If you plan to retire early, you are eventually going to become a “professional” money manager as in a sense you will be managing your money for money. You will, of course, be operating on a much smaller scale and so you will have a much easier job than a real professional who is subject to regulations and other restrictions.

Note: The investment overview now lives on the ERE wiki
and covers more strategies than described below.

Now, you could pay some “25 year old fund manager with a bachelor degree from a top tier university” 1% to do this. However, this means that instead of multiplying your monthly expenditures by 300(=12/0.04) you must multiply them by 400(=12/(0.04-0.01)). This is akin to giving Wall Street a third of your money. While this may be an acceptable solution for someone planning to work for 30 years, letting other people manage your money significantly impacts the time horizon of early retirement: You have to work 33% longer before you can pull the trigger.

Learning to manage your own investments is not easy and you will have to spend considerable time educating yourself. As a science, investment has not progressed beyond description and analysis(*). As a predictive science, investing is very much lacking. There have been some statistical inroads but beyond that investment theories generally seem to read as someone’s autobiography.

(*)It is interesting to know that formal education in investing tends to focus on description and analysis while popularizations seem to mainly focus on theories.

And that is exactly the point. If everybody did the same thing, investment growth would be naturally limited by GDP growth and GDP growth would be naturally limited by world growth. Yet pick up any book (or blog) and you will find people happily extrapolating exponentially into the sky, the DOW 50000 kind of thinking. I call this kind of thinking “stupid” :-P

You may stop for a moment to meditate on what the popularization of a given investment strategy will do to the returns of that strategy. Indeed, it will significantly depress the historical returns and it could even make them negative if you get in at the end.

I think it is important that each player or agent (and you will become one) in the stock market use a strategy that is entirely tailored to the individual. It will take time and “investment-introspection” to find this strategy e.g. you won’t know if a particular strategy will let you sleep well until you tried it.

I can tell you which strategy I am converging towards. Of course to put this in perspective you also have to know what kind of emotional or behavioral stance I take.

  • I do not believe the stock market is some bonanza to long term automatic wealth. Hence, I do not buy&hold forever.
  • In terms of market cycles, I never believe that these are special times.
  • I see investing as paying for a future cash stream. My discount rate is 3%+plus inflation. (I think for the experts, this will tell you how I go about implementation right away. If you don’t know what I’m talking about, you HAVE to learn … or pay someone who did it).
  • I am far less concerned about the market value of my portfolio than I am about the future and security of my cash stream.

Here are my buying and selling rules.

  1. For any given company I will set a minimum entry point yield, typically 5% for companies and 10% for REITs.
  2. I will enter a position gradually. Buying stocks in round lots of 100.
  3. I will also set exit point yields, typically 3% for companies and 5% for REITs.
  4. Once the stock price moves close to the exit point, I will pursue two strategies depending on the stock. If it is a volatile stock I will sell calls with a strike price around my exit price. If it is a nonvolatile stock or it does not have options, I will set a limit order at the exit price.
  5. If there are no stocks to buy, I will buy short maturation (next year maturation) single issue corporate bonds rating above junk.

My portfolio strategy is as follows

  1. I will own no more than 20 different companies. This allows for substantial diversification while still making it possible to follow each company individually.
  2. No company should exceed 10% of my total holdings. I will not rebalance if it happens, but I will not buy more.
  3. I will own mainly US companies. It is easy to get international exposure by owning transnationals. My international exposure is in my 401k/IRA (currently less than 10% of my holdings) because it makes doing taxes easier. I am willing to sacrifice returns for this.
  4. I follow no strict asset allocation. My asset allocation is determined by my trading strategy above. For the same reason I do not rebalance.

When it comes to buying stocks, it gets tricky. Usually there are 10 or more criteria of what makes a perfect stock. Unfortunately, all of them are never fulfilled. This makes pulling the trigger a judgment call. When it comes to pure screen metrics, I like a P/B below 1, but I am willing to entertain higher values. I also like trailing earnings yields higher than 10% (P/E<10), but again I am willing to entertain lower values. I think debt/equity ratios are also also important(*). Ideally this should be 0, but often you don’t get a deal like that.

(*) Which is more impressive? Assets of of $200000 with $0 in debt or assets of $500000 with $300000 in debt? Both have the same net worth (equity), but the first have a debt/equity ratio of 0 whereas the latter have a debt/equity ratio of 150%. Hence the former is a much more financially secure/stable person/company.

See how this process works. Relying strictly on measurable metrics is like hiring a person based on their GPA. It may give you an indication, but it does not give the whole story. The important idea is that the numbers are not the end all but their give an indication of where to look and where not to look. To get a better idea, I read through the 10K and last few 10Qs and try to find some conference call transcripts to get an idea of what kind of management the company has. In general though I read as much as I possibly can about the company. As with anything, the more you read the easier it becomes to understand subsequent readings.

My 5 biggest positions as of today are: WFC, GE, WAG, HRP, and UPS. You will note that these stocks have been kicked lately and that they are heavy on financials, real estate, and transports. These are bad stocks to own going into a recession but pretty good going out of one.

For further reading, I recommend the The Dhandho Investor and The Intelligent Investor. I would start with the first. For those who can handle light college level math (should be everybody in my opinion), Investment Science is quite good!

Incidentally ,I believe it is superior to invest within your field of competence whether it is the stock market, real estate, or plumbing. I use the stock market, but you may find the other things work better for you. This is where the investment-introspection I mentioned above becomes important.