My Investment Process In 5 Steps:
From Data To Decisions
For DIY beginners in need of a systematic way to build wealth
Investing can be quite daunting, especially in the beginning. You need to figure out where to start, what to watch out for or how to decide what is best for you. But do not let yourself be intimidated — as long as you follow a system, a clear, well-thought-out approach that aligns with your goals and your ability to tolerate risks, you can do it. My own approach consists of 5 main steps, which I follow consistently, irrespective of how complex some of them may be depending on the circumstances or the type of investment because discipline and consistent adherence to your strategy is the key to success in this endeavor. You can customize your own process in a similar manner to ensure you meet your own financial objectives.
The content of this post does not constitute financial or investment advice. It is intended for information and education purposes only. The author is not affiliated with any brokerage, bank or European institution cited below.
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You will often hear online influencers telling you that everyone should “simply buy an index ETF and be done with investing”. Unfortunately, we are all different people — our life and financial goals vary widely, and their timing — even more so. We are constrained by so many different (and oftentimes, rather specific) factors in our lives that we cannot all manage our money in exactly the same way. We need to factor all that in when making our financial decisions, even if that makes us feel uncomfortable or uncertain because it makes the whole process seem more complex. Furthermore, there are numerous indices on many asset classes, implementing various investment styles or strategies, not all of which are suitable for everyone.
This is the reason why, instead of looking for a one-size-fits-all asset (class), we need a broadly applicable process that we can (almost) universally follow and adapt to our custom circumstances. As long as you have that, you can manage your mentality and thinking in the context of a clear framework that guides your steps and prevents you from making mistakes due to impulsive irrational actions.
Below I describe the process that I follow in a simplified manner. It contains 5 main steps: (1) collecting input data and information that I anticipate I will need to make my decisions; (2) developing a plan to know what I can afford to invest and how that impacts the rest of my financial life; (3) analyzing the economic and market circumstances to develop expectations for various asset (classes); (4) designing my portfolio; and (5) monitoring changes in circumstances and markets, managing risks and adjusting accordingly. I am not necessarily recommending this exact process for every investor but in my experience, it is flexible enough to be used (and adapted) for a wide range of circumstances, risk profiles and preferences. If you are a more sophisticated individual investor, each step can be enhanced by the addition of more complex modeling and analysis, of course.
Step 1: What do I need to begin: The inputs
This is crucial for any financial decision: you need to be aware of your financial status, including your goals, constraints and risk profile, as well as the economic and market environment. To complete this step, some data gathering and research are needed:
– Personal balance sheet — this requires you to get a grasp on your monetary, investment and retirement assets (such as cash and checking accounts, money market accounts, stock, bond, ETF and other investment positions, tax-deferred retirement accounts, etc.), real assets (such as primary residence, personal property such as vehicles or art collections, lifestyle assets such as electronics or household appliances) and debts (including short-term payment obligations such as current bills or liabilities up to 12 months, as well as long-term liabilities such as mortgage debt, auto loans, etc.). Why is this information important? It allows you to see your current net worth and overall financial condition and assess the extent to which your indebtedness can prevent you from achieving your financial goals or investing. It also shows you how liquid you are, whether your emergency funds are sufficient and what exposures you already have and might want to avoid in the future.
– Personal cash flows — for this, you will need to dig a little into your accounts and track some of the regular and irregular payments and incomes there. You need to capture all salaries, wages, bonuses, additional benefits, dividends, interest earned, tax refunds, pensions, support payments received, other investment/plan distributions etc. before tax. On the other hand, you will need a good understanding of what you spend and where — both in terms of fixed/variable regular expenses (such as rent, food, utilities, regular transport, loan payments, tax payments, debt service, insurance premiums, etc.) and discretionary outflows (e.g., entertainment, eating out, house renovation, medical costs, taxis, etc.). Why is this needed? This information will allow you to understand how you can optimize your spending vs. your income, and how to create a budget (see step 2) or a plan, in which you explicitly allow for a given amount to be invested.
