Investing blind
You’re walking in the street with a suitcase filled with $100,000. And, before you ask, you’re not a member of the Italian mafia, a drug baron or a corrupt foreign government official from a collapsed state. You’re just you.
You take a seat outside a quaint little coffee shop, put your briefcase down, fingering it gingerly, nervous that some unscrupulous thief might snatch it. Despite behaving like a deranged Gollum from the ‘Hobbit’ caressing his “precious”, you manage to call over a waitress and order a cappuccino.
An elegantly dressed man in a Savile Row suit approaches and asks if he can sit with you. You have never met this person before. Without saying a word you gesture to him to take a seat.
He casually orders an espresso, which promptly arrives. Leaning forward, he looks you straight in the eye and then confidently tells you to hand over the briefcase so he can look after it. You stare at him, completely petrified at what he might do if you don’t.
He looks at you and explains reassuringly that he’s the expert. According to him, it’s better than keeping the money in the bank with interest rates so low as they are. It will just rot away with inflation if you do.
So would you do it?
Not unless you are a complete donut.
Unfortunately, this sort of thing happens to the best of us, including me. The problem is that we don’t always know how our savings are invested, whether it’s in our corporate pension plan or private investment portfolio. We offer our blind trust to the asset management industry without really appreciating the risks.
Take the first investment I ever made. It was in a mutual fund – an S&P 500 index tracker to be exact. It was a disaster. I was a student at the time, working at Boots Opticians and I was so proud of my first investment foray that I told all my friends – big mistake. I bragged about it endlessly. Then the tech bubble burst. Woops.
My class mates at university made fun of me. And, as we were all economics students, they gave me a tonne of unhelpful advice. I was told that I should have shoved the money under my mattress, used it to improve my dress sense or spent the whole lot on beer and video games. Either way, I would have got a much better return-on-investment.
I promised myself from that day onwards, I would never be so blind and ignorant in what I put my money into. (If you want to know what an index tracker is or an ETF, there is a great video on YouTube by Owain Bennallack from the Motley Fool).
By the way, I’m not against investing in index trackers or ETFs. Actually I’m a massive fan. They’re cheap and can be very useful for asset allocation and risk management. Plus, they can offer access to difficult to reach markets or investment strategies.
The mistake I made was that I trusted the index construction methodology and the risks involved. The same applies for anything you invest in. This could be a hedge fund or private equity in a small start-up – it doesn’t matter. If you don’t completely understand the risks you are taking, you might as well be playing Russian roulette. Sooner or later the odds will go against you.
The reason I bought this tracker fund was because I read a book called, “A Random Walk Down Wall Street“, which had been written by Princeton University Professor Burton Malkiel.
He claimed that “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one selected by experts”. So I thought, why should I pay a portfolio manager to invest in US stocks if most of them underperform anyway.
First, let me put this into context. There is this long-standing idea that the S&P 500 is nearly impossible to beat. This is what I firmly believed back in 2001. At the time the index had compounded nearly 14 percent during the previous 20 years. And, in the last half of the 1990s, it had compounded by a staggering 26 percent. Then the tech-bubble burst, followed by the Financial Crisis seven years later, resulting in a lost decade for US equities.
This meant that if you had invested in a S&P 500 index tracker during the “noughties”, you wouldn’t have got very far. Luckily, I bailed before I found this out. It turned out to be the worst decade ever experienced by the US equity market. It even surpassed the lows of the 1850s (the first global financial crisis) and the 1930s (the Great Depression). But, it wasn’t all bad. Emerging market equities and bonds did well over this period. As did TIPS and long-dated US Treasuries.
Here is what I learnt from this experience?
1. Don’t hire a monkey
Professor Burton Malkiel was wrong. You may think they look cute and cuddly and even intelligent at times, but they make terrible portfolio managers. They have a tendency to smash stuff, pee all over your things and steal your tea and biscuits.
2. More seriously, I looked backwards
I bought a market cap index which is inherently backward-looking by design. Think about it. The largest weights go to the biggest companies in the index. These firms have already grown and are at the mature stages of their business cycles. You are effectively overweight the ‘has beens’ and underweight the smaller future winners. It’s a classic buy high, instead of buy low strategy. It’s like driving forward by looking into the rear view mirror. It’s stupid.
