Advice from notables (part 1 of 2)

Conflicts of interest usually tend to nullify advice that is offered in good faith, whether it’s for monetary gain or not. The recipient of the advice wants to believe that conflicts are minimized and their best interests are at the forefront. Often this is not the case within the financial services industry, as the advisor is looking to maximize profits, sometimes at the unnecessary expense of their clients.

Listed below are some of the more notable pieces of advice, (in our opinion) and they all come from people who stood to gain nothing from sharing their expertise. Put differently, conflicts of interest were absent at the time these notables wrote or spoke about how they navigate the markets. Each quote is followed by our commentary to add some more context to their insight.

"The investor's chief Problem – even his worst enemy – is likely to be himself."

-Benjamin Graham

Pride comes before the fall, especially when it involves investing. It’s very easy to be overly confident when the markets are going nowhere but up. It’s when things take a turn for the worst that successful investors are made. Whether it’s taking advantage of depressed housing prices, or value averaging on the funds you’re invested in as prices fall, opportunity does exist even when it seems like it’s all doom and gloom. And it’s at these times when the individual investor often makes decisions that are counterproductive to their financial well-being.

Take, for example, the knee-jerk reaction most people have when the market corrects 1-2% on any given day. The immediate inclination is to sell, and sell fast. But when that happens, you essentially lock in losses, and unless your goal is to tax-loss harvest come tax time, your overall return on investment will diminish. Overconfidence is omnipresent among investors, all you have to do is ask someone’s opinion on where they think the market is going and you’re almost certain to receive an answer that does not include the words “I don’t know.” But the reality is no one really knows what the market is going to do. They may make educated guesses, but nothing more. So the next time you want to go with your gut and either buy or sell without careful thought and analysis, you’re probably better off waiting a while lest you become your own worst enemy.

"Trust in time rather than timing."

-Burton Malkiel

Continuing with the theme of overconfidence, Malkiel eloquently sums up an important truism when it comes to investing: time in the market is much more crucial than jumping in and out of the market at the right times. The latter simply can’t be done with any consistency or precision. To time the market means you have to know not only the right time to buy, but also the right time to sell. Doing this again and again not only costs money in transaction fees and taxes, but it also takes an emotional toll with the ups and downs that occur even during intraday trading sessions.

There have been numerous days when the market has fallen 15% or more just in a matter of hours, so to exit your position and then re-enter hours, days, or weeks later, is a task that challenges even the most seasoned traders on Wall Street. Contrast the timing of market fluctuations with the amount of time spent in the market and the risk one assumes is certain to decrease. Invest early and often, not erratically and belatedly.

"If you have trouble imagining a 20% loss in the stock market, you shouldn't be in stocks." -John Bogle

Bogle’s advice is invaluable. He has written extensively on everything from corporate governance to the mutual fund industry and even his incredible heart transplant. We like this suggestion because the investing public should not invest in stocks without being prepared to lose money. It’s similar to walking in a casino, but with games like roulette and blackjack there’s no underlying intrinsic value, other than say for entertainment purposes. With companies, though, over time there’s a greater likelihood that money will be made as opposed to lost because companies produce goods and services; casinos just produce winners and losers.

Bogle’s point is realistic because losing 20% in a matter of hours on a particular stock is not uncommon. But the same can be said for the upside of investing in stocks; fortunes have been made from owning single stocks, not in a matter of hours of course, but certainly over a few years. Just don’t let the upside potential blind you from the downside hazards.

"Both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm."

-Warren Buffett

The first part of Buffett’s sage advice is a direct attack at the multi-billion dollar brokerage and investment advisory industry. And rightly so. It’s safe to say that in the aggregate, individual investors would be much better off if these industries did not exist. That’s not to say that many people could benefit from having someone by their side who could advise them on what to do with their hard-earned money. But, with the way in which the industry currently operates, investors are wasting hundreds of thousands of dollars on people who most likely cannot consistently outperform an index fund. So why do so many people continue to use financial planners, investment advisors, or other money managers? We believe it’s largely due to either misinformation or the falsehood that these professionals can beat a simple S&P 500 index fund.

Ignoring the daily chatter is also pertinent to investing with success. Buffett stays far away from Wall Street because he doesn’t believe the talking heads will give him an advantage. Indeed, he views it as an impediment to his success, or to anyone looking to make money in the markets for that matter.

So-called bubbles

Every economic phenomenon has its day when the investing public turns its back and looks for an alternative way to make a return on one’s capital. Whether it’s hedge funds, real estate, or Exchange Traded Funds (ETFs), the popularity of these investment instruments wax and wane in accordance of where money has been made compared to where money will be made.

