One of the more damaging pieces of advice to the average investor is Warren Buffet’s famous investment rule:
“Rule No. 1: Never lose Money. Rule No. 2: Never forget Rule No. 1”
While this folksy wisdom has a great ring to it, it can be easily taken out of context. I think what Buffet is trying to say is not to gamble with your money and be prudent in your decision making. Many investors read this rule and believe that they should literally attempt to not lose money when they invest. Over the past 20 years, Buffet’s own company, Berkshire Hathaway, has had 6 losing years, with one of them erasing approximately 1/3 of his shareholder’s value. That means over the last 30 years, he has broken his own rule 30% of the time!
Investing involves risks. Those risks aren’t just theoretical. Historically, the stock market goes down around 1 out of every 3 years. For those who are trying to follow Buffet’s rule, how are they going to deal with this simple fact? Unfortunately, we tend to see it manifest itself in market timing, the act of trying to get in and out of the market at the right times. No one we know of has been able to do this consistently enough where you could attribute their performance to skill versus just plain luck. Buffet himself eschews the practice of market timing. He once wrote that his, “favorite holding period is forever”.
Those investors who want to follow Buffet’s rule have three strategies they can lean on to help them implement this idea of not losing money:
- Time period- over one year periods, the stock market has negative returns about 30% of the time. Conversely, there has never been a 20 year period in the S&P 500 where returns have been negative. The longer time you have, the lower the probability of losing money.
- Diversification- when you buy one or two companies, the risk of loss is high. In fact, we wrote about this in a prior post. Since 1983, 39% of all publicly traded stocks have lost money. You must spread out your bets to ensure you don’t pick one or two losers that can cause permanent losses.
- Discipline- there will be bad times. Probably the easiest way to violate Buffet’s rule is to sell your investments AFTER a loss. Having the discipline to stick with your investment strategy after a difficult period is a key factor in avoiding permanent losses.
I think amending Buffet’s rule would be immensely helpful. Here is how I would word it:
“Rule No. 1: Don’t lose money, permanently. Rule No. 2: Never forget Rule No. 2”
By implementing the three strategies we’ve listed above you have a much better chance of following that rule.
Many of us at Greenspring used to be in the stock picking game. It was really hard. While our experience may have been anecdotal, there is new evidence coming out to support the idea that stock picking is a low probability strategy. The Value Walk blog has posted a very interesting study on this topic. Here are some of the major findings:
- Since 1983, the US stock market has consisted of 8,054 publicly traded stocks (including delisted stocks)
- 39% of stocks since 1983 have lost money
- 64% of stocks underperformed the Russell 3000 during their lifetime
- 18.5% of stocks lost at least 75% of their value over their lifetime
If you are keeping track at home, that means that you have a 1 in 3 chance to pick a stock that outperforms the index. When I first read these statistics, I was astonished. I figured that it should be about a 50/50 chance, since half the stocks should outperform and half should underperform. The data tells us something different. What we find is there is a very small contingent of stocks that have HUGE returns, while nearly 2/3rds failed to keep pace with the index. To put it another way, index returns are significantly influenced by just a small group of winners. If you don't happen to have some of these winners in your portfolio, you have a high probability of underperforming. Here is a really interesting chart:
The chart shows that only about 6% of all the stocks significantly outpace the index, but they have a huge influence on the overall returns of the index. What is the chance that you will be able to pick one or more of the stocks? In looking at it from an attribution standpoint, it is even more astonishing. 25% of the stocks in the US over the past 30+ years have accounted for ALL of the gains!
When you start to understand the math and statistics behind stock picking, it should become increasingly clear that owning the entire market is a much safer and prudent strategy than trying to concentrate your bets.
Diversification is the only free lunch when it comes to investing. I think investors nod their heads when they hear this phrase but most don't truly believe it. Do you? If you agree with this, have you bought any individual stocks in the past? If so, I ask you again, do you believe in diversification because your actions don't match your beliefs?