3. I also thought I was being smart
This is a typical mistake made by many investors. We over overestimate ourselves and credit luck with skill, especially after we read books. And, if it doesn’t work we blame it on hindsight and then find something new and smarter to invest in.
Have you heard of smart beta? Ok, don’t be put off by the name because it really is not that smart. Get yourself another coffee if you need to. It’s not boring, trust me! I work in finance.
Smart beta are investment strategies that use alternative index construction rules to avoid the failings of traditional market cap indices.
Some try to target ‘value’ by giving a greater weight to stocks with cheaper valuation metrics. This is to ensure investors buy low and not high. However, value stocks are cyclical. After the dot-com bubble they performed well, but then underperformed following the Financial Crisis, which favoured growth stocks more.
Smart beta indices may also favour ‘momentum’ companies whose stock prices are steaming along nicely. Yet they can also inadvertently expose you to bubbles like the dot-com period that hurt me i.e. they too have a risk-driven cycle.
There are also smart beta indices that favour low-volatility stocks within a market cap index. It sounds great, except that what was low volatility yesterday might be high volatility the next day – remember how financials did in 2008.
What you need to remember is that smart beta strategies are still backward-looking, regardless of which financial metrics they crunch. They tend to swap one risk for another when you compare them to their market-cap counterparts. Finally, they can end up being self-fulfilling, where everyone jumps in and ruins the once previously rosy performance. If you’re interested, there is a great paper called “How Can ‘Smart Beta’ Go Horribly Wrong?” by Rob Arnott, one of the pioneers of smart beta.
See, I told you it was I interesting.
However, please don’t misinterpret what I’m saying here.
I’m not against index trackers, ETFs or smart beta strategies. I invest in them myself as part of my own investment portfolio. What I’m saying is don’t pile into one of these and say, “Great, that’s my exposure to US equities done”. This is the mistake I made.
Buying a sole index tracker, or any vehicle for that matter, to gain exposure to a single market isn’t sufficient diversification. There are risks you are exposed to, even though your money is spread far and wide across many great US companies.
Every variation of index construction exposes you to different risk factors, including those within smart beta. You need to actively manage each one of these when you construct and maintain your portfolio. By allocating dynamically across different risk factors as your portfolio’s building blocks you can achieve a better risk-return profile rather than looking at your portfolio as a collection of asset classes.
“A Random Walk Down Wall Street” was one of the best books I‘ve ever read on investing. I admire Professor Burton Malkiel for trying to empower the little guy – the ordinary investor. It’s a cause I follow and fight for every day. It’s why I’m writing this post. Have a look at the last one I wrote if you’re interested: “Why I work in asset management“.
The mistake I made was that didn’t understand all the risks factors involved in what I invested in. In theory, a skilled portfolio manager should be able to help you do this. Their ability to understand the stocks they pick at an intimate and fundamental level, should help tackle these risk factors for you.
They would normally do this before adding, trimming or selling a stock position by conducting fundamental analysis and going out to meet the senior managers of these firms.
Of course not all portfolio managers are good at their jobs and some charge too much for what they do. They may hug the index, clock off at lunchtime and go down the pub for the rest of the afternoon. If they do, fire them.
There are, however, good portfolio managers who actually work hard for their money and don’t charge excessive fees. Index products are not a substitute for what they do. They are, however, a useful complement. I would construct a portfolio that blends both and appreciates the different risks that each one brings or offsets within your portfolio.
The good news is that there are lots of online tools to help you do this. Even assessing the portfolio manager, needn’t be that difficult.
I discovered this great website yesterday called SharingAlpha. It’s new and rates portfolio managers based upon the “wisdom of the crowd effect” from the collective ratings of investment professionals. They have signed up 350 fund selectors since launch two months ago. And, their virtual fund-of-funds feature shows you your track record on fund selection, plus ranks your success in terms of asset allocation.
Therefore, do yourself a favour and do some research. Understand what you are investing in, whether it’s with a portfolio manager or in an index product.
Don’t invest blind.