Take for example, passive investing, an investment strategy whereby an investor can simply buy a basic S&P 500 index fund, sit back, dollar cost average, and more likely than not come out ahead of someone who actively trades stocks, or buy and sells shares of funds regularly. And this includes highly compensated professional money managers who charge to manage your portfolio.

Passive investing has gotten so popular that in 2009 demand for Bloomberg terminals, which assist traders who actively play the market, decreased by about 20,000 systems as institutional investment companies turned to indexing in search of higher returns.1 Just as recent as last year, demand for Bloomberg terminals saw another decline by as much as 3,000 units; indeed, the passive investing phenomenon is still in full swing, and for good reason. Some market pundits are screaming bubble as capital continues to flow into funds tracking indexes without any end in sight. That may be alarming to some, but we believe that this so-called bubble is different than others in a much more profound way: it is not driven by people seeking excessive returns. The same cannot be said for people who wanted to get rich quick by flipping houses at the peak of the housing bubble, nor can it be said for investors who parted with several hundred thousand dollars to gamble with a hedge fund manager. And it certainly cannot be said for those who speculate in gold, silver, or whatever the metal du jour happens to be.

The reason we think that passive investing is most likely not in a bubble is because the quest to match the market without incurring high costs is not driven by the quest to make millions at the drop of a hat. That, and, historically bubbles have nothing to do with investment techniques and everything to do with asset classes. Value investing, first championed by Benjamin Graham, never experienced bubble-like conditions, even as Warren Buffett was consistently making billions from the strategy. The same cannot be said for the dot-com bubble that occurred from 1995 to 2001.

Burton’s bubbles

Burton Malkiel wrote about the history of bubbles in his magnum opus A Random Walk Down Wall Street, where he highlighted financial manias that have inflated (and subsequently deflated) prices of everything from tulips back in the 17th century to houses during the subprime crisis in 2007-08. Each example Malkiel discussed involved an asset class, not a technique of investing. More than anything, investors have learned over the years that they’d be much better off entrusting their money to an index fund than to a professional money manager, an actively managed mutual fund, or a highly compensated financial planner. After all, the more fees an investor pays up front, the less return they’re guaranteed to have.

The numbers are staggering. Since the financial crisis in 2008, there has been a two trillion dollar swing in cash flow from active into passive funds. In other words, investors are voting with their wallets and pouring trillions into index funds while simultaneously moving trillions out of active funds that promise to beat a particular benchmark index.2 So why the drastic change? The probability of a professional money manager beating an index fund has become so low and so widely published that the investing public has had enough. Take a look at any SPIVA report card, which is regularly published by Dow Jones Indices, to measure the success of these professionals. The latest report is particularly damaging to active management because it’s difficult to defend a strategy that loses 92% of the time. And that’s the best result over the 15-year period ending December 31, 2016. When compared against mid- and small-cap funds (as opposed to large-cap), active has lost to passive 95% and 93% of the time, respectively. Time periods are not cherry picked either. Compare the two investing styles against any period, from one year to 20 years, and the outcome is not too far off. It’s unlikely that a bubble will ensue from a winning strategy.

Emerging opportunities

Passive investing is not likely to experience a bubble precisely because there will always be investors who believe that they can beat the return the market offers, whether it’s on their own, or with the help of an investment advisor or fund manager. The ego of those in the business is much too strong to yield to a computer that tracks an index. Moreover, the capital markets would be much worse off if active investing fell by the wayside. Active investing must remain as part of an overall strategy for both individuals and the market as a whole. If it ceases to exist, there would be no one concerned with how companies conducted business, nor would there be value investors who determine the intrinsic value of a company and then buy or sell based on their analysis, consequently forcing management to either improve operations or dissolve and start anew.

Active investing is a necessity, it just isn’t a prudent strategy to invest the majority of one’s savings, especially if their risk tolerance is low.

One area where there tends to be an opportunity to make a return in excess of what an index fund might deliver is with emerging markets. The benchmark index that tracks some of these international funds is called the S&P/IFCI Composite. Over the one-year period ending June 30, 2016, this index actually lost to the average emerging market active fund 58% of the time.3 The winning streak ends as the time period extends to three-, five-, and ten-year periods, but there could be some opportunity to exploit the inefficiencies of such a market. Opportunities are there to earn outsized returns, especially when it comes to viable investment strategies that will undoubtedly persist over trendy asset class bubbles.

