by Lars Kroijer
bid/offer spread
price impact
transaction tax
turnover
information/research cost
capital gains tax
transfer charge
custody charge
advisory charge and
your time.
Depending on your circumstances and portfolio size you may find that it costs more than 1% each time you trade the portfolio (the low, fixed, online charge per trade is only a small commission percentage if you trade large amounts). This is certainly less than it used to be decades ago, but for someone who is frequently trading their portfolio it will be a major obstacle to performance. In addition, capital gains tax amounts can add up for frequent traders and the ‘hidden fees’ like custody or direct or indirect costs associated with research and information-gathering come on top. The more this adds up to, the greater the edge someone will need just to keep up with the market.
I recently saw a particularly cringeworthy advertisement where a broker compared trading on its platform to being a fighter pilot, complete with Tom Cruise style Ray-Ban sunglasses and an adoring blonde. I remember thinking, ‘I would love to sell something to whoever falls for that.’ The platform makes more money the more frequently you trade, and the broker obviously thinks that you will trade more if you believe it’ll make you be like Tom Cruise.
Some readers may dismiss this book as a load of rubbish. They may consider themselves to be sophisticated investors who can outperform the market. I hope this group at least has its opinions on edge challenged, and perhaps gets better at defining exactly what its edge is as a result of reading this book. But if you are going to actively manage your own portfolio I would encourage you to consider a few things:
Be clear about why you have an edge to beat the market, and be sure you are not guilty of selective memory. Unlike predicting the winner of Saturday’s football game, predicting that Google was going to double when it later did makes us appear wise and informed. Perhaps we are subconsciously more likely to remember that than when we proclaimed Enron a doubler. Because we add and take money out of our accounts continuously we are unlikely to keep close track of our exact performance and can continue the delusion indefinitely.
Do not trade frequently. If you turn over your portfolio more than once a year you should have a really good reason to do so. The all-in costs of trading are high and greatly reduce long-term returns.
Pick 12–15 stocks you feel great about that are not all in the same sector (preferably also not in the same geographical area) and plan to stick to those for a very long time. Warren Buffett says his favourite holding period is ‘forever’, suggesting that successful investors do not frequently trade in and out of investments.
Do not start panicking if things go against you.
You may decide you have an edge in one sector, geographical area or asset class. That’s fine. Do exploit this edge, but invest like a rational investor in the rest of your portfolio.
Continuously reconsider your edge. There is no shame and probably good money in acknowledging that you belong to the vast majority of people that don’t have an edge. Investors who initially do well in the markets will often think it was skill rather than luck based on that first experience. Many reconsider later …
How you cost your time spent managing your portfolio is individual to you (we each value our time differently) and while some consider it a fun hobby or game akin to betting, others consider it a chore they would rather avoid. Someone may spend 10 hours ‘work time’ a week on their portfolio which at an ‘opportunity cost’ of time of $50 an hour for 40 weeks is $20,000 a year on top of all the other costs discussed. This clearly makes no sense for a $100,000 portfolio and is too costly even for a $1 million portfolio. On top of everything else this investor would benefit from the reduced time involved in running a simple rational portfolio.
Should we give our money to Susan and Ability?
If you conclude that Susan is as plugged in and informed as anyone could be, why not just give her our money and let her make us rich?
Many investors do invest their money in the many tech-type products and Ability and its peers continuously develop mutual funds for everything you can imagine. There are funds for industrials, defensive stocks (and defence sector stocks for that matter), gold stocks, oil stocks, telecoms, financials, and technology. Many investors have become ‘fund pickers’ instead of ‘stock pickers’. Even today, years after the benefits of index tracking have become clear to many investors there is perhaps $85 invested with managers that try to outperform the index (so-called ‘active’ managers) for every $15 invested in index trackers.
When investors pick from the smorgasbord of tempting-looking funds how do they know which ones are going to outperform in future?
Is it because investors have a feeling that IT stocks will outperform the wider markets?
If so, you are effectively claiming an edge by suggesting that you can pick sub-sets of the market that will outperform the wider markets? Consistently picking outperforming sectors would be an amazing skill.
Is it because of Susan’s impressive CV (investors think that someone with her impressive background will find a way to outperform the market)?
If so, you are essentially saying that you know someone who has an edge (Susan), which is really another form of edge. This is the kind of edge many hedge fund investors claim. Funds will say, for example, ‘through our painstaking research process we select the few outstanding managers who consistently outperform’. Maybe so, but that is also an edge.
Is it because investors feel Ability has come up with some magic formula that will ensure its continued outperformance in its funds generally?
There is little data to suggest that you can objectively pick which mutual funds are going to outperform in future.
