When we review prospective client portfolios, it is almost guaranteed some portion of their money is invested in some sort of active management strategy. As you may know, active management is the strategy of attempting to beat a benchmark. This could be done through market timing (buying and selling at opportune times) or stock picking (buying winning stocks and selling ones that will underperform). The alternative strategy is often called passive management, though we like to call it "evidenced based" management. Essentially, you own the entire market and don't try to time when to buy or sell securities or pick one stock over another. The "evidence" suggests that this method of investing has a much higher probability of success.
As I was thinking about the idea of probabilities, I thought it might be fun to compare active management to another game that is all about probabilities…blackjack. First, let's look at the statistics on active management. Actual results* show us that 17% of stock mutual funds have beaten their benchmark over the last 15 years. Bond funds fared much worse, with only 7% beating their benchmark during the same period. If the goal of active management is to beat a benchmark, they are not doing a very good job.
So what about blackjack? The odds you will win one hand of blackjack (factoring out ties) is 46.36%. But we are measuring 15 years of whether an active manager can beat the benchmark. What is the chance you will win money at blackjack if you play 15 hands in a row? The answer: 17.5%.
Long story short- you have almost identical odds to walk away with more money after 15 hands of blackjack than you do trying to pick an active manager that will beat the market over 15 years. The odds are much worse trying to pick a bond fund that will beat the market. We all have heard that as long as you play for a long enough time, the house always wins. Maybe you should think about who the "House" is when you are investing and shift the odds more in your favor.
*The US Mutual Fund Landscape, 2016 Report
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:
- In 2004, a similar natural, double-strand pearl necklace sold at Christie’s for $3.1 million. This is a 1.1% annual return over time (much worse than inflation)
- The 5th Avenue mansion is listed in NYC tax assessments at $52 million (probably much less than what it is actually worth). This is represents a 4.2% return over this time period.
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.
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.
You may recognize the quote in the title from the movie Anchorman. If not, here is the clip to refresh your memory:
This can be a lot like stock pickers, pundits and TV personalities. Except the percentage of the time they are right are usually way under 60%. A man like Marc Faber fits it to this camp. For some reason he continues to get TV time with headlines like this one: Marc Faber: S&P is set to crash 50%, giving back 5 years of gains. At first blush, this sounds pretty scary. That's the main reason CNBC is publishing it. They know that fear sells and you are much more likely to watch a clip about a major market crash than something much more useful like diversification, cost management or tax minimization. Unfortunately, no one seems to fact check their contributors actual results (who really cares about the data anyways?). Here is a great chart showing Marc Faber's record over the last 7 years:
He seems to predict a market crash as often as a meteorologist predicts rain. Of course, at some point he'll be right. The only problem is that if you continue to follow his advice, you'll most likely be broke before this happens. This post is not meant to insult Marc Faber, but to illustrate the folly of predictions. This is just another example to run (not walk) away from anyone who is using prediction for the basis of advice. It may seem like making changes to your portfolio based on the prediction of what stock is going to do well, or whether the market is high or low makes sense, but nothing could be further from the truth. Base your investment strategy on evidence and logic and all of this stuff just becomes noise.
Wouldn’t it be great if investors could navigate the markets like we navigate through traffic- -guided by red, yellow, and green lights? If we had signals that told us with certainty what direction the economy was headed, then we might have an edge in our investment strategy; we would know when it was a good time to invest, when to proceed with caution, or when to put the brakes on.
Unfortunately, the reality is that the market is murky and unpredictable. As the economist Paul Samuelson once put it: “The stock market has called nine of the last five recessions.” The market marches to its own drummer, or rather to many drummers, as it processes information from millions of investors about whether they want to buy or sell a stock.
Earlier this year when US Equities were down 10% many thought this was the first sign of impending doom for the economy. Well, we all know what happened. By the end of the quarter, the market had recovered from losses and entered positive territory. Although the economy is not without some areas of concern, it turns out wages are rising, corporate profits continue to be healthy, and inflation remains tame.
But if anything could shed light on the future of the economy, wouldn’t the stock market be the most logical place to look? Shouldn’t we be able to check a benchmark index like the S&P 500, which has come to define the US stock market, and gain some helpful insights? No, says Julieta Jung , PhD in Economics, who does research to inform policy makers and aid discussion at the Dallas District of the Federal Reserve.
Ms. Jung points out in a recent Economic Letter to the Federal Reserve Bank of Dallas that Indexes such as the S&P 500 are flawed mirrors of the economy and therefore fail to predict GDP. She notes that half of the components in the S&P 500 are manufacturers but when you look at US GDP, service providers account for more than ¾ of GDP output. Also, the stock market and the economy react very differently to shocks. The market can turn on a dime when unanticipated news or events occur until investors digest what has happened. In contrast, households and businesses adjust to the same news much more slowly.
So what is an investor to do if she is uncertain about the direction of the economy and not sure if it is a good time to invest? First, understand that the stock market is not the economy and there is no reliable signal that can tell you it is a good, bad, or indifferent time to invest. Second, understand that your portfolio needs to be designed to match your tolerance for risk so you can stay invested through the inevitable ups and downs. Third, and most important, do what we constantly tell our clients to do- -focus on things you can control. We can’t control what the market will do but we can exert some control over certain things such as costs, taxes, investment discipline, and portfolio allocation. Our advice: Focus on these areas that will have a meaningful impact rather than on trying to decipher market gyrations.
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.