– Financial goals — your financial goals need to be clearly articulated with specific amounts and timelines. They represent outcomes or accomplishments that are intended to motivate you to achieve certain financial or life milestones, overcome certain financial or life challenges, or give meaning/purpose to one’s life. I have written extensively about the importance of this step, with examples and my own framework in this article. Goals give you a structured guideline for what is and is not best to have in your investment portfolio and without them you would be like taking shots with a blindfold over your eyes.
– Risk profile — here, you need to be aware of your willingness and capacity to take on risks. Some investment choices might be way too complex and risky relative to your profile (e.g., defined by parameters such as age, tolerance for volatility, personal preferences, etc.) while others might not be sufficiently risky relative to your ambitions and goals. Why is it necessary? Because the risk profile essentially sets the scene for your investment decisions — as the intersection of your ability to withstand and/or recover from financial losses, how much risk you need to take to achieve your financial goals, your willingness to take it, and your propensity to react in different ways to it. To make a useful assessment, you need to consider a variety of relevant aspects, most of which I have introduced and explained in this article.
– Needs, constraints, preferences — we all operate in the context of our life’s circumstances — some of us plan home purchases in 3-month’s or 1-year’s time, others need liquidity tomorrow to make a mortgage payment, and yet others need to take care of 3 children or an ill relative. Many would also make their financial choices based on more specific requirements, for instance — never invest in companies who pollute the planet, or never take out loans for household purchases, etc. Such custom constraints and preferences need to be factored in as they can introduce subjective or self-imposed limitations on our investment decisions.
– Macro and markets — while beginners might not be prepared (or have time) to do a stand-alone analysis of the economy, a single company or the situation in various financial markets, that does not mean they cannot gather data and research by professionals. But of course, this step does mean that individuals would either need to acquire at least some knowledge or be ready to consult an advisor. The important thing to remember is that the risk and performance, as well as the suitability of investments, are assessed based on certain macro and financial variables. And the economy and markets themselves have a cyclical behavior which is explained and tracked using some of these variables. Individual company or index performance can be driven by factors linked to the broader economy and market sentiment, the specific sector or related industries, or the fundamentals of the individual firm. So this input is quite critical in understanding and evaluating different investment choices, and forming expectations for the future which directly influence the final decision.
If you already know how to do all of this — or have done it before — great! Then you might be ready to plan, analyze, and then structure your portfolio. If you have not, then this preliminary work is something I highly recommend you do not skip, as much as it may seem tedious and time-consuming. Proper preparation can mean the difference between building wealth consistently and struggling with numerous financial errors.
Step 2: Plan what you can and should afford
Using the information collected in the first step, you can create a more detailed plan for your investments (without defining the portfolio yet). First, you can use a budgeting method or a more comprehensive financial plan to determine what amount and when you will/can afford to invest to meet your financial goals, which also aligns with your cash flows, needs and constraints. This will make the task of determining how much to invest every month much easier and will provide clarity looking forward, which will enable you to automate the process and impose discipline around the investment process. I personally prefer a reverse budget due to its advantage in prioritizing my goals, i.e., investing.
Next, based on the risk profile assessment, you can determine how much risk you should take and how it should be budgeted. It is important to keep in mind that risk tolerance evolves over one’s lifetime and depending on circumstances, goals development, earnings, indebtedness levels, etc. This means that if you are planning for a longer-term horizon, you should be mindful of such dynamics as this will impact your asset allocation and strategy. For instance, it might be suitable to be more aggressive earlier in your life as your age, long-term investment horizon and future earning potential (your human capital) could allow you to take more risks. But with advancing age, a more moderate or a more conservative approach could become more prudent if your ability to recover from financial losses and your liquidity diminish more significantly.