Is it because your financial adviser considers it a sound choice?
First figure out if the adviser has a financial incentive, like a cut of the fees, in giving you the advice. The world is moving towards greater clarity about how advisers get paid, making it easier to understand if there is a financial incentive in recommending some products. Keep in mind that comparison sites also get a cut of the often hefty active manager fees. Now consider if your adviser really has the edge required to make this active choice. Unless he has a long history of getting these calls right I would question whether he has the special edge that eludes most (and would he really share this incredibly unique insight if he had it?).
They have done so well in the past
Countless studies confirm that past performance is a poor predictor of future performance. If life was only so easy – you just pick the winners and away you go …
We are often driven by the urge to do something proactive to better our investment returns instead of passively standing by. And what better than investing with a strong performing manager from a reputable firm in a hot sector we have researched?
Mutual fund/unit trust charges vary greatly. Some charge up-front fees (though less frequently than in the past), but all charge an annual management fee and expenses (for things like audit, legal, etc.), in addition to the cost of making the investments. All-in costs span a wide range, but if you assume a total of 2.5% a year that is probably not too far out. So if someone manages $100 for you, the all-in costs of doing this will amount to approximately $2.5 a year come rain or shine.
If markets are steaming ahead and are up 20% or more every year, paying one-tenth to the well-known steward of your money may seem a fair deal. The trouble is that no markets are up 20% a year every year. We can perhaps expect equity markets to be on average up 4–5% a year above inflation. So you need to pick a mutual fund that will outperform the markets by 2%, before your costs, in order to be no worse off than if you had picked the index tracking exchange traded fund (ETF), assuming ETF fees and expenses of 0.5% a year. (ETFs, which are investment products that are traded like normal stock, will be discussed later.)
You need to pick the best mutual fund out of 10 for it to make sense!
To give an idea of how much the fees impact over time consider the example of investing $100 for 30 years. Suppose the markets return 7% a year (a 5% real return plus 2% inflation would be a reasonable expectation – see later) and the difference becomes all too obvious over time – see Figure 2.1. (There is a 2% fee disadvantage in this mutual fund case compared to the tracker fund.)
Ability and its many competitors go to great lengths to show their data in the brightest light, but a convincing number of studies show that the average professional investor does not beat the market over time, but in fact underperforms by approximately the fee amount.
Figure 2.1 Index tracker versus mutual fund returns over 30 years
There is of course the possibility that you are somehow able to pick only the best-performing funds. Suppose you had $100 to invest in either an index tracker, or a mutual fund that had a cost disadvantage of 2% a year compared to the tracker. Suppose also that the market made a return of 7% a year for the next 10 years. Finally assume that the standard deviation1 of each mutual fund’s performance relative to the average mutual fund performance was 5% (the mutual funds predominantly own the same stocks as the index and their performance will be fairly similar as a result). Figure 2.2 shows the returns of an index tracker compared to 250 mutual funds with those inputs.
Comparing an actively managed portfolio to an index tracker is unfortunately not as simple as subtracting 2% from the index tracker to get to the actively managed return. The returns will vary from year to year, and in some years the actively managed fund will outperform the index it is tracking. Some funds will even outperform the index over the 10-year period. If you can pick the outperforming fund consistently, you have an edge. If you can’t, you should buy the index.
In approximately 90% of the cases in the 10-year example above, the index tracker would outperform the actively managed mutual fund, which is roughly in line with what historical studies suggest. So in order for it to make sense to pick a mutual fund over the index tracker you have to be able to pick the 10% best-performing mutual funds. That would be pretty impressive.
Figure 2.2 Ten-year performance of 250 active managers versus an index tracker
If you did not have an edge and blindly picked a mutual fund instead of the index tracker you would, on average, be about $30 worse off on your $100 investment after 10 years because of the higher costs. Had it been a $100,000 investment the difference would be enough to buy you a car.
You can bet your bottom dollar that the 10% of mutual funds that outperformed the index would trumpet their special skills in advertisements. Historical performance is however not only a poor predictor of future returns, but it can be very hard to distinguish between what has been chance (luck) and skill (edge). Just as one out of 1,024 coin flippers would come up heads 10 flips in a row, some managers would do better simply because of luck. In reality the odds are much worse in the financial markets as fees and costs eat into the returns. However, ask the manager who has outperformed five years in a row (every 50th coin flipper …) and she will disagree with the argument that she was just lucky, even as some invariably are. Likewise some managers underperform the market several years in a row simply due to bad luck, but those disappear from the scene and thus introduce a selection bias as only the winners remain. This sometimes makes the industry appear more successful than it has been.
