Investing Demystified
Page 1
Contents
Acknowledgements
About the author
Foreword
part 1 Introduction
1 Introduction to markets and portfolios
Where do we hope to end up?
2 What is an edge over the markets and do you have it?
The competition
You just have to pick your moment
The costs add up
Should we give our money to Susan and Ability?
You need to pick the best mutual fund out of 10 for it to make sense!
Outside stock markets
Being rational
3 What are the key components of the rational portfolio?
Asset split in a rational investment portfolio
Understand the level of risk you are comfortable with
Don’t put all your non-investment eggs in one basket
Reducing tax has a large impact on long-term returns
Paying too much in fees destroys asset growth
Implementation
Speculate less, sleep better!
part 2 The rational portfolio
4 The minimal risk asset – safe, low-risk returns
Buy government bonds in your base currency if credit quality is high
Perhaps diversify even the potentially very low risk that your domestic government fails
Matching time horizon
Inflation-protected bonds
What will the minimal risk bond earn you?
Buying the minimal risk asset
Summary
5 World equities – increased risk and return
Buy equities from around the world
The advantage of diversification
What are world equities?
Expected returns: no promises, but expect 4–5% after inflation
Lars’s predictions
In summary
6 The risk of equity markets
Understanding the risk you take to get returns
The standard deviation
You can lose a lot!
Don’t assume that markets always bounce back
Diversification and the false sense of security
Risk rethought
7 Adding other government and corporate bonds
Adding government bonds
Only add government bonds if they increase expected returns
The government bonds we should add to the rational portfolio
Adding corporate bonds
If history is any guide …
Getting practical
Corporate bond returns also depend on credit quality
Return expectations of the rational portfolio
Adjusting the rational portfolio
Using equity risk insights in the context of a full rational portfolio
The rational portfolio allocations
Special case: if you want a lot of risk
8 Incorporating other assets
What else do you have?
Other assets
Not just geography
The institutional investor
Other assets rethought
9 What is omitted from your rational portfolio and why
Avoid investments that require an edge or those you already have exposure to
Property – don’t do it unless you have an edge
Private equity, venture capital and hedge funds
Commodities
Private investments (or ‘angel’ investing)
Collectibles
part 3 Tailoring and implementing the rational portfolio
10 Financial plans and the risks we take
Building your savings
The super-cautious saver
Risk/return
Generalising the examples
Keeping it real
Reacting to disaster
A few ways to think about portfolio allocations
Stages of life
A few rules of thumb
Adding government and corporate bonds
11 Tax
Tax adviser or accountant
Ask your adviser
Rational portfolio adjustment
12 Liquidity
Selling your investment
Minimal risk liquidity
The equity portfolio and ‘risky’ bonds are highly liquid
Getting paid – illiquid investments should generate better returns
Liquidity rethought
13 Expenses