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.
I literally cringed when I read this article on Bloomberg. I am not sure why our DNA hasn't adapted to fight against the greed that seems to totally blind us to the fact that when something is too good to be true, it is. The article tells the story of a hedge fund in Atlanta that has generated returns of 13, 24 and 91% since 2013. That's not all, as you read further you find this:
Meyer is so confident in his approach that he offers an extraordinary guarantee: With Arjun, you will never lose money. His price of admission is steep, however. Investors must hand over their cash for a decade. If they exit early, Meyer keeps half the principal.
If that isn't enough to make investors run, here are some more pieces of data:
- He has no employees
- A computer comes us with the trades, since he can't "manually do something like that"
- He's been through 3 auditing firms
- There are irregularities surrounding how much money they manage (anywhere from $39 million to $338 million)
- No one seems to be able to explain how he earns these returns
- He doesn't send audited financial statements to his investors
- He invests in treasury bonds, which are yielding almost nothing today
- Oh, last one…he's under investigation
But still, you have some of his investors making comments like this:
David Recknagel, a sales executive in Detroit, met Meyer when the money manager was doing consulting work. Recknagel says he invested in Arjun after losing confidence in big banks and money-management companies. He concedes he’s not sure how Meyer does what he does. “I understand it in general, but I probably don’t understand it completely,” Recknagel says.
One more quote from another investor:
Jeff Roberts, who runs a real-estate appraisal company in Asheville, North Carolina, says he met Meyer in 1989, while the two were at First Union. They became friends after Meyer, wearing jeans and a T-shirt, turned up one day in a Ford pickup to give Roberts a lift. A 12-pack of Budweiser rested on the front seat. Roberts says he’s invested several hundred thousand dollars and Meyer has been great.
“How many hedge-fund managers can you get to call you back? The guy that’s actually the investment officer or, you know, chairing the fund? It just doesn’t happen," Roberts says.
Roberts and Recknagel say they’ve also enjoyed a Statim perk: Meyer extends inexpensive short-term loans against their investments. Recknagel says he’s used the money to invest even more with Meyer. He says he also has a Statim corporate American Express card.
I truly hope that my instincts aren't validated, but I would venture to guess that this article could be the beginning of the end for this hedge fund. While it seems like common sense, here are some tips to make sure your investment advisor isn't running a scam:
- Make sure you fully understand the investment strategy your advisor is using with your money
- Check out your advisor on the SEC and FINRA websites- you can check to see if they have any disciplinary history
- If it sounds to good to be true, it is. There is no free lunch when it comes to investing.
- Make sure a third party custodian holds your money if you are working with an independent advisor. Using a Fidelity, Schwab or TD Ameritrade can prevent the outright fraud that can happen when an advisor commingles his client's assets
If it walks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck. For the investors in this hedge fund, I think they are going to find out the hard way.
The Presidential race is heating up and both sides are preparing for battle. Republicans and Democrats alike will tell you that if they don't win, the country will be in for a horrific four year stretch. The county's populace seems to be just as divided with politics as polarizing as ever. While conventions, stump speeches, and political scandals may be great for the news media, a recent study has come out confirming our long-held view: politics have no place in portfolios. Researchers studied the returns of hedge fund managers that supported Republican candidates after Obama was elected. The results weren't pretty:
Upon closer inspection using monthly regressions, we find that the Democratic managers outperformed the Republican managers from December 2008 to September 2009 by approximately 7 percentage points annualized return, which conversely is a high price paid by Republican managers and their clients to maintain a consistency of beliefs.
You may think if a certain candidate gets elected this country is going down the tubes. Hopefully, you continue reading this article, step back from the brink, and don't make any changes to your portfolio. None of this is meant to say that Republicans or Democrats are better for the economy (or as managers). What we are saying is that who is in office has very little impact on stock market returns. Studies have found this to be case, but investors still seem to entangle their political beliefs with their portfolio. One of the reasons given in the paper for the underperformance of the Republican hedge fund managers was the idea of cognitive dissonance. The Cognitive Dissonance Theory states that individuals tend to seek consistency among their beliefs and opinions (ask yourself what type of news you watch or articles your read). When inconsistencies between facts and attitudes don't match, our unconscious works to either change our beliefs or silence the facts.
