chasing trends and temptations.

Since each investment philosophy is developed to suit the investment firm, or perhaps the individual investor, there are no standard procedures for writing one. If you are developing an investment philosophy for the first time, and you want to invest like a pro, ensure you cover the following topics:

• Define Your Core Beliefs
  The most basic and fundamental beliefs are outlined regarding the reason and purpose of investment decisions.
• Time Horizons
  While investors should always plan on long-term horizons, a good philosophy should outline your more exact time frame.
• Risk
  Clearly define how you accept and measure risk. Contrary to investing in a savings account, the fundamental rule of investing is the risk/reward concept of increasing your expected returns with increased risk.
• Asset Allocation and Diversification
  Clearly define your core beliefs on asset allocation and diversification, whether they are active or passive, tactical or strategic, tightly focused or broadly diversified. This portion of your philosophy will be the driving force in developing your investment strategies and build a foundation to which to return when your strategies need redefining or tweaking.

Successful firms also implement product funds that reflect their investment philosophies and strategies. Since the philosophy drives the development of the strategies, core style investment strategies, for example, are usually the most common in most successful product lines and should also be part of an individual plan. Core holdings or strategies have multiple interpretations, but generally, core equity and bond strategies tend to be large cap, blue chip and investment grade types of funds that reflect the overall market.

Successful firms also limit their abilities to take large sector bets in their core products. While this can limit the potential upside when making the right sector bet, directional bets can help add significant volatility to a fund.

When defining an investment strategy, follow a strict discipline. For example, when defining a core strategy, do not chase trends. Although of course investors may have defined momentum strategies that are incorporated into the overall investment plan.

When outlining a sound investment strategy, the following issues should be considered.

• Time Horizon
  A common mistake for most individual investors is that their time horizon ends when they retire. In reality, it can go well beyond retirement, and even life, if you have been saving for the next generation. Investment strategies must focus on the long-term horizon of your investment career, as well as the time for specific investments.
• Asset Allocation
  This is when you clearly define what your target allocation will be. If this is a tactical strategy, ranges of allocations should be defined, if strategic in nature. On the other hand, hard lines need to be drawn with specific plans to rebalance when markets have moved. Successful investment firms follow strict guidelines when rebalancing, especially in strategic plans. Individuals, on the other hand, often make the mistake of straying from their strategies when markets move sharply.
• Risk Vs. Return
  Clearly define your risk tolerance. This is one of the most important aspects of an investment strategy, since risk and return have a close relationship over long periods of time. Whether you measure it relative to a benchmark or an absolute portfolio standard deviation, stick to your predetermined limits.

Investment strategies define specific pieces of an overall plan. Successful investors cannot beat the market 100 percent of the time, but they can evaluate their investment decisions based on their fit to the original investment strategy.

After you have survived a few market cycles, you can potentially start to see patterns of hot or popular investment companies gathering unprecedented gains. This was a phenomenon during the Internet technology investing boom. Shares of technology companies rose to rock star levels, and investors – institutional and personal – piled on funds. Unfortunately for some of those companies, success was short-lived, since these extraordinary gains were unjustified. Many investors had deviated from their initial investment strategies to chase greater returns. Don't try to hit home runs. Focus on base hits.

That means trying to beat the market by long shots is not only difficult, it leads to a level of volatility that does not sit well with investors over the long term. Individual investors often make mistakes such as using too much leverage when markets are moving up, and shying away from markets as they are falling. Removing the human biases by sticking to a set approach and focusing on short-term victories is a great way to fashion your investment strategy like the pros.

Taking cues from successful professional investors is the easiest way to avoid common errors and keep on a focused track. Outlining a sound investment philosophy sets the stage for professional and individual investors, just like a strong foundation in a home. Building up from that foundation to form investment strategies creates strong directions, setting the paths to follow.

Investing like the pros also means avoiding the temptation to drift from your investment philosophy and strategies, and trying to outperform by large margins. While this can be done occasionally, and some firms have done it in the past, it is nearly impossible to beat the markets by large margins consistently. If you can fashion your investment plans and goals like those successful investment companies, you can invest like the pros.