A Necklace For A Manhattan Mansion?

Nearly one-hundred years ago one of the best (and worst) barters occurred in New York City.  I read the entertaining story recently and found it fascinating.  While it is a great tale of American history, the message is wholly relevant to investors today:

Described by The New York Times as "one of the finest" residences in the area, the Plants' New York City residence was on the corner of 52nd Street and Fifth Avenue. It was built in an Italian Renaissance style of limestone with marble accents.

When Maisie Plant fell in love with the natural, oriental pearl necklace, Pierre Cartier sensed an opportunity. Pierre, the savvy businessman, proposed the deal of a lifetime: He offered to trade the double-strand necklace of the rare pearls — and $100 — for the Plants' New York City home. The necklace was valued at $1 million, while the building was valued at $925,000, according to The New York Times.

The pearls were worth more than the Mansion at the time. Why were the pearls so costly? Cultured pearls had not fully entered the marketplace yet, which meant that each natural pearl had to be found by divers. It had therefore taken Cartier years to assemble the 128 graduated, perfectly matched pearls of Plant's necklace. Additionally, diamonds were becoming less valuable because of recent discoveries in Africa. Because of their rarity, natural pearls had become the symbol of the well-to-do socialite.

Maybe it's the way my brain works, but I wanted to find out who really made out in this deal, and to what extent.  Below are the values of what the trades would be worth today.  In doing some further digging and research, I found the following info:

Sadly, Ms. Plant's heirs sold her necklace after her death at auction for a mere $170,000 in 1957 (a loss of 86% from her purchase price).  So, Cartier was the winner in this trade.  What is not even mentioned, is that for the past 97 years, the 5th Avenue building also was producing income (via rent) which makes its true value hard to even quantify over time.  This is just another example of why we tend to shy away from commodity type investments like precious metals.  They cannot grow, cannot produce income and your returns come from the hope that someone else will be willing to pay more than you did.

Just in case you were wondering, over the same time period, stocks would have turned the same investment into $271 million (without accounting for dividends)!  Just another example of the power of investing in businesses and not just hard assets.

Soccer and Investing Have Similar Qualities

The author Malcolm Gladwell recently explored the idea of strong-link and weak-link networks in his podcast, Revisionist History.  A strong-link network is when a few great people matter most to your success.  A good example of this would be basketball.  When you have LeBron James on your team, you don't need a whole lot of other superstars to be great.  In fact, you could have a bunch of below average players on your team and still win the championship.  A weak-link network is when an above-average group matters most.  In keeping with the sports analogy, soccer is a great example of this.  An above average team has a better chance of winning than a team with one superstar.  The reason is that the entire team is essential to win the game.  Lionel Messi is considered the best soccer player on the planet now, but it still may take 5 or more passes from his teammates to set him up to make a play.  If you have below average teammates your success will be limited.

So what type of network is investing?  Is it better to try to pick a few stocks with the hope of having one or two be huge gainers (strong-link network) or have an above-average type of portfolio with no superstars, but no disasters either (weak-link network)?  We are of the belief that the weak-link network, by diversifying the portfolio using low-cost funds (not superstars but above average) is superior when it comes to investing.  Here is our thinking:

  • Losses are harder to recover from- if your portfolio goes down 50% then up by 50%, you are not back to even.  You are down 25%.  A weak-link strategy lessens the probability of major losses because of the diversification benefits.
  • Loss aversion- a strong-link strategy would require major fortitude to see substantial portfolio volatility (since this strategy would be more concentrated).  Loss aversion refers to an investor's tendency to prefer avoiding losses to acquiring equivalent gains.  We believe most investors trying to pursue a strong-link strategy would have a higher tendency to bail out of their portfolio at the worst possible time.
  • There is no evidence that strong network strategies would work- trying to pick a few great investments can work, but most evidence seems to suggest that positive results are more based on luck than skill.  Luck is not an effective investment strategy.
  • The odds are against you- research shows that picking individual stocks (a strong-link strategy) is a low probability approach.  During their lifetime, 64% of stocks underperformed the Russell 3000.  You have about a 1 in 3 chance of outperforming the overall market when you pick a stock.  The weak-link strategy of owning the market gives you a higher probability of success.

Instead of trying to pick the next Apple, focus on a weak link-strategy.  Make sure every part of your portfolio is above average. Maybe not the best, but above average.  The way to ensure you have above average investments is to focus on low-cost, passive vehicles.  Research tells us these investments won't be number one in their asset class, but they will be in the top third.  This is a textbook weak-link strategy.

Active Management ALWAYS Underperforms

Active asset management is the strategy of picking a small number of holdings with the goal of outperforming the broad index.  For example, an active manager may invest in small US companies and pick 40 of those companies to include in his portfolio with the hope of outperforming the actual 2,000 small US companies in existence.  Most people believe that with enough hard work and intelligence this is very possible, especially in areas where there is less competition (like small companies, emerging market stocks or high yield bonds).  But there is a simple truth that the active managers won't tell you.  The average active manager in any asset class will always underperform his/her benchmark.  It is simple math that Nobel prize winner Bill Sharpe wrote in his brilliant paper, The Arithmetic of Active Management:

Because active and passive returns are equal before cost, and because active managers bear greater costs, it follows that the after-cost return from active management must be lower than that from passive management.

Think of it this way.  The ownership of an entire asset class is made up of the combination of passive investors (those that buy and hold the entire asset class) and active investors (those that pick and choose the funds they want to own inside that asset class).  If the passive investors own the asset class (some portion of it), the remaining active investors MUST own that same asset class if you look at them in the aggregate.  Therefore, if one investor overweights Walmart in their portfolio, some other investor must be underweighting it.  It is impossible for everyone to overweight or underweight a stock since someone has to own it.  In the same vein, when an active manager buys a stock (and profits from it) someone has to have sold it to him (and therefore lost out).  Trading is a zero sum game amongst active managers.

Notice, I have not said that all active managers will underperform.  It is the average of all active managers that will always underperform because of their fees.  There will be winners and there will be losers, but the average active manager will always do worse than his/her benchmark (FYI- this plays out perfectly in the data).  This is true over any time period:  one day, one month, one year, or 100 years.  So, if you believe in this simple math equation, you need to ask yourself one more question- can I pick a manager (or be one myself) that will be in the minority camp of active managers that outperform?  We'll save that topic for a future post.

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.