When it comes to investing, it is best to ignore politics. In almost all cases, they have very little impact on financial markets.
Have you ever felt intimidated by the markets? Thought that investing was only for really smart people? Maybe you hear jargon like “beta”, “derivatives”, or “standard deviation” and it just goes over your head? Contrary to what you may think, you can be the smartest person in the world and still be a terrible investor.
If I told you history’s most famous physicist failed miserably at investing would you think differently? Sir Isaac Newton, the man who conceptualized three laws of motion, pioneered calculus, and discovered the color spectrum among other accomplishments, was a terrible investor.
Setting—England, early 1700s. The South Seas Company is formed in anticipation of having a monopoly on trade to the Spanish colonies in South America after the War of Spanish Succession (1701-1714). The outcome of the War did not bode favorably for the company. Even though the company had completed no voyages to the new world after 5 years, its leadership turned to advertising false claims of success and wild (but false) tales of the company’s adventures.
It was during this time that Sir Isaac Newton invested in the company, watched the stock rise, and sold making a handsome profit. Filled with greed and regret that he gotten out too early as he watched his friends make more money, he jumps back in, this time with an even bigger bet. Shortly after, the bubble bursts and the sell-off begins. Newton loses the majority of his fortune and supposedly forbids anyone to utter the words “South Seas” in his presence ever again.
You might say, that’s interesting, but that was also 300 years ago. Things are different today and with the information and technology available to us now, this amusing tale of Sir Isaac Newton is no longer relevant. A lot of things about our world has changed since the days of Newton but human nature has not.
Fast forward to the year 2000. Take the people with IQ’s in the top 2% of the population and see how they do at investing. Eleanor Laise did exactly that when she looked at the investment performance of the Mensa Investment Club between 1986 and 2001. She found that Mensa had a 2.5% average annual return. Compare that to the S&P 500 which had a 15.3% return during the same period. Not much has changed after all- smart people can STILL be terrible investors.
We may have put a man on the moon, cured polio, and created the internet in the past 300 years but we are still not immune to being really bad investors. If smart people can fail at investing what does that mean for the average person? It means that you don’t have to have a top IQ or have invented the telescope (Newton pretty much did that too). It just means that you 1) need to invest for the long-term and not be swayed by the latest buzz and 2) you need to be disciplined to ride out the inevitable ups and downs of the markets.
We have written before about the recency bias, and it appears this phenomenon may be reappearing. A report by the CFA institute shows that 33% of retail investors and 29% of institutional investors are forecasting another full-blown financial crisis in the next three years. Now, I am not exactly sure what a "full-blown financial crisis" means but lets take a look at history since 1928 when the S&P 500 has lost 40% or more (peak-to-trough), which I think most of us would define as a crisis:
- 1929-1930: -44.7%
- 1930-1932: -83.0%
- 1932-1933: -40.6%
- 1937-1938: -54.5%
- 1973-1974: -48.2%
- 2000-2002: -49.1%
- 2007-2009: -56.8%
So, in the 88 years we can measure, we have 7 occurrences of the stock market crashing more than 40%. By the way, 4 of them happened during the Great Depression which saw many fits and starts, so the crashes were interspersed with gigantic rallies as well. Since the Great Depression, we only have 3 market crashes of 40% or more, and two of them happened in the same decade. Is it surprising that 1/3 of investors are forecasting a crash? It seems like it should happen every few years. That's how the recency bias works…we extrapolate recent events and assume they will continue into the future.
The reality is that stock market crashes tend to happen when people aren't predicting them. How many people were forecasting the stock market to fall in 1999. Who was calling for real estate prices to collapse in 2006? Stock markets crashes start when sentiment is high and the future is bright. Fast forward to today and investors are anything but optimistic. We are not predicting the future. We may see massive declines in the market over the next few years, but if 1/3 of investors are already expecting this, you have to ask yourself one important question: is the bad news everyone seems to be expecting already priced in?
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.