I was inspired to write this post by a conversation I had this afternoon at a lunch event. I sat next to a gentleman who has been working in the capital markets for about 40 years. We were discussing active, passive and smart beta strategies. Our conversation revolved around the idea that much of what passes for investment strategy is an incoherent jumble of half-truths and gross oversimplifications. The reason for this is that investors are always looking for THE ANSWER. You can move a lot of product pretending to have it.
What is THE ANSWER?
It is the magic asset, or strategy, or star manager that beats the market like clockwork. It is the alluring promise of “equity returns with less risk” (whatever that’s supposed to mean). It is the siren song that drew investors to hedge funds in the mid-2000s and draws them to private equity and venture capital today.
In reality of course there is no magical asset class, strategy, or manager. There is only the ever-shifting landscape of the capital markets. In capital markets, the only constant is change. Fortune ebbs and flows. Just when you think you have the game figured, the game will change. Count on it. George Soros calls this “reflexivity.” The game changes in response to how we play it. Don’t like it? Too bad. That’s America.
People do not like change. They especially do not like change of the reflexive kind. And don’t get me started on cognitive dissonance. Nothing wrecks Average Joe’s head quite like trying to hold two contradictory ideas in his head at the same time. Because people prefer order, stability, predictability and logical coherence, we as financial professionals tend to coddle them. We show them charts of historical capital market data and pretend it is meaningful. We make neat little graphs showing historical drawdowns and recoveries and emphasize that things always turn out okay in the long run. What we don’t give them is THE TRUTH. Most of them can’t handle the truth.
Because THE TRUTH is that there is no single ANSWER. There is only a long list of general principles in constant conflict with one another. And the reality is that sometimes things don’t turn out okay in the long run.
In that spirit, I will endeavor to answer some common questions as truthfully as I can. Note that as always, this is not financial advice. I have no idea what your personal situation may be. I am not in a position to be advising you to do anything. And anyway when you are through reading you will probably be more confused than when you started. Silver lining: you will be incrementally closer to understanding the truth about investing.
So here we go.
Is it better to invest actively or passively?
It depends on what you want to achieve.
If you are comfortable earning broad market returns, and you want to maximize tax efficiency and minimize costs, passive strategies are probably the tools you are looking for.
If your goal is to generate extraordinary capital appreciation, you must concentrate capital in equities with extraordinary compounding potential, and you must hold these positions for a very long time. Perhaps that means starting your own business. Perhaps it means owning a concentrated portfolio of individual stocks. Perhaps it means investing a significant portion of your investable net worth with a single asset manager. Warren Buffett didn’t get to be a billionaire buying index funds, no matter what he writes in his shareholder letters.
What if the broad market doesn’t return what it has historically and it ruins my financial plan?
Too bad. There is no law saying you are entitled to a particular return over time. The future is fundamentally unknowable. The best way to protect yourself from unexpected financial shocks is to save a significant portion of your income, carry as little debt as possible and invest a portion of your savings in personal development. Note that all of those things are things you can control, unlike the financial markets and the macroeconomy.
What if I can’t pick the right stocks/managers/business opportunity and I lose all my money?
Too bad. There is no law saying you are entitled to a particular return over time. However, if you are unwilling to devote a significant amount of time learning about business, accounting, capital markets and psychology, it is unlikely you will do well investing. Don’t be ashamed of that. It just means you will need to seek out professional advice, the way I sought out a coach when I wanted to change careers from writing to finance. You will be better for it in the long run, and contrary to what you read in the news there are many highly competent advisors out there who want to help you achieve your goals.
What if I can’t pick the right stocks/managers/business opportunity and I significantly underperform the broad market averages?
Too bad. There is no law saying you are entitled to a particular return over time. If you are that concerned about underperforming the broad market averages you should invest passively. The future is fundamentally unknowable. The best way to protect yourself from unexpected financial shocks is to save a significant portion of your income, carry as little debt as possible and invest a portion of your savings in personal development. Note that all of those things are things you can control, unlike the financial markets and the macroeconomy.
How do I know I am picking the best investment manager?
You don’t and you can’t. Don’t waste your time and energy thinking about this. If you go this route, focus more on avoiding the worst managers, and developing an investment discipline you can stick to over time, through thick and thin.
Isn’t it true that no one can beat the market?
The average investment manager will not beat the market over time, especially net of fees and taxes. However, that is the “average” and there are many talented managers who do outperform over the long run on a net basis. Unfortunately, most of the managers who outperform over the long run will suffer extended periods of underperformance, and most investors will not be sufficiently disciplined to stick around for the good times. In my opinion, picking managers is every bit as difficult as picking stocks. Perhaps even more so.
So if I am invested with a poorly performing manager I should just hold on longer until the good times come?
No. Poor performers often continue to perform poorly, and this poor performance is exacerbated by outflows of investor capital. If this persists for an extended period, it will render the asset manager’s business non-viable and the fund will liquidate, crystallizing your losses.
So how do I know if performance will turn around?
You don’t know. And you can’t.
Grrr… this is getting annoying. Fine. How can I try and figure it out?
Better, grasshopper. You are slowly learning to ask the right questions!
You need to understand the manager’s investment philosophy. You need to understand the way she looks at the world, the way she thinks about value creation and what she perceives as her “edge.” Is she focused on long run intrinsic value creation or the shorter term re-rating of market expectations? (Hint: when she models companies, does she use a discounted cash flow or earnings methodology, or does she compare price multiples such as EV/EBITDA to peer companies?)
You need to assess whether her portfolio is in sync with how the capital markets are trending, or whether she is a contrarian. If she is a contrarian, you need to assess whether and when the market will turn in her favor, and whether you can hold out for that long psychologically.
You also need to understand her investor base, the health of her business, the loyalty of her team and her personal goals. If she is losing assets and is motivated primarily by business success (versus “winning” at the game of investing) she will be more likely to liquidate (a.k.a return investor capital to spend more time and energy with family).
This sounds hard.
Why should it be any easier than mastering any other technical or artistic skill?
Well, I can trade commission free on Robinhood.
You can cook elaborate meals in your home kitchen, too. Yet you don’t expect your butternut squash risotto to earn three Michelin stars.
Thinking back on the first part of this conversation, I notice you repeat yourself a lot.
Is that so? Gee. Maybe there’s something to that…