The fundamental principles of investment strategy

Strategy is a term so “sexy” that nowadays it is used everywhere – in business, politics and even establishing family and close relationships. The concept and definition of strategy over the centuries has provided people with an opportunity to evaluate their actions in depth. However, we find many common features in investment and the art of war. So lets find a a solution to the riddle of Investment Strategy!

Strategy has evolved from military activity.

I need not dwell on the term “strategy” for I assume readers of my articles are sufficiently educated in this regard. To put it simply and succinctly, “strategy” refers to some kind of bigger, more general plan which includes objectives, methods and means and a combination of resources and practices for achieving certain predetermined aims.

Strategic activities could already be seen in the behavior of prehistoric animals, in the power games of rulers from thousands of years ago, but also in the Bible if one analyses the demands of God and the subjection of people to them.

While prehistoric strategies mainly derive from mythologies, more contemporary interpretations of strategy originate above all in the military and war. One could name Plato (or philosophy in general), Homer, commander Sun Tzu, the infamous Machiavelli and later Clausewitz, and why not even Napoleon with his unwinnable wars, as the founders of strategic thinking. By the way, Sun Tzu’s book “The Art of War” is available also in Amazon as well and is quite an interesting read for those mastering the art of leadership.

Why did strategy evolve from the military? And how are war and the military connected to investment?

In the physical world (one having physical connections), in mathematics and in economic theory in general, events are interconnected, actions have consequences and future events are predictable to a great extent.

But from a strategic point of view, as the predictability of certain events is very high, we see that in reality, strategy is not needed in order to achieve a goal. We can solve such tasks without any real obstacles using physics and mathematics. But if all of the events taking place in the world were mathematically provable, then in reverse, the result itself should already be predictable at the moment you begin to solve the task. In reality, however, this is not the case. To understand uncertainty from a strategic point of view, we must briefly look at war and the military.

In the military, different commanders and military strategists have used the help of mathematicians quite extensively to achieve success in battles. There have been attempts to figure out the ideal trajectory, the optimum number of soldiers in troops, the placements of troops, etc. It is true that on paper, everything functioned perfectly. And as is often said nowadays, a business plan works perfectly in Excel. The reality, however, was different from what the mathematicians had foreseen.

In other words, when the battle took place, there was little time for calculations and all kinds of measurements and optimizations no longer held water. Independent of calculations, the final result of the battle became indeterminable. It was also observed that the proportion of the forces – or in other words, the number of men – was not always crucial. Factors which were very difficult to describe affected the course of the battle. It should be noted that military strategy in its ideal form was not written down later in history either.

As the battle itself was chaotic and the final result indeterminable, people began to develop other activities which could lead to success. And so transactions with allies, intelligence activities, etc. began to emerge.

As the result of the war was unpredictable, warfare from then on was referred to as “the art of war”.

Investing and strategy

No one is likely to disagree with me when I say that investing appears to be a very confusing thing. It is a wide-ranging field which, however, does not exist as a separate scientific discipline. Investing encompasses all kinds of activities and scientific disciplines; mathematics and psychology are probably the most important.

Considering that investing is not an exact science and a great deal of uncertainty accompanies this activity, investing is also referred to as an art – the art of investing.

Let us rephrase that. Comparing the art of war and the art of investing, we see that while both involve setting an objective, the final result remains indeterminable and unpredictable during the process.

The predictable and unpredictable world

We do not know how the prices of stocks will change in the future, what will happen with the economies of different countries and regions, what kind of turnover will be achieved in the coming year by one company or another, when the supervisory board will dismiss the management board, when one company will make an acquisition proposal to another, etc.

I can’t even imagine what the world would be like if everything was predictable. Let this remain a matter for sci-fi writers. A certain part of life, however, is still predictable on a large scale – that the sun rises, that milk turns sour, that the car starts in the morning, that a headache goes away after taking medicine, etc. In short, both predictability and unpredictability are natural parts of our life.

For some reason, people know how to behave, and do so relatively well, in predictable situations; less so in unpredictable situations.

Surprisingly, we can conclude here that life is possible because it is unpredictable. How so?

Namely, we always have something to hold on to in unpredictable situations – we are guided by previous similar situations, we establish links between different events and, in the end, if all else fails, we can still rely on our gut feeling. Decisions based on instinct are largely random, and if the result achieved is what we expected, we call it luck.