Outside stock markets
The discussion of edge is not exclusive to stock markets. You can have an investment edge in many areas other than the stock market and profit greatly from that edge, for example:
Will Greece default on its loans?
Will the price of oil increase further?
Will the USD/GBP exchange rate reach 2 again?
Will the property market increase/decrease?
The list goes on …
Being rational
For someone to accept that they don’t have an edge is a key ‘eureka’ moment in their investing lives, and perhaps without knowing it at first, they will be much better off as a result. At this point you are at least hopefully considering a couple of things:
An edge is hard to achieve and it’s important to be realistic about whether or not you have it.
Conceding that you don’t have an edge is a sensible and very liberating conclusion for most investors. It makes life a lot easier (and wealthier) if you acknowledge that you can’t better the aggregate knowledge of a market swamped with thousands of experts that study Microsoft and the wider markets.
1 A standard measure of risk that gives an idea of the range of returns you could expect and with what frequency.
chapter 3
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What are the key components of the rational portfolio?
Once you have conceded that you don’t have an edge on the market, unfortunately you are not done. In fact you have only arrived at the starting point of your rational journey!
Doing nothing with our assets is not a sensible solution: we need to put our money to use to get the best return for the risk we take, just like we would if we claimed we had an edge. Figure 3.1 shows a list of issues that a rational investor needs to think about. The remainder of this book covers these issues.
Figure 3.1 Issues that the rational investor must take into account
Asset split in a rational investment portfolio
In creating the rational portfolio we split our assets into the lowest-risk assets that preserve capital and risky assets that have to generate returns, and combine the two according to our risk preference. In the low-risk bucket we should have the highest-rated and liquid government bonds, ideally available in the base currency of our investments.
If we want to achieve anything other than the very unexciting return profile of low-risk government bonds we have to turn to riskier assets. We acquire these riskier assets not for the sake of adding risk, but because we hope to get great investment returns from them. The majority of rational investors are best off with a cheaply bought index tracker of world equities as their risky assets. It is a major evolution in the investing world that products tracking these indices are now readily available: just 15 years ago they were not.
Some books on investing involve intricate arguments about why certain geographical areas or sectors of the equity markets will outperform and provide a safe haven for the investor. On the contrary, the most diversified portfolio you can find offers the greatest protection against regional declines. Also, since we are simply saying ‘buy the world’, the product is very simple and should be super cheap. Over the long run that will matter greatly.
Someone willing to add a bit of complexity to the very simple portfolio of world equities and minimal-risk government bonds could add other government and corporate bonds (see Figure 3.2). While these additions make a lot of sense and I have them in my personal portfolio, unfortunately the product offerings in the space still leave something to be desired. Creating broad and cheap index-type exposure for bond portfolios is not as simple as for equities and there is a tendency for the products to be dominated by US and European securities in particular.
Elements of the rational portfolio are summarised as follows:
Asset class Description
Minimal risk asset UK, US, German, etc. or equivalent. Credit quality of maturity matching investor’s time horizon.
Equities World equity index or as broad as possible.
Other government bonds Diversified return generating government bonds of varying maturities, countries and currencies; we have used those rated sub-AA as a good indicator.
Corporate bonds Broad range of corporate bonds of varying maturity, credit risk, currency, issuer and geography.
Figure 3.2 Elements of the rational portfolio
You may have noticed that there are some investments that are not part of this portfolio: property, private equity/venture capital, commodities, hedge funds, private investments
(including angel capital, etc.) and so on. Buying these asset classes requires an edge. Whether you invest in regional property, a private equity fund or buy coal, you are claiming that you know something about future performance that the rest of the world does not. Also some of those investments are similar to the exposure you already have through your broad market exposures (at a small fraction of the cost) and are often very illiquid. The liquidity of the rational portfolio is one of its most underappreciated features; having the ability to readily realise cash can be critical in some circumstances and something the rational portfolio provides.
Even during the darkest days of 2008–09, unless you had assets similar in size to a really rich oil sheik, you could unwind your portfolio at short notice if need be. If you badly need liquidity then having that option is priceless.
Understand the level of risk you are comfortable with
The products that rational investors use may be similar, but the proportions are not. If you have £105 and need £100 for heart surgery in a year, your risk profile is very different from someone with £100 at the age of 30 who needs £150 40 years hence. Our needs change over time as we age or our circumstances change. The risk you are willing to take at age 60 is typically very different from what you were willing to take at 40. Everyone is different and individual circumstances will determine what your mix of low-risk and riskier assets (like the equity markets) will be. The elements of the portfolio don’t change, but the proportions of the risky assets do.