 |
Brad Steiman,
Head of Canadian Financial Advisor Services
Vice President
Financial Advisor Services,
Dimensional Canada
|
July 2012
“. . . Investing is like music in
that true classics stand the test of time and remain relevant long after they
were initially composed.”
For more than a decade, I have had
the privilege of hearing many colleagues discuss the fundamentals of investing in
simple and effective ways. Everyone puts their own words and music to this set of
ideas, but the following are what I consider the top ten greatest hits, with a
few of my own verses added to the mix. Greatest hits aren’t new, by definition;
therefore, this article merely aims to chronicle and arrange them in a storytelling
sequence, where one connects to the next, rather than in order of importance or
priority. Trends change and fads come and go, but investing is like music in
that true classics stand the test of time and remain relevant long after they
were initially composed.
1) CONVENTIONAL THINKING
Consider the questions people ask
upon learning you are a financial advisor. “What stock should I buy?” is a
common response. They want to know if you can help them discover the next
Apple. Another frequent request is, “Where do you think the market is going?”
They want to know if now is a good time to be invested in the market, or if
they should bail out of stocks instead. If you have no answer, then surely you
know a hot money manager or can identify the next Peter Lynch for them.
All
these questions share something in common—you are being asked to make a forecast!
Therefore, conventional thinking seems to be that, in order to have a
successful investment experience, you must look into your crystal ball and
predict the future.
2) MARKET FORCES
There is a completely different
approach that all investors should at least be aware of, and it wasn’t
developed by the big banks and brokerage firms on Wall Street. It originated and
evolved in the halls of academia and is based on a mountain of evidence showing
that free markets work because the price system is a powerful mechanism for communicating
information. As F.A. Hayek pointed out in his Nobel laureate lecture, “we are
only beginning to understand how subtle and efficient is the communication mechanism
we call the market. It garners, comprehends and disseminates widely dispersed
information better and faster than any system man has deliberately designed.”1
What
does this mean in the realm of fiercely competitive capital markets? Simply, that
prices are fair. Competition among profit-seeking investors causes prices to
change very quickly in response to new information, and neither the buyer nor
the seller of a publicly traded security has a systematic advantage. Therefore,
the current price is our best estimate of fair value.
3) JUST MY OPINION
Despite the strength of market
forces, many investors may never lose the urge to form an opinion about the
future, or to ask their advisor for one. However, if you choose to offer your
outlook for the future, it should be followed by a reminder that you don’t make
investment decisions based on an opinion—yours or anyone else’s. If the
compulsion to act on an opinion is too difficult for your investors to resist, ask
them if it is conceivable that they are the only one with the information upon
which their opinion is based. If the answer is no and the information is widely
known, then why wouldn’t it already be reflected in prices? For example, the
claim that “everyone knows interest rates are going up” should be met with the fundamental
premise that if the statement were literally true, rates would have already gone
up! The logic behind how markets work is a formidable response to any forecast
of the future.
4) MAN VS. THE MARKET
Not only is this logic formidable,
but the evidence supporting it is also compelling. If free markets fail, it would
be easy for investors to systematically beat the market, but in reality, man
versus the market isn’t a fair fight and most of us should accept market forces
rather than resist them. There is a large literature devoted to analyzing the
results of professional money managers. It dates back over four decades to the
original study of its kind conducted by Michael Jensen in 1968. The experiments
have been repeated many times with better models applied to larger and more
reliable data, but the results continue to confirm the original conclusions. As
you’d expect, some managers are able to beat the market on a risk-adjusted
basis, but no more than you would expect by chance.
Furthermore, it must be the case that, in
aggregate, investors earn market returns before fees. This doesn’t just hold
over the long run, but at every instant due to the adding up constraint. The
market reflects the collective holdings of all investors, so the value-weighted
average investment experience must be the market return minus fees and
expenses. This is not just a theory; it is a universal unconditioned truth
relying solely on simple arithmetic.
This
arithmetic leads many investors to think that, since money managers aren’t like
children from Lake Wobegon (who are all above average), a winning investment strategy
attempts to identify above-average managers and avoid all the others. But can
you systematically identify in advance managers who will outperform the market
after adjusting for the risks they took? Although it is hard to imagine there aren’t
skillful managers, the challenge facing investors is that true skill is hard to
distinguish from pure luck.
Identifying managers who have outperformed in the
past is just as easy as looking up the scores from last night’s sporting
events, but there is very little persistence in the performance of managers and
no documented way of determining who will outperform in the future. Most regulators
require sales communications to contain the disclaimer that PAST PERFORMANCE IS
NO GUARANTEE OF FUTURE RESULTS with good reason. Regrettably this warning sign
is treated like a posted speed limit and dismissed with flippant regularity.
This doesn’t mean professional money
managers are stupid! There are undoubtedly many smart ones who take their job
very seriously and work hard to get the best results they can for their clients.
But the market is hard to beat because there are so many smart managers—and not
in spite of it. If you take the world’s greatest bass fisherman to a dry a
lake, he won’t catch any fish. He’s still the world’s greatest bass fisherman,
but that’s beside the point if there isn’t anything to catch.
5) EVERYONE CAN WIN
It is not necessary for someone to
have a lousy investment experience for you to have a successful one. Everyone can
win because with capitalism there is always a positive expected return on
capital. The expected return is there for the taking, and as a provider of
capital, you are entitled to earn it. That doesn’t mean it’s guaranteed to be
positive, but only that it is always expected to be positive.
Realized returns are uncertain
because the market can only price what is knowable. The unknowable is by
definition new information. If it is considered bad news, or if risk aversion
increases and investors require higher expected returns, then prices will drop.