Randomness is in itself an extremely interesting field of study. I recommend reading N. N. Taleb’s book “Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets“. This is an excellent book which radically alters one’s mindset towards the world and stock markets.

Can we copy investment success?

In the case of investment, however, one cannot talk about strategy in such a way as in business or the military, for example. Within each field, strategy is made up of components peculiar to it, and the activities and tactics are largely different. For example, finding allies is likely not an important supporting activity in investing, or intelligence activities may even be prohibited outright.

It is impossible to go about investing without a strategy, especially if an investor wishes to be successful. Observing successful investors and monitoring and analysing their activities in the long term, we note some definite links between different activities to be guided by.

It is also important that in the case of investing, a couple of unique strategies can be identified which can be copied and imitated, thereby achieving success.

In general, such an anomaly is not found in other fields, as competition forces such inefficiencies to be eliminated. Let this be called the effectiveness of markets.

Nonetheless, in this sense, investing is an art. And art is how it always is. Materials and resources are available to all in the same way, whereas the painted picture is completely different for every person.

This illustrative fact is one of the main reasons why I think that investing strategies are more or less reproducible.

In investing we are not attempting to achieve victory against one person, but dealing with the environment. This means our adversary does not fight against us with a similar or different strategy.

If we reduce the competition to a smaller number of people, the situation becomes more similar to a battle and reproduction of a strategy becomes either very beneficial or completely pointless. Such is the case with achieving success as well. If we realize what our opponent’s moves are, we have gained a significant advantage. In the case of the market, it is essentially impossible to see through the opponent’s moves, as the number of opponents is indefinite.

Let’s tie the different threads together.

Since the market is unpredictable, strategy must be built on a spot where it can be put into practice. 

In the case of investing, one must deal to a large extent with oneself when putting a strategy together.

In other words, when composing an investing strategy one must above all evaluate one’s own activities in an environment which cannot be altered and whose predictability is close to zero.

Once the investor understands this important principle, creating a strategy around investing or understanding investing activities becomes significantly easier.

The strategy is built to overcome obstacles

As a basis, we have the classic approach to developing a strategy. In other words, when we begin composing a strategy, we generally have a vision of where we want to arrive at. In the military, for example, we want to win a battle; we describe the environment, our resources and opportunities and the obstacles to achieving our goal. On the basis of this we begin to put together a plan and choose activities.

I emphasize the word “obstacle”. During a battle, it is inherent that obstacles (above all, fatal ones) have to be overcome to achieve a goal. In business, the obstacles are less tragic, but the obstacles are also quite easy to identify – be they the lack of initial capital, licences or resources for starting a business. Obstacles can be identified, and many of them stem from the environment.

The different approaches of beginners and professionals:

  • Investing laymen say that the environment is a major obstacle when it comes to investing (for example, by saying that “the market is moving in the wrong direction”).
  • Experienced investors, however, distinguish themselves from the environment. For them, the environment is what it is: just the environment.

If the environment is the same for everyone, then it is not an obstacle.

And if the environment is not an obstacle, one needs to look the other way. One must look into the eyes of the adversary, or in other words, he who has decided the environment is an obstacle to himself. To put it another way, the biggest obstacle in investing is the investor himself.

If strategy is, in simple terms, a method or plan for overcoming obstacles, then when composing an investing strategy we must above all overcome obstacles originating from within ourselves.

Saying this, we arrive at why the legendary Warren Buffett refers to the book “The Intelligent Investor” as the most important book on investing of all time.

When I read this book for the first time in 2003, I understood very little of it. Yes, I understood the principles described in it, but I did not understand why working on oneself was so important when it comes to investing.

Thus, controlling oneself means resisting human weaknesses.

For example, waiting for stock prices to fall in order to purchase them cheaply when they do. Yes, precisely the ability to wait is one of the important qualities of an investor.

I shall not go further into the personal qualities and peculiarities of investors at this point, however. A lot of literature exists on this subject and the books referred to above summaries it in the best possible way.

Much has been written about investing strategies as well and I believe that if one reflects a little on the subject, thinking about strategies may seem slightly easier and more interesting.

A.Roosalu