There are only two ways to invest (part 3)


carolina-pimenta-J8oncaYH6ag-unsplashSo there are two basic strategies to invest, and your first decision as an investor is to decide which road to take. In part 2 we talked about the active option, in part 3 we’ll cover the alternative option: passive investing.

Whereas active investing feels right, passive investing is a little counter-intuitive. You actually don’t have to do anything to be a successful passive investor. You should probably have an understanding of how the market works and have a conviction about why you’re investing the way you are, but as far as activity goes you’re taking it real easy.

One of my favorite analogies for passive investing is salmon fishing. Salmon fishing is not sport fishing, it’s almost like harvesting, like work. The importance is not in casting and reeling (a staple of sport fishing), the importance is in how well you’re set up. You need to have varying types of bait at varying depth of water, you might try variations in boat speed, variations in direction, variations in water depth, etc. The important thing is to be equipped to catch a fish at any moment by diversifying your offering as much as possible. Once you’re all rigged up, you sit back and let the market do its work.

The basic question here is about whether or not you’re confident in the fact that the market is efficient. If you believe the market is efficient (which data supports) any attempt to outperform the market by actively picking stocks or timing the market is vain. Instead of spending time on all different types of analysis and market trends, the focus can be on how to design the most efficient portfolio possible, how to diversify in the best possible way. Instead of trying to bet and predict the market, you simply need to own the market as efficiently as possible. It’s an entirely different game.

Passive investing is a wonderful thing, it reduces a great deal of stress. A poor year of returns is simply a result of the market, it’s not the result of some poor guesses by you or anyone else. A recession is no longer terrifying because you’re well-diversified and you understand that the market always bounces back, that the average market downturn lasts less than a year. Your retirement is no longer a question of ‘if,’ but of ‘when.’ A passive investor is free from analyzing endless piles of company data, the uneasiness about the market sectors they’re invested in. Passive investors don’t have to worry about how the riots in Hong Kong, or Bolivia, or Lebanon, or Iraq will affect their portfolio. It’s an entirely different way of being.

So the first decision you’ve got to make as an investor is whether you’ll be active or passive. That’s certainly not the last question you’ll have to answer, but it’s a very important one and one that set the direction of your investing journey and your financial future.

Value Investor (part 1)


Value investing sounds really cool. It sounds savvy, it sounds smart, it sounds responsible, it sounds like it makes a lot of money. I mean, Warren Buffet is a value investor!

So what is a value investor? Well, a value investor is someone who invests in value companies. So what’s a value company? I’m glad you asked. Essentially, a value company is one whose stock price is about the same (could be a little higher or lower) than its intrinsic, or book, value. A lot of words there but stick with me. The intrinsic value of a company is what you get when you add up all the company’s assets, its land, warehouses, products (which can include patents), equipment, cash, etc. It might seem a little odd that a company’s stock price wouldn’t always be close to its intrinsic value, but the stock market prices of growth companies (the opposite of value companies) can actually trade multiples of 8 times higher than its intrinsic value. This happens because the market expects the growth company to continue growing. Value companies aren’t typically expected to grow much, they’re often characterized as distressed. So value investors are analyzing these value companies and deciding which ones they think are actually undervalued and which ones could bounce back. Again, it sounds great, they’re the brilliant nerdy guys reading all of the fine print and finding the deals in the stock market, the companies that are underpriced. All you have to do is hitch up to their wagon and ride those value companies up when everyone else figures out how valuable they actually are. Sounds pretty responsible, right?

A semi-famous value investor, Michael Burry, featured in the Big Short (as Christian Bale) crushed the growth stock market from 2001-2005. In the middle of 2005, he was up 242% when the U.S. large growth market (S&P500) was down 6.84%. Michael Burry is the quintessential weird genius that we love to fall in love with, and hand our money over to. He did things differently, he didn’t take normal massive fees, he was incredibly awkward with people in person, he kept to himself, he obsessively studied the interworkings of the companies he invested in, just about everything you would expect from the next market genius. He’s most famous for predicting, and attempting to short, the housing crash in 2007. And now’s he’s rich, and semi-famous, and still investing. He recently stated that passive investing is a bubble, that he’s concentrated on water (you get it), that GameStop is undervalued, and that Asia is where it’s at. While these investment tips might accord with the laws of value investing, they hardly seem prudent.

Michael Burry is definitely smarter than I am, but here’s what I know:

1) Ken French, a professor of finance at the Tuck School of Business, Dartmouth College, who has spent much of his adult life researching and publishing in the sphere of economics and investing, conducted a study of mutual-fund managers (Luck versus Skill in the Cross-Section of Mutual Fund Returns) and found that only the top 2% to 3% had enough skill to even cover their own costs. Eugene Fama, another father of economic and investing academia, who co-wrote the paper with Ken French, summarizes their findings this way: “Looking at funds over their entire lifetimes, only 3% demonstrate skill after accounting for their fees, and that’s what you would expect purely based on chance.” Of the managers who do exhibit enough skill to cover their own costs, it’s hard to determine whether an actual skill is at work or it’s simply a facet of luck; most free-market scholars lean towards luck.

