Open options

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It’s 2019. The industrial revolution began over 200 years ago. Political democracy was ratified almost 250 years ago. Capitalism began its ascent somewhere around 500 years ago. In 2019 the world is a much different place and changing at a much more rapid pace than ever before. The rise of technology, the commitment to political freedom, and the resilience of free markets have resulted in remarkable life improvements. We have more free time, we understand the concept of a vacation, we even live longer. But maybe the most impressive change in the last 500 years is the incredible increase in the number of options we have. We’ve got multiples of ketchup options at the grocery store, we’ve got multiples of grocery store options within driving distance, we’ve got endless options for entertainment built right into our TVs, we’ve got so many bars and restaurant options we can’t keep track of where we’ve been and where we’d still like to visit (just me?), we’ve got innumerable product options staring at us from our phone screens, we’ve got travel options, vacation options, gym options, school options, cell phone options, clothes options, housing options, the list goes on. The sheer volume of options seems a little crazy when you think about it, but we love all our options. Options are great, they’re an essential part of freedom, they give us the ability to direct our lives to a degree. For most of history people didn’t have many options. As far as work went, the option was to essentially do what your parents did (which was probably farm). Now we’ve got thousands of career options, and that’s a wonderful thing.
The flipside of all these options is the requirement to make lots of choices. Options are great, choices are work. They’re work because you have to sift through all of the options, but more so because you eventually have to make a decision. The word ‘decision’ comes from the Latin root ‘decidere’ which literally means ‘to cut off from.’ Making a decision involves choosing one option instead of a bunch of other options, it means cutting off the other options, it means giving up the other options. So that’s a problem, what if we really liked having all those options? Options equal freedom!
The real problem with our abundance of options is that it gives us the illusion of freedom but it’s often crippling. We begin to idolize our options to the exclusion of making decisions, to the exclusion of making progress. We become content to maintain the beautiful platter of options without ever making a commitment to any. I suspect that this is especially true in our work. I love to vacillate on different strategies for my business, different side-hustles I could start, different events I could host. I love to ‘keep my options open’ so to speak. But in the end, that’s just wasted time. You could spend your entire life keeping your options open and never accomplish anything. The fear is that once you commit something you’ve got to be all in and you’ve got to say ‘no’ to the other options, but the alternative is to live a life of waffling waste filled with eternally open options. That’s definitely worse. So make a decision!

Are you track-record investing?

Track record investing is the third and last detrimental investment trap I’ll discuss here. Like stock picking and market timing track record investing is as it sounds, using track records or past history to determine whether or not a money manager or specific fund is a good investment.

Track record investing is tricky because we evaluate track records all the time, they’re a normal part of our lives. I use Apple computers instead of windows computer for a few reasons, not least among them is the track record of Apple devices to outlast their windows counterparts. I buy specific products on Amazon only after reading far too many reviews to determine the track record of said product. Track records are not bad, they’re actually super helpful. But, when it comes to investing, it’s dangerous to rely on the same mechanism we use to evaluate Amazon products to decide whether or not a money manager or mutual fund is a good investment. Here are a few reasons why:

The number one disclaimer in the world of investing is “past performance is not indicative of future results.” Why is that phrase posted everywhere? Well, first, because it’s the law. But more importantly, it’s because we so badly want to use track records to determine which mutual funds to invest in, and it doesn’t work. Like we learned about stock picking, people can’t consistently predict the market. If a mutual fund manager does well one year it does not indicate that the manager has figured something out, it means he or she got lucky. People can make guesses about the future, and they do, but no one knows the future, and the market will move based on things that will happen in the future.

A fun example of this past performance issue is Morningstar’s famous five star rating system. Morningstar has long rated funds year after year with one to five star ratings, and it’s a big deal to earn the coveted five stars. However, since 2010 Morningstar has stated that the cost of a fund is a better predictor of its future success than Morningstar’s star rating, essentially admitting that the rating system is useless for evaluating future performance. Track records cannot help when it comes to choosing specific investments.

Another issue with this past performance stuff has to do with the data consumers actually see. Investment companies are notorious for practicing something called selection bias. Selection bias means that if a mutual fund does really poorly, the investment company will kill it and expunge its data from their records so that it has no effect on the overall statistics consumers see. Unfortunately those dead mutual funds often have a drastic effect on returns for real people. The worst 200 funds that were killed between 1923 and 2016 averaged a cumulative return total of -81%. Not only does past performance have nothing to do with future results, but the data consumers see only muddies the water.

So should we shun all data when it comes to investing? Definitely not. It’s important to make a distinction between past performance data, which relates to specific funds or managers or even whole firms, and long term market data, which teaches us about how investing works and where returns come from. I use historical market data all the time, not as if those are returns my firm has achieved since the 1920’s, but to help people understand what to expect from the market, and to show them why diversification is so important. So just remember, past performance really isn’t indicative of future results. Look for an advisor who understands the academics of investing, not one who shovels you past performance data.

Pay attention to asset classes, not returns

When people think about deciding between investment advisors, or mutual funds, or even stocks, the temptation is to look at past performance. That’s the default. And it seems basic, you’re looking for returns, what else would you look at? What else could you even look at?

The problem is the past performance we see is short term. You’ll see three to five year histories on your account statements, Morningstar defaults at a ten year history (if the fund has been around that long), and the news rarely talks about anything further back than the last year. Those are relatively short periods of time, especially when we’re talking about market returns. Instead of comparing past performance in advisors and mutual funds over the past ten years, we should be looking at long-term historical returns of asset classes.

An asset class is a group of similar securities that tend to move together. The main general asset classes are equities (stocks), fixed income (bonds), and cash. Each of these, but especially the equities group, can be broken down further. In equities, we see large vs small, value vs growth, U.S. vs international. For an example, a very popular asset class is U.S. Large Growth, which is basically the S&P 500. We have returns data on these asset classes all the way back to the early 20th century. That information can tell us much more than the past ten years. We can see which asset classes tend to outperform others, we can see how the different asset classes correlate to each other, and we can know what returns and risk a fund or portfolio can expect over long periods of time. A ten-year history of returns is almost irrelevant. Over ten years any asset class could outperform any other, but we don’t know when or which. So to look backward at the performance of a fund is not only unhelpful, it’s more often hurtful. A good ten-year history on a fund, or even an asset class, deceives us into thinking the performance will continue in the future. The short-term history the only information we know to use, and besides that, it seems to make sense. But that’s the opposite of a good investing strategy. Instead, let’s analyze the asset class data going back as far as it goes, understand where returns come from, and diversify our portfolio’s in a way that’s consistent with the data. Then we let the market perform and deliver results. Our balanced diversified portfolio won’t always be the big winner year by year, but over the long haul, it will outperform anyone trying to predict market movements based on ten-year histories, or any other material information.