Ferri: 3 Keys to a Successful Investment Strategy

Benz: Rick, you are currently working on a book, and you have focused on what you see as the three key tenets that every investor should follow when managing his or her portfolio. Let's cycle through those and talk about the concepts for each of those?

Ferri: Sure. So, my view of a successful investment strategy or being a successful investor relies on three key principals. First thing we need is a philosophy, which is a belief about what happens in the markets. You could believe that there are active managers out there and you can find them and you can hire them and they are going to outperform the markets or you could believe that you can move money between asset classes at appropriate times and you can get a better return than just being in the markets. Or you may believe in a passive approach where you are a strategic holder, meaning you are going to set up a portfolio of stocks and bonds based on your specific needs. So, you might have 60% stocks, 40% bonds over the next 10 years, and you're going to rebalance. These are philosophies about the markets and maybe don't believe that you can outperform the market, so you are going to use all index funds or exchange-traded funds, and that's your philosophy.

Benz: So, it matters what philosophy it is though, right?

Ferri: Absolutely. Well, philosophy is important because it then determines the next level. You have a philosophy, and then from the philosophy, then you develop a strategy.

Now, here is where you're going to dig into the nitty-gritty of how you are going to actually manage your portfolio. What percentage are you going to have in international? What percentage in emerging markets? How are you going to be picking funds? The nitty-gritty of putting the portfolio together and the allocation of that portfolio. If you are going to be doing tactical asset allocation, how are you going to be doing it? When are you going to be doing it? So, this is the nitty-gritty.

Strategy comes from philosophy. If you don't have a philosophy, you can develop a strategy, but it's only going to blow apart the next time it doesn't work for a month or two. And you are going to go onto another strategy, and that's the worst thing you can do.

So the philosophy, strategy, and the last key is discipline. Now, you have the strategy to go forward; you have to have a way of implementing the strategy and maintaining the strategy in order to become successful at your philosophy. If you can't maintain the portfolio, if your discipline breaks down, then the strategy begins to break down, and if the strategy begins to break down, then the philosophy can break down and the whole thing breaks down, and then you really don't have a plan.

So, it's those three keys. Philosophy first, come up with what your view is of the entire world, if you will, and how you are going to manage your portfolio; the nitty-gritty of portfolio selection; and then the implementation process, which is what I call discipline. Those three keys.

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Benz: What if the philosophy is fundamentally flawed. So, for example, I might say, "Well I think I can do a great job of picking whatever is the next hot sector. So, my strategy is going to be tactical." What if that central philosophy wasn't good to begin with?

Ferri: My view on that might be a little bit unorthodox. It's that if you consistently believe in that philosophy and you have a way of implementing that strategy based on that philosophy, then you are going to be right about as many times as you are going to be wrong and after net of commissions and fees, you are still going to come out OK because you followed a discipline.

So, your opinion might be "That way of doing it is wrong. My opinion is it's right." That's not my opinion, but I'm just being the devil's advocate. And what I found is that if you are able to develop a strategy, even if it's tactical, even if it's picking active managers who you think are going to beat the market, and you maintain that strategy for many, many, many years and you follow it with discipline, then you are going to do OK. You are going to do better than the person who has no philosophy, so they have a strategy today. Two years from now they change their strategy to something else, and two years later they change their strategy to something else. Those people are the ones that are going to do poorly.

Now, I believe that the best philosophy is the Boglehead philosophy, which is very low-cost, do a strategic asset allocation to different index-type funds based on your needs. And then you implement that with index funds and the allocation as I described. That's the discipline, to maintain that. As Jack Bogle says, stay the course. I believe that will give you the best returns. That makes the most of the markets.

But next to that, the people who are doing the active strategies, if they maintain discipline over years and years and years and years, they generally do OK. It's the people who don't have the philosophy; that's the problem. They are the ones who do poorly. They are ones who are always turning over their portfolio, chasing the hot dots, doing all the things that really hurt a portfolio in the long term. I know it's a little unorthodox, but that's the way I see it.

Benz: Well, Rick, thank you so much for being here.

Ferri: Thank you. Appreciate it.