1.http://www.thenational.ae/business/personal-finance/is-passive-investment-the-next-bubble

2.http://www.businessinsider.com/sp-report-on-active-manager-benchmark-underperformance-2017-4

3.https://us.spindices.com/documents/spiva/spiva-us-mid-year-2016.pdf

A great dichotomy

Wal-Mart is probably the most famous low-cost retailer in the world. It’s also one of the most successful. The ability of its founders and executive management team to consistently provide products at prices that millions of Americans can afford has made the proprietors and shareholders extremely rich. The Walton family is by far and away the wealthiest family in America with a combined net worth of nearly $150 billion. The Waltons knew that by controlling costs, they could maintain affordable prices for everyday goods that millions of people would purchase. With a 24.5% gross margin rate in 2014, Wal-Mart earns its enormous profits by literally turning pennies into billions. The company is so successful that its annual revenue exceeds the nominal GDP of Hong Kong.1

So what does this have to do with investing? Other than the obvious fact that investing in Wal-Mart at its inception would’ve paid large sums thereafter, this example highlights a division between what something costs and what consumers value, above and beyond the price of a good or service.

A great dichotomy exists between cost and value, not only in the retail space, but also in many other industries. Consumers shop at places like Wal-Mart not because everything they offer is cheap or on sale for a dollar or two, but it’s due to the value—perceived or otherwise—that these companies offer. It’s the same reason shoppers pay an annual membership fee to use Costco’s services and obtain price discounts based on volume and overall economies of scale. The membership sees value in the company, despite not having the lowest prices among its peer group.

Value investing

Almost everyone is in search of value. Both shoppers and investors alike want to believe they’re getting more than what they view is a fair price. One of the most prominent of all investment authors is Benjamin Graham, who penned his magnum opus in 1949 which would later serve as Warren Buffett’s guide to value investing. The Intelligent Investor is probably the most famous investment book of all time, and Buffett used it to lay the foundation for his success, as he would later go on to become the best value investor of all time.

Value investing is basically the idea that certain assets may be intrinsically less than what the market, or a subset of investors, is pricing that particular asset, whether it’s a private company, a public stock, or a piece of real estate. In other words, investors are actively trying to determine which assets are undervalued and they’re buying in anticipation of either the market realizing their higher intrinsic value or, in the case of Buffett, they’re actively working to improve the companies, to subsequently increase the inherent value of the company.

This investing philosophy is a very popular strategy for money managers and individual investors because behind the idea is the notion that a certain skill set is required to make money, unlike more speculative methods like technical analysis, whereby traders try to predict future price movements of a stock based on historical chart formations. The prerequisite knowledge to value a company is reflective of how financially viable the company is, whereas the know-how to trade stocks based on charting is more of a lesson in human behavior than anything.

We’re not discounting the fact that there have been many traders who have made lots of money buying and selling equities. Over one, two, or even three years, it’s very possible that Joe Trader sitting at his home computer could choose a handful of stocks that could outperform the S&P 500, even after transaction costs and taxes. It’s when you’re taking a longer time horizon that the odds of beating a simple index fund will tend to favor the computer tracking the benchmark rather than the trader tracking line formations.

In the vanguard

Just as Wal-Mart is in the vanguard as a leader in retail, there’s a fund company headquartered in Valley Forge, Pennsylvania which recognized that by controlling their cost structure they could pass on savings to their customers in the form of higher returns on their investment. The Vanguard Group operates at cost, which in the words of its founder Jack Bogle, made it the very first “mutually owned” mutual fund. The investors who invest in the funds actually own those very same funds, not a third-party management company, like the majority of other investment companies. This structure has led to the entrustment of more than $3.5 trillion of investors’ capital with the organization, making it among the largest companies by assets under management (AUM) in the world.

Vanguard’s AUM grew exponentially when the overwhelming research pointed to an overall inability of the average money manager to beat a basic benchmark index, leading to a passive investing revolution of sorts. But Vanguard still recognizes the importance of offering investors actively managed funds as well; they just do it in a way that almost ensures higher yields to their customers. Because with lower cost structures like that of Wal-Mart, they’re providing value without compromising on the quality of the funds they offer. The results are telling. Since 2007, 92% of Vanguard funds have outperformed their peer-group averages. Over one-, three-, and five-year periods ending December 31, 2015, at least 81% of active funds offered by the company have beaten other actively managed funds.2 It doesn’t get much clearer than that.

Cost and value are not synonymous. If cost mattered more than value, price would be king, not the overall experience and mutually beneficial paradigm that has shaped how companies now view their proposition to the public. Adam Smith wrote in the Wealth of Nations that the sole role of the producer is to serve the consumer. For companies like Wal-Mart and Vanguard, they’ve perfected the art of servicing the client, and the value of their offering is evident.

1.https://www.fool.com/investing/general/2014/01/21/wal-mart-and-target-have-the-worst-gross-profit-ma.aspx

2.https://vanguardinstitutionalblog.com/2016/06/09/the-cost-value-paradox/?refer=iigweb_researchcommentary