There are some fascinating numbers coming out about winners and losers in the market this year. Take a look at this chart from the Irrelevant Investor blog:
The Russell 3000 is comprised of approximately 98% of the publicly traded stocks in the US market. While the average stock is down over 20% from its all-time high, the Russell 3000 is only down 2.9% from its all-time high. How is this possible? There is a small group of stocks that are keeping this market afloat. This is not very different from history either. According to the blog, since 1926:
- The average return of all stocks is 9.9%
- Excluding the top 10% of performers, the market return falls to 6.5%
- Excluding the top 25% of performers, the market return is negative at -0.3%
This shows us how important diversification is. Market returns are historically driven by a small number of high flying stocks. Sure you could pick one of those stocks in advance and really have outsized returns, but the odds are against you. It is much better to diversify. Smooth out your returns and accept what the total market will give you by owning the entire market.
We've all heard it before: don't put all your eggs in one basket. Intuitively, it makes sense. If we concentrate our assets in one area we will have a lot of problems if that area does poorly. Therefore, if we spread things out, the risk of significantly underperforming is mitigated. This is not a new concept. King Solomon, who is considered one of the wisest men to ever walk the earth, preached this strategy 3,000 years ago. In Ecclesiastes he wrote, "Divide your portion into seven or even eight for you do not know what mistfortune may occur on earth."
This all makes sense in theory. But it is hard to implement and stick with a diversified strategy over time. Why? Because you will always have a number of asset classes in your portfolio that are underperforming. It will be tempting to "sell the losers". The last few years are a great example of this. A diversified portfolio has significantly underperformed the S&P 500. The simple fact is a diversified portfolio will ALWAYS underperform the best performing asset, since diversified nature of the portfolio will normalize the return somewhere between the best and worst asset class. Today it is even more difficult because the asset class you see all the time (CNBC, internet, etc) is the one that is doing the best, and therefore, the one all diversified investors are trailing.
Below is a chart of the best and worst performing asset classes from 2006-2009:
One thing to notice is the difference between the best and worst asset class each year. In most cases the delta is in excess of 50%. The other thing to notice is how there is no pattern to discern what is going to be the best, or worst, investment in a given year. As an investor, if we choose a diversified portfolio we have to give up the fantastic gains we could experience by putting all our money in the best asset class in order to avoid having all our investments in the worst one. For most of us, this is a worthwhile tradeoff. You just always need to remember that when you are properly diversified you'll always have something to complain about.
David Swenson, the chief investment officer of the Yale endowment fund, has gained notoriety over the past several decades for his management of the Yale endowment fund. In the early 1990s he decided to place a gigantic chunk of the endowment into alternative assets like real estate, hedge funds and private equity. The results were spectacular. From 2000 to 2012 Yale's endowment returned about 12% annually while US stocks averaged 2% during the same period. Not only have other institutions followed suit, but so have individual investors. Retail mutual funds investing in alternative strategies have exploded, aided in part by the success of endowment funds like Harvard and Yale. Instead of being some fringe investment strategy, alternatives have become mainstream, with over $300 billion in these products.
While Yale has focused on alternatives, Norway has gone the opposite direction. Here is an article from 2013 in the WSJ:
Does anything sound familiar here? Extremely broad diversification, focus on small and value companies, low cost. This approach is the one touted by Greenspring on behalf of its clients. In fact, the nearly $1 trillion Norway Pension Fund is invested almost identically to Greenspring clients. It is somewhat comforting to us to know that the largest institution in the world has adopted the same approach. I thought it would be interesting to go back and see how things have fared for both institutions since the financial crisis and ensuing recovering. From the period of June 30, 2007 to June 30, 2014 the Yale Endowment has averaged 5.71% per year. During that same period, the Norway fund has averaged 5.23%. A nearly identical return, but the Yale endowment has experienced 34% more volatility than the Norway Fund.
Before you take this data and assume that you can't hurt yourself by investing in alternatives, please remember that Yale has $24 billion in assets and an investment office of 28 professionals working on this fund. That gives them significant access and leverage in pricing. Two factors that will be working against you. In addition, there is a train of thought that Yale's outperformance will be difficult to continue. Because so many institutions have followed their lead, the opportunities available to them will not be as favorable due to other organizations competing for the same deals. Conversely, it is not that hard to invest like Norway. It can be done through mutual funds or ETFs and at a very reasonable cost. We believe Norway's approach, which is certainly less sexy than Yale's, will be the best alternative for investors in the future.
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.