The problem for average investors is that when they aim for superior results, it more often than not leads to below-average performance. It's amazing how easy it is to do worse by trying to do better. The single greatest challenge you face as an investor is handling the truth about yourself. This is why it's an unrealistic goal for the average investor to try to become the greatest investor in the world. A far more worthy goal is being better than average, which is totally realistic and achievable. Better than average can lead to impressive results in terms of investment performance over long enough time horizons. It's all about harnessing the power of thinking long-term, cutting down on unforced errors, and having the patience to allow compound interest to work in your favor.
The question is: How does one go about this?
Here is some standard investment advice that is both simple and effective:
1. Think and act for the long term.
2. Ignore the noise.
3. Buy low, sell high.
4. Keep your emotions in check.
5. Don't put all of your eggs in one basket.
6. Stay the course.
These are all great pieces of advice. The question is how. How do I know what long term even means for me? How do I buy low and sell high? How do I keep my emotions out of the equation? How do I diversify my portfolio correctly? How do I stay the course and reduce the noise that finds its way into my portfolio? These are the questions I seek to answer throughout this book. What to do is not nearly as important as how to do it.
The biggest problem for most people is that good investment advice will always sound the best and make the most sense when looking back at the past or planning ahead for the future. It will rarely sound so great in the moment when you actually have to use it. As you will see throughout, this is both extremely simple, but maddeningly difficult at the same time. As Warren Buffett once said, “Intelligent investing is not complex, though that is far from saying it is easy.”
This line sums up the point of this book very well.
CHAPTER 1
The Individual Investor versus the Institutional Investor
When “dumb” money acknowledges its limitations, it ceases to be dumb.
I was fresh out of college and in the early days of my career in the money management industry, but I could tell this talk was a big deal. It was one of my first big industry conferences and it was standing room only. The room was packed with professional investors, portfolio managers, and consultants, all eagerly awaiting the message to be delivered by a well-known billionaire hedge fund manager. There was a buzz in the air. At every investment conference there is always one speech that every attendee circles on their agenda. This was that speech.
After taking the podium and making the customary break-the-ice joke, the headline speaker got right into his speech. It covered a wide variety of topics on the markets and the investment industry in general. It was very data driven, but interesting and even funny at times. You could tell that he had plenty of practice over the years speaking to large crowds such as this one. There were no note cards or PowerPoint slides. It was like you were having a one-on-one conversation with a business associate. Everyone around me was frantically scribbling away in their notebooks so they could look back on his words of wisdom in the future. Once the bulk of the current market outlook was through he decided to spend some time going over the big changes he foresaw in the investment management industry in the coming years.
He made the claim that many of the best, academically tested, evidence-based investment strategies from the past – once only reserved for the wealthy elite at a very high cost – would soon become available to all investors through low-cost exchange-traded funds (ETFs) and mutual funds that could be instituted on a systematic, quantitative basis. At the time ETFs were still a relatively new product, so this was somewhat of a bold call that not many were making at the time. He was predicting a sea change in the industry.
In way of background on ETFs, the industry has experienced explosive growth in assets under management in the past decade and a half. ETFs in all financial asset classes carried only $70 billion in assets in the year 2000. By the end of 2014, that number was closer to $2 trillion, an unbelievable growth trajectory.10 For the uninitiated, an ETF is very much like a mutual fund in that it allows you to hold a number of different securities under a single fund structure. This allows investors to buy a diversified pool of securities so you don't have to buy them each individually. The biggest difference is that ETFs trade on the stock exchanges throughout the day, just like individual stocks, whereas mutual funds transactions only happen at the market close. ETFs are also structured in a way that that makes them very tax and cost efficient, so they're cheaper, on average, than mutual funds. ETFs have better transparency of their holdings than mutual funds, as you can view ETF holdings on a daily basis. They aren't nearly as affected by forced buying and selling as mutual funds can be.11 ETFs are allowing enterprising fund companies to slice and dice risk factors, sectors, regions, and asset classes in a number of interesting ways. This should only continue in the future, as these strategies will become more and more specialized. ETFs are worth paying attention to as they will only carve out an ever-larger market share of investor dollars over time.
Back to the investment conference: I found myself nodding in agreement with this fund manager as he surgically laid out the reasoning behind the potential shift to make better investment strategies available at a lower cost to more and more investors – increased competition, availability of information, a dearth of academic studies on back-tested strategies, and the fact that most professional portfolio managers came from similar schools of thought. This was making it harder and harder for portfolio managers to justify their claims of superior investment processes at a much higher cost to the individual investor. The line of thinking was that these newer products wouldn't offer the possibility for enormous outsized gains, but at a reduced cost to the investor, would give similar returns on a net basis after costs, the only thing that really matters in the end.
When the speech was over, there was a Q&A session that gave the professional investors in the room a chance to follow up with this hedge fund manager about his speech. Participants quickly hurried to the microphones to ask this famous investor a question. The first audience member, looking a little flustered, didn't waste any time as he asked, “How are we ever supposed to sell these lower cost funds to our clients? Won't this be an admission that we're buying sub-par funds?” As I looked around the room I noticed nearly every other investor nodding their head in agreement. One by one they all took their turn asking similar questions.
“How can we justify the use of inferior funds?”
“Don't you understand that you get what you pay for?”
“How do we prove our value-add when selecting these types of funds?”
“How could we ever sell the fact that we're not buying the best of breed funds at the highest cost? We might as well admit we don't know what we're doing!”
At first, this reaction by my fellow, more experienced investors, made absolutely no sense to me. Why wouldn't they be thrilled about the fact that certain strategies would now be much more accessible at a lower cost in a more shareholder-friendly investment vehicle? Wasn't the investment industry becoming flatter and more cost-effective a good thing for advisors, consultants, and investors alike?
Then I started to realize my naiveté. I was still a rookie in the field of finance. Not everything works in black and white when it comes to products and investment choices in the financial services industry. All of the pros in the room were thinking about the same thing – signaling. If they were using inferior products at a lower cost, they would be signaling to their clients