Overview – The Importance of Investment Paradigms
When starting out as an investor for the first time, one of the struggles many investors face (or will potentially face) is not knowing what exactly they need to do.
Every investor knows that they need to put money down today to get more in the future, but before an investment decision is made, there are several in-between steps that an investor will need to take. These in-between steps are the ones some investors struggle to formulate when they’re just starting out.
While common reasons such as a lack of experience or a lack of knowledge are valid, there exists another potential issue – the investor lacks a clear mental framework that determines how to fundamentally approach investing. That is, they don’t have an investment paradigm in mind to follow.
Some investors don’t have a mental framework, and as a result, struggle to figure out what specific actions to take because they don’t have a set of principles to guide them.
Sure, an investor can cobble together what actions they plan to take on a case-by-case basis, but without a clear investment paradigm in mind, an investor is only making their lives that much harder in the future.
If an investor intends on staying for the long term, then they’ll need to have an investment paradigm in mind to guide their actions today and ones far into the future.
What Is an Investment Paradigm, Anyways?
Before continuing our discussion, let’s first understand the definition of a paradigm. According to the Merriam-Webster dictionary, a “paradigm” is defined as follows:
“a philosophical and theoretical framework of a scientific school or discipline within which theories, laws, and generalizations and the experiments performed in support of them are formulated.
Broadly: a philosophical or theoretical framework of any kind.”
In a previous article, investing was defined as follows:
“An investment operation is one which, upon thorough analysis promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
Therefore, we can define an investment paradigm as:
“The theoretical framework which contains the theories, laws/principles, and generalizations that dictate the pursuit of investment operations.”
Put another way, an investment paradigm is simply a framework that dictates the specific actions, decisions, and thought processes of an investor. Randomly purchasing shares is simply an action, but purchasing shares because they are selling for less than their intrinsic value is an action guided by a specific investment paradigm.
Of course, this definition of an investment paradigm is an arbitrary one, but regardless of how it’s defined, a paradigm will always be the high-level framework investors use as a reference when making investment decisions.
Why Investment Paradigms Are So Important
For some investors, adhering to a specific framework to help guide their actions sounds a bit tedious, and even a bit unnecessary. After all, what’s the point of adhering to a set of overarching principles if you can just make things up on the fly?
To highlight the importance of having a clear framework in mind, let’s look at an example.
Imagine you have two investors: investor A, who doesn’t have an investment paradigm in mind, and investor B, whose investment paradigm of choice is value investing.
Now, imagine that both investors are tasked with analyzing the same prospective investment. Eventually, they must decide whether this is a good opportunity or is something not worth putting their money into. Both investors have access to the same materials (annual/quarterly reports, conference call transcripts, etc.) and are given the same amount of time to complete their work.
Investor A, not having a set of principles to dictate their actions, simply picks up the reports and heads straight to the financials. They notice that both revenue and profit have increased every year, expenses are going down, free cash flow is constantly positive, and everything else seems to be in good order.
After reading a few more reports and seeing more of the same, investor A concludes that this investment is worth pursuing.
Investor B, on the other hand, takes an entirely different approach. Value investing has several major ideas and principles, so they know exactly what sort of actions they need to take before making a decision.
As a value investor, investor B understands that their ultimate goal is to determine the investment’s intrinsic value and to make sure they have a wide enough gap between the intrinsic and market values. All the in-between steps that investor B takes serve the purpose of moving them closer to their goal of arriving at an intrinsic value.
When investor B goes through the financials, they notice the same things that investor A did: strong revenue and profit, positive cash flow, and decreasing expenses. Although these are encouraging, investor B understands that these metrics alone won’t be enough to serve as a make-or-break for their decision.
Eventually, investor B arrives at an intrinsic value and learns that it is less than the market value, that is, the investment is overpriced. Because of this, they decide not to pursue this investment.
Notice how two investors, even after reviewing the same material, arrive at different conclusions simply because they fundamentally differ on how they approach investing.
Investment paradigms are so powerful because they essentially streamline your analytical process: you know exactly what criteria prospective investments need to satisfy, so your job is to assess whether they have been satisfied to an acceptable degree or not.
Investors with no paradigm in mind will quickly find their approach unsustainable because they constantly need to come up with criteria on the fly for every prospect they come across. You can’t expect to invest for the long-term if you’re always reinventing the wheel.
In engineering, it’s uncommon to find a problem that hasn’t been solved before. Because the same problems have been solved over and over again, engineering standards and precedents are established to quickly solve these problems again in the future.
New buildings are constructed all the time, but regardless of where you decide to build one, you know exactly what procedures to follow. There’s no need to figure out how to construct a building from scratch because it’s already been done countless times before – you just need to follow the pre-established guidelines and adapt them to your current construction scenario.
Investment paradigms are similar in this regard – no matter what situation you come across, you know exactly how to approach it because you know exactly what actions you need to take. The specific applications will differ based on the circumstances, but the thought process remains unchanged.
