The Greatest Hits of Investing
Just like the Beatles greatest hits, the fundamentals of investing stand the test of time and remain relevant long after they were initially composed. MPM Wealth Advisors values simplicity, so if the investing world today makes you want to yell “Help!”, take a minute to “Get Back” to the basics by reading our summary of “The Greatest Hits of Investing” written by Brad Steiman, head of Canadian Financial Advisor Services and Vice President Financial Advisor Services at Dimensional Canada.
This article arranges the “Greatest Hits” in a story telling sequence, where one connects to the next, rather than in order of importance or priority. Click the link at the bottom of the summary to download the entire article.
- Conventional Thinking. Investors often look to financial advisors for the next hot stock tip or advice as to where the market is going and when is the best time to invest. All of these types of question share something in common – they seek a forecast. Therefore, conventional thinking seems to be that, in order to have a successful investment experience, you must be able to predict the future.
- Market Forces. There is a completely different approach that originated and evolved in the halls of academia. It is based on a mountain of evidence showing that free markets work, because the price system is a powerful mechanism for communicating information. Simply put, prices are fair. Competition among profit-seeking investors causes prices to change very quickly in response to new information, and neither the buyer nor the seller of a publicly traded security has a systematic advantage. Therefore, the current price is our best estimate of fair value. To learn more about this topic, see our January 24, 2014 video post titled “The Power of Markets”.
- Just My Opinion. Despite the strength of market forces, many investors may never lose the urge to form an opinion about the future, or to ask their financial advisor for one. If the compulsion to act on an opinion is too difficult, ask yourself “am I the only one with the information upon which my opinion is based?” If the answer is no, and the information is widely known, then why wouldn’t it already be reflected in prices?
- Simple Arithmetic. There is evidence supporting this logic. If free markets fail, it would be easy for an investor to systematically beat the market, but in reality, man versus the market isn’t a fair fight and most of us should accept market forces rather than resist them. There is a large literature devoted to analyzing the results of professional money managers dating back over four decades. The experiments have been repeated many times with better models applied to larger and more reliable data, but the results continue to confirm the original conclusions – some managers are able to beat the market on a risk-adjusted basis, but no more than you would expect by chance.
- A Dry Lake. This arithmetic leads many investors to think a winning investment strategy attempts to identify above-average managers and avoid all the others. Identifying managers who have outperformed in the past is just as easy as looking up the scores from last night’s sporting events, but there is very little persistence in the performance of managers and no documented way of determining who will outperform in the future. That’s why most regulators require sales communications to contain the disclaimer that PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. There are, undoubtedly, many smart money managers who work hard to get the best results they can for their client, but the market is hard to beat because there are so many smart managers – and not in spite of it. If you take the world’s greatest bass fisherman to a dry lake, he won’t catch any fish.
- Everyone Can Win. It is not necessary for someone to have a lousy investment experience for you to have a successful one. Everyone can win because with capitalism there is always a positive expected return on capital. That doesn’t mean it’s guaranteed to be positive, but only that it is always expected to be positive. Realized returns are uncertain, because the market can only price what is knowable. The unknowable is, by definition, new information. If it is considered bad news, or if risk aversion increases and investors require higher expected returns, then prices will drop. This is the market mechanism working to bring prices to equilibrium where, based on new information, the expected return on capital remains positive and commensurate with the level or risk aversion in the market.
- Effective Diversification. Not all risk generates higher expected returns. Markets only compensate investors for risks that are “systematic” and cannot be eliminated. For example, a car salesperson won’t offer you a lower price on a new car if you agree to ride without a seatbelt. It is a risk that can easily be avoided by buckling up! Similarly, investors shouldn’t expect an additional reward for concentrating a portfolio in a few securities, diversifying by broker, or divvying up assets among money managers in an uncoordinated way that does not eliminate risks they shouldn’t expect compensation for bearing. Effective diversification, on the other hand, means allocating capital across multiple asset classes around the globe to suit the investor’s unique circumstances, financial goals and risk preferences.
- More than a Map. Travelling the road to a successful investment experience requires more than just a map. Building a portfolio that puts all these ideas to work is one thing, but staying on route is something else altogether. Keeping your hands on the wheel and your eyes on the final destination requires the emotional discipline to execute faithfully in the face of conflicting messages from the media and the investment industry. Tuning out the noise is even harder when it is amplified by an investment industry thriving on complexity and confusion.
- Behaving Badly. Investors ought to periodically review their plan and stick to it if the approach is still the right one. But adhering to a prudent investment strategy often becomes elusive in a world of continually streaming news and complex investment products. These forces can overwhelm human emotion and lead many investors astray. For more information on this topic, see our January 14, 2014 post titled “Investment Resolutions”.
- Simple but Not Easy. A prudent investment approach following these fundamentals is like a steady diet of healthy food – simple, effective, boring and difficult to maintain. It is well documented that good food, exercise and sufficient sleep will improve the odds of being healthier. It is also well documented that accepting that markets work, avoiding stock picking and market timing, effectively diversifying your portfolio and paying attention to costs will improve the odds of being wealthier. It sounds simple, but it isn’t easy.