This is the market mechanism working to bring prices to equilibrium where,
based on the new information, the expected return on capital remains positive
and commensurate with the level of risk aversion in the market. The opposite
would be true if the new information is considered good news or if risk
aversion declines. This is how well-functioning capital markets maintain a
strong and pervasive relationship between risk and expected return. There is no
free lunch.
6) EXCELLENT VS. UNEXCELLENT
But stocks and bonds don’t all have
the same expected return. Conventional wisdom says that if you want better returns,
you must uncover the limited number of truly outstanding companies. In other
words, the stocks and bonds of these “excellent” companies, based on their superior
fundamental measures (e.g., return on assets, earnings to price, etc.), should
have a higher expected return than the stocks and bonds of “unexcellent” ones. While
this implies an “excellent” company should pay a higher interest rate if it borrows
money, intuition suggests that lenders will assess the strength and relative
riskiness of borrowers and charge the riskier unexcellent ones higher rates.
The same concept should apply in the stock market.
The market is a closed system
where there must be a buyer for every seller and an owner for every stock and
bond. There are no orphaned securities! It is mathematically impossible for
investors to collectively limit their holdings to the stocks or bonds of excellent
companies, so the riskier companies must offer an incentive for investors to
buy (or continue to hold) their stocks or bonds over those of a safer company.
The incentive comes in the form of higher expected returns. The market is not
fooled, but rather, rationally pays a higher price for—and accepts a lower expected
return from—the stocks and bonds of excellent companies, and vice versa.
Therefore, the unexcellent company has what is referred to as a higher cost of
capital, which is equivalent to the investor’s expected return.2
7) EFFECTIVE DIVERSIFICATION
However, not all risks generate
higher expected returns. Markets only compensate investors for risks that are “systematic”
and cannot be eliminated. For example, the Green Bay Packers won’t pay Aaron
Rodgers more money to play football without a helmet. It is a risk that can
easily be avoided if he puts on his helmet and buckles up the chin strap!
Similarly, investors shouldn’t expect an additional reward for taking the risk
of concentrating their portfolio in a few securities, industries, or countries
because the increased risk of doing so is easily eliminated through effective
diversification.
To diversify effectively, investors allocate capital across multiple
asset classes around the globe to suit their unique circumstances, financial
goals, and risk preferences. Ineffective diversification, on the other hand,
includes concentrating a portfolio in a few securities, diversifying by broker,
or dividing up assets among money managers in an uncoordinated way that does
not eliminate risks they shouldn’t expect compensation for bearing.
8) MORE THAN A MAP
Travelling the road to a successful
investment experience requires more than just a map. Building a portfolio that puts
these ideas to work is one thing, but staying on route is something else
altogether. Keeping your hands on the wheel and your eyes on the final
destination requires the emotional discipline to execute faithfully in the face
of conflicting messages from the media and the investment industry.
Investors
are bombarded with information designed to lead them off course and toward more
conventional means that involve excessive trading, higher costs, and frequent
detours based on the latest prognostication from talking heads or so-called
gurus.
The simple message to let capitalism
be your guru quickly becomes stale and completely lost among the attention- grabbing
headlines of the day. A constant reminder that the media is in the
entertainment industry and their objective is not to give sound advice but to
attract an audience may help tune out the noise.
Tuning out the noise is even harder when it
is amplified by an investment industry thriving on complexity and confusion,
while frequently shunning simple yet effective solutions. After
all, the most lucrative products to sell are often the ones in which investors
don’t really know what they are getting or how much it costs.
9) BEHAVING BADLY
Investors ought to periodically
review their plan and stick to it if the approach is still the right one. But
adhering to a prudent investment strategy often becomes elusive in a world of
continually streaming news and complex investment products. These forces can overwhelm human emotion and
lead many investors astray.
A vast
amount of research into how the human brain is wired documents tendencies known
as behavioral biases. These biases make even highly intelligent investors particularly
susceptible to the conventional approach of Wall Street and the messages
purveyed by the media. An entire field of study known as behavioral finance, a
mix of economics and psychology, has discovered biases that influence
investment decisions. They have technical names like overconfidence, mental
accounting, regret avoidance, extrapolation, and self attribution bias. What do
they all mean? In a nutshell, investors may not be rational, but they are
normal—meaning they’re often their own worst enemy.
10) SIMPLE BUT NOT EASY
A prudent investment approach
following these fundamentals is like a steady diet of healthy food—simple, effective,
boring, and difficult to maintain. It is well documented that good food,
exercise, avoiding too much alcohol, and sufficient sleep will improve the odds
of being healthier. It is also well documented that accepting that markets
work, avoiding stock picking and market timing, effectively diversifying a
portfolio, and paying attention to costs will improve the odds of being
wealthier. It sounds simple, but it isn’t easy.
The helpful comments of Eduardo Repetto are gratefully acknowledged.
1.
Friedrich August von Hayek, “The Pretence of
Knowledge”
(lecture to the memory of Alfred Nobel, December 11, 1974)
http://www.nobelprize.org/nobel_prizes/economics/laureates/
1974/hayek-lecture.html/
(accessed July 6, 2012).
2.
The excellent vs. unexcellent example provides
a simple explanation of pricing (i.e., expected returns) based on risk, but
risk is technically not that of the company by itself
but of the company in the overall portfolio. For example, if you are a bank and
have loans to many excellent companies in the same
industry, you may lend at the same rate to an excellent company in the same industry or an un-excellent company in a
different industry.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This article is provided for informational purposes, and it is not to b construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.
©2012 Dimensional Fund Canada ULC. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited.