Investment paradigms are so invaluable because they aren’t restricted to only one type of investing. For example, value investing isn’t restricted to just securities (stocks, bonds, options, ETFs, etc.) – its tenets are applicable to other forms of investing such as real estate, art/car collections, commodities, etc.
So, whether you want to focus solely on stocks or you want to be a real estate tycoon, having a clear framework in mind will help you reach your goals in a timely and effective manner.
Some Common Investment Paradigms
There are countless investment paradigms in existence, but obviously, we can’t go over all of them. Instead, we will briefly go over some common ones you may encounter, or at least hear about.
Please keep in mind that these descriptions are simply meant as an overview of each paradigm. These are by no means in-depth explanations.
Value Investing
First created by Benjamin Graham, and later brought into the mainstream by Warren Buffett and countless other prominent investors, value investing is a paradigm every investor will, at the very least, hear about at least once in their lifetime.
Simply put, value investing is the practice of assessing an investment’s “true” value, known as its intrinsic value. One of the major principles of value investing is that an investment’s price at any given point in time (its market value) isn’t an accurate reflection of its true worth.
Value investors seek to purchase investments when the market value is less than the intrinsic value and to sell when intrinsic value exceeds its market value.
(For more on value investing, read about it here).
Growth Investing
Next, we have growth investing. People who adhere to this paradigm look for investments that have a high probability of appreciating significantly, eventually sell them, then pocket the difference.
A growth investor who focuses on securities may look for stocks that have a strong chance of increasing significantly in price then proceed to sell at a sufficiently high price.
The same can also be done in real estate investing: purchase a property, let it increase in value, sell the property, pocket the capital gains.
Growth investing is talked about more in-depth in the book Common Stocks and Uncommon Profits by Philip Fisher.
Growth at a Reasonable Pace (GARP)
Peter Lynch, the former manager of the Fidelity Magellan Fund, popularized the investment paradigm known as GARP: Growth At A Reasonable Price.
This paradigm combines the growth-investing element of looking for investments with strong prospects of capital appreciation, but at the same time uses value-investing techniques to prevent overpaying – that is, to avoid purchasing an investment for more than its intrinsic value.
SRI/ESG Investing
In recent years, more and more investors have started to shift their focus from earning as much money as possible from their investments to making sure they create a bright future for the next generation.
Socially Responsible Investing (SRI), sometimes also known as Environmental, Social, and Governance (ESG) investing is focused on finding investments that help advance society as a whole in a way that is sustainable.
An increasing number of investors are making ESG a key criterion when looking at prospective investments. However, there is no clear consensus whether focusing on ESG when looking at investments results in better returns or not.
(For more on ESG, read about it here).
Customizing a Paradigm in a Way That Suits You Best
It’s important to note that just because you adhere to a certain investment paradigm doesn’t mean there’s no room for flexibility. Investment paradigms represent specific approaches to investing, but investors are free to tweak a paradigm in a way that works for them.
Benjamin Graham is widely known as the investor who pioneered value investing and was also the mentor of Warren Buffett (and many other prominent investors). Naturally, Buffett also chose to follow the principles of value investing, but he didn’t totally replicate Graham’s style of value investing.
In The Intelligent Investor, Buffett explicitly states that his style of value investing is heavily influenced by Graham, but isn’t an exact copy of it. Buffett notes that after graduating from Columbia, Graham advised him not to enter the securities market right away, but Buffett decided to ignore this advice, confident that his style of value investing would work. Clearly, whatever he did has worked out very well for him.
Every investor is unique, so it would be absurd to think that every investor who adheres to a certain paradigm would take the exact same approach. There are countless investors who adhere to value investing, but all of them have their own unique styles based on their individual quirks and experiences.
Not only that, but investors are free to create a hybrid paradigm if they want. Peter Lynch did this when he created GARP, and as more investors start to place greater emphasis on ESG, it wouldn’t be surprising to find variations of paradigms such as value investing and growth investing that have been tailored to focus on ESG.
There are many investment paradigms to choose from, but adhering to a certain paradigm doesn’t mean adhering to a rigid set of rules. Investment paradigms help guide an investor’s thought process, not tell them what they can and can’t do.
If you feel that you have a better chance of achieving your goals by tweaking an investment paradigm in a way you feel suits you best, then, by all means, go for it.
Wrapping Up
If an investor wants to continue investing for many decades to come, then they’ll need a mental framework to guide their thought processes and decision-making. You can’t expect to achieve consistent, long-term success by making everything up as you go along.
Eventually, an investor will need to have an investment paradigm in mind.
Investment paradigms are so crucial to an investor’s success because they help streamline the analytical process – you don’t need to come up with new criteria or decide what to focus on every time you assess an investment because your paradigm already takes care of that for you.
Whether you’re looking at stocks, real estate, or pieces of art, the principles of an investment paradigm can be applied and adapted to virtually every investment scenario you come across.
There are countless investment paradigms to choose from, and investors are free to customize them as much as they want. Ultimately, what matters is that an investor has a clear mental framework for them to reference, today and in the future.