Finally, your investment plans do not exist in isolation. This is why it is best to consider them as part of a more comprehensive financial plan. For instance, there are country-specific tax consequences of your investment decisions (e.g. capital gains taxes, dividend taxes, special rules for taxation of cryptocurrencies or ETFs) and the type of account in which you execute them. Your retirement accounts may already have certain exposures to (or concentrations in) assets or asset classes, whereas, in your discretionary investment account, you might wish to avoid those. You might plan for your state-funded retirement income to be complemented by your personal investment income — so you will need to plan a strategy accordingly. And of course, what happens with your assets in the unfortunate event of your death? This is where you will have to link up with your estate and succession plans.
Step 3: Time to dig deeper — the analysis step
In this step, you have to use the data at your disposal (e.g., macro, company-specific or other financial data and information) together with the tools available (e.g., regression analysis, correlation analysis, models, forecasts, valuations, technical & fundamental analysis, etc.) to evaluate how attractive the investments in the opportunity set are. As a first step, you can use some filtering and sorting criteria on the full investment universe (available in your country or region) to narrow it down as much as possible. That means, excluding those assets or funds that do not meet certain initial criteria (e.g., currency, country of domicile or of the underlying company(ies), costs, asset class, past returns, risk characteristics, etc.).
Next, you can also filter out factor or sector exposures that you deem are not fitting for you — whether because of preferences, risk tolerance, the information you have about the phase of the cycle, or some long-term investment theme. Be mindful that such rule-of-thumb exclusions can be double-edged swords as they could allow you to simplify what remains to be analyzed and speed up the process for you, but this way you can also unwittingly remove assets with high performance potential without having analyzed them fully. This is why it is best to use rules based on research or rules that have proved to be valuable based on practical experience, in a variety of market environments.
The remaining asset classes or funds can then be subject to more rigorous and detailed analysis. But let us take a pause here: what should you do if you are not an expert and cannot perform any kind of analysis? Your best options are to either consult an expert (such as a financial planner or an investment advisor) or consult research available as a free or paid service. Many financial institutions and research & consultancy firms publish such research online for free, but of course — it is a result of their own proprietary analysis, valuation and forecasting models or risk assessments. It might be written to sell a specific narrative to clients or to convince clients about an investment theme that the bank believes in, which does not necessarily mean that such an investment would be suitable for every individual or that it will perform as the bank predicts. You would be better off referring to research that is not aimed at selling anything, is independent or better yet — multiple pieces of research relying on various research methods. In any case, interpreting and understanding such research may still be a difficult task for a complete novice and you might still require expert help.
What I mentioned in the previous paragraph is the reason why I recommend to every beginner investor to focus on acquiring as much knowledge as possible first and then practice for a while as needed in making decisions and assessing how that knowledge works its way (or not) into the real live markets. It is also the reason why I started my blog — to empower people with such financial literacy so they develop this ability to “fish” for themselves. I would go as far as to say that gaining a fundamental understanding of financial markets, the economy and its cycles, and investment instruments is a necessary prerequisite for anyone insisting on a “do-it-yourself” (DIY) approach and not relying on an investment professional. Because the market and the economy will absolutely surprise you, any formula or model could eventually disappoint you, any relationship known from historical data can turn against you. And you need to be prepared for this if you want to be successful and achieve your goals.
Below you will see a few types of analysis I personally perform (the list is not exhaustive) in this step which help me properly manage my investments. This is not a recommendation and every investor needs to tailor their analytical approach to what is relevant for them. But this approach is also flexible and comprehensive enough that you could still benefit from a number of its components.
The goal of the analysis is to come up with expectations about risk and performance, which can be used to decide on the optimal individual investment portfolio. Professionals use various models to estimate expected returns, variances and covariances, as well as optimization models to calibrate the optimal weights for each asset or asset class. Nowadays such models are available in spreadsheet or code format for free online, or various implementations of these models are available directly on specialized web platforms or paid applications. Many of them can be used by laypeople as well and provide down-to-earth explanations of the results and methodology.
Step 4: Decisions, decisions — the strategy & portfolio structure
It is time to put the information and analysis to work — in this step, the available investment products are reviewed and compared in light of the expectations for their future performance and risks. It is crucial that potential investments are assessed for their suitability — that is, based on your financial goals, circumstances, needs, existing portfolio, risk tolerance, knowledge and experience — do they fit well in your portfolio? Remember that not every investment opportunity will be suitable for every portfolio or every individual, regardless of the potential return. This also entails understanding fully the products’ features and risks — otherwise, you may end up with a position in something whose complexity you are unaware of and do not know how to manage. You should think about the following:
– how does adding this investment change the risk and return profile of your entire portfolio (e.g., additional concentration or diversification, additional risk-adjusted returns)?
– is this product within my risk tolerance and do I understand fully its risk drivers and how they could impact my position in a stressed market/economic environment?
– does this investment help adhere to my investment strategy or cause a deviation from it? does that contribute to achieving my financial goals or not?
– does adding this investment to my portfolio mean I will violate some of my constraints or ignore some important circumstance relevant for my financial situation and goals?
In my process, this suitability test is applied to every product I consider adding to my portfolio. For a product to be suitable, I need to make sure it is consistent with my overall strategy — but a beginner might not yet have such a strategy in place. Moreover, a beginner might not know how exactly to formulate a strategy. An important thing to keep in mind is that a strategy consists of more than just the allocations within the portfolio — it captures the process, the rules and the logic you follow to make your investment decisions as well. It also includes the reactions and behaviors you should exhibit once something expected or unexpected happens. The strategy will also depend on your financial goals, risk profile and circumstances as described above. Some examples:
– Bottom-up strategies — data is collected at the individual asset or company level, then analyzed to form an opinion or expectation about future performance and risks (e.g., based on fundamentals) or to form an opinion about a wider section of the market; this could be done by using financial modeling and valuation tools and assessing a company’s competitive advantages, growth potential, etc.
– Top-down strategies — these strategies start at the macro level by studying variables describing the past, present or future (projections) of the macroeconomic environment, policies, overall market conditions and demographic changes; this could involve defining allocations based on country/regional analysis, implementing strategies for sector and industry rotation, using thematic investing (e.g., based on broad macro, geopolitical, tech, etc. themes and structural factors), etc.
– Factor-based strategies — this involves identifying return- and risk-driving factors, i.e., variables that are believed to be driving asset performance and can help predict future risk and return; examples include value investing, growth investing, momentum investing, etc., or equity style rotation strategies where over time the investor could switch the exposure to various return drivers depending on underlying macro, financial market or other conditions which impact their performance.
– Passive indexing — these are low-cost strategies where the portfolio replicates the performance of a certain (usually well-diversified, but not necessarily) benchmark index (e.g., the S&P 500, the DAX, the MSCI World Index, etc.). Choosing the right index must factor in the desired exposures to risks, as well as the acceptable segments of the market, currencies, capitalization size, style and other characteristics.
– Passive factor-based strategies — if a given individual investor does not want the full benchmark index exposure but rather just a portion of it that reflects only preferred risk factors, then a part of the portfolio reflecting those factors can be isolated — and an investment in that subset of constituents can be made; this can be done for various factors where such indices are available (e.g., value, growth, size, momentum, low volatility, quality, etc.).
Most beginner investors start with passive strategies, which may be a reasonable approach for the majority of individuals if it fits with their circumstances and objectives. You need to fully understand what the strategy entails and how to execute it properly before making such a decision — if you do not have sufficient experience and knowledge or do not have the confidence that you know how to manage it, even when market circumstances change drastically, then you might be better off relying on a professional.
Based on the expectations, you will need to come up with a strategic asset allocation — that is, the split of your investment portfolio across assets/asset classes for the purpose of achieving your long-term investment objectives, in line with your goals, constraints and risk tolerance. As mentioned in the previous step, this usually requires an optimization process of some kind and the result can often be several possible allocation choices. I have used Monte Carlo simulation, traditional Mean-Variance Optimization (MVO), a Conditional Value at Risk (CVaR) based model and Risk parity models, but I have found that the Bayesian approach of the Black Litterman model works best and is more flexible for my needs (here is a simple implementation video for Python).
For a novice who is not familiar with such optimization models, I would suggest using applications provided by reputable sources (no affiliation or recommendation), such as PortfolioVisualizer, PortfoliosLab, or the PortfolioAssetSimulator. Alternatively, you can also use risk-tolerance-based simplified allocations for conservative/moderate/aggressive portfolios, which are generally not well-tailored to individual needs and goals but are more transparent and easy to follow. This is a last-resort, more generic approach that I do not favor.
Finally, as part of your strategy and allocation decisions, you will need to consider how often and how you will review your portfolio and rebalance it. The characteristics of the portfolio (returns, risks, concentration/diversification) will change over time with the impact of market moves and the changes in the economic regimes even if you consistently follow your strategy. Hence, you would be better off defining in advance certain limits, within which you can tolerate deviations (e.g., the overall changes in the weights of various assets/asset classes/countries/currency exposures/factor exposures, etc.) and corresponding actions that you can take (e.g. buying, selling, holding, hedging, adding insurance, etc.) to return to a more “comfortable” allocation that fits your profile. Similarly, if your circumstances and risk tolerance change, you can also adjust your strategy and allocation, as well as your limits.
Step 5: Don’t be asleep at the wheel — monitor & adjust
The last step requires you to remain vigilant about your portfolio. It is not necessary to check your investment account every single day or follow every single piece of news but it is important to know what factors can influence your investments and keep an eye on them. What I do is the following:
– Performance & risk monitor — I have a dashboard of various performance and risk metrics in place for my portfolio and individual positions (e.g., various return measures, Sharpe, Treynor, Sortino ratios, Alpha, tracking error, diversification ratio, concentration measures, VaR and CVaR, M², sensitivity measures, correlations, technical metrics, etc.) which I can look at and which helps me stay on top of any development and see any signs of increased risk.
– Breakdowns — additional analytical tools break down performance and risk drivers for me so that I can understand various factors in more detail and make the right decision.
– Limits & actions — for each risk metric, I have a set of tolerance thresholds, and whenever they are breached, I have defined what actions I can take depending on the reason, in order to prevent major losses.
– Macro & market monitor — this allows me to track rapid moves and shocks in the economy and the financial markets, and model impacts on my portfolio based on such developments, including during times of stress.
– Projections — I use various models to update my estimations of expected returns, correlations and risks.
Remember, these are just tools and they can be available to you in various forms. For example, you can monitor macro developments and variables in tools such as PiQ (affiliate link) or TradingEconomics (no affiliation or recommendation). You can use a brokerage account that has analysis and monitoring tools. Or you could construct such a tool in an Excel spreadsheet, where you can also monitor asset prices via web queries or the built-in stock history function (at least some). The main takeaway here is to keep yourself regularly informed and ready to take appropriate action according to your strategy and your own rules. And since so many things can change that imply such actions, this step should feed back into all the previous steps and aspects of the process.
Conclusion
The 5 main steps of my process are rather simple, but depending on how sophisticated and knowledgeable an individual investor is, the sub-steps and tools used can become rather complex. My view is that beginners should rather use what they know and are comfortable with, following the structure and logic of the process (and adjusting where needed), rather than chasing accuracy in more complexity. Remember that the key is to develop a strategy and an allocation that fit your goals and constraints, respect your risk tolerance, and provide you with a clear structured approach that prevents you from making errors and reacting irrationally to market surprises. This will help build discipline and consistency, which will allow you to build wealth in the long run. If your goal is short-term profiting from market fluctuations with intraday trading, then the suggestions in this story will likely not apply to you.
Author: Nikolay
Founder of MoneyCraft