2) Fama continues: “Even the active funds that have generated extraordinary returns are unlikely to do better than a low-cost passive fund in the future.” Some managers do well enough to cover their own costs and beat the market in a given year. Unfortunately, their success languishes quickly and they regress to the same plane that active managers on the whole occupy, which is underperforming the market.

So is Michael Burry, or any value investor, the weird, brilliant savant that we desperately want to attach our life-savings to, or is he one of the 3% of managers who have done well enough to cover their own fees, but who the data says is more likely to regress to market underperformance mean than to do it again? I know which side I’m playing.

Are you market timing?

Market timing is the practice of moving money in and out of the market, or in and out of specific sectors of the market, based on a belief that the market, or specific sectors of the market, will do well (in which case you’d be in) or poorly (in which case you’d pull out) in the future. If you’ve read about stock picking, market timing might sound familiar. Market timing is similar because it’s also built on a false premise that the market is inefficient, but it’s also a little bit different. Market timing is more subtle than stock picking. Instead of a belief that you can buy underpriced stocks and sell overpriced stocks, market timing is a larger bet on the future of entire market sectors. It gives the allusion that you can simultaneously be well-diversified and engage in market timing since you might always own a few different asset classes. It’s sort of like stock picking in disguise (it’s often called ‘tactical asset allocation’ which sounds super smart) because it’s essentially picking market sectors (asset classes) instead of stocks. Market timing can seem more legitimate than stock picking, but it’s still essentially gambling.

Market timing is unfortunately just as pervasive in the investing world as stock picking. It is often incited by panic, people move their money around or out when the market seems especially scary and move it back again (or not) when the market feels more safe. The timing tends to be exactly opposite of what should be done, people end up selling low and buying high and sacrificing millions of dollars in returns. But damage is done apart from panic too. Dalbar (an investor research company) reports that the average equity (stock) fund investor stays invested in their funds for only 4 years before jumping to a different set of funds, perhaps unintentionally market timing. Money managers routinely shift strategies within popular mutual funds (referred to style drift), shifting focus between market sectors. Pundits constantly discuss market trends which include market timing suggestions. Similar to stock picking, we’re so immune to market timing that it just sounds like normal investing at this point. That’s bad, here are a few reasons why:

1) People are bad at market timing. A study by William Sharpe conducted in 1975 (Likely Gains from Market Timing) concluded that in order for a market timer to beat a passive fund they would have to guess right about 74% of the time. An update to the study by SEI Corporation in 1992 concluded that the market timer would have to guess right at least 69% of the time, and sometimes as high as 91% of the time in order to beat a similarly invested passive fund. So the important question is: does anyone guess right with that frequency? Maybe you’ve made your own guess by this point, the answer is a resounding no. CXO Advisory did a fascinating study on the success ratios of market timers between 2005 and 2012. They looked at 68 ‘experts’ who made a total of 6,582 predictions during that period. The average accuracy of all predictions? 46.9%, well short of the minimum 69% threshold. These predictions sell news subscriptions and online adds, but they’re detrimental to investor returns.

2) Market timers miss out on returns. Trends are a big topic in the world of investing. Market timers analyze previous trends, they track current trends, and they look for the next trend, it’s incessant. Nejat Seyhun in a 1994 study entitled “Stock Market Extremes and Portfolio Performance” analyzed the period between 1963 and 1993 (a total of 7,802 trading days) and found that only 90 of the days were responsible for 95% of the positive returns. That’s about 3 days per year on average where 95% of returns came from. In all the misguided ‘trends’ talk and the popular practice of moving money in and out and all around, market timers routinely miss the most rewarding days in the market. Instead of focusing on market trends, investors would do much better to focus on the whole market and ride the general stint of the market upwards.

3) Market timers misunderstand the market. The most culpable cause of market timing is panic. People do crazy things when they’re scared and their money is on the line. Don’t get me wrong, the stock market can seem pretty scary, and it definitely involves money, but just because it seems scary doesn’t mean you should be scared. The average market crash of 10% or more lasts just under 8 months, 4 months until it hits the bottom, and just under 4 months to return to the pre-crash high. That’s not so scary. Over the last 93 years (going back as far as we have super-reliable data) 68 years were positive by an average of 21%, 25 years were negative by an average of 13%. Also not so scary. There are 45 countries in the world with free markets and the ability to buy and sell stocks and over 17,000 companies to invest in. What would it take for a well diversified portfolio to lose everything? Only some type of global apocalyptical event, at which point you probably wouldn’t be concerned with the amount of money in your portfolio. That is scary but not because of the market, it’s actually pretty reassuring as far as your portfolio is concerned. Instead of panicking, investors would do much better to rebalance during turbulent markets and capture returns on the way back up.

So market timing is a losing game. It can’t provide any consistent value to a portfolio, it actually causes a drag on returns, and it’s often driven by an inaccurate understanding of the market. Unfortunately it’s prevalent, and many portfolios engage in market timing while investors remain unaware. So take a look, have an advisor do an analysis for you. It pays to understand how you’re invested and to avoid market timing in your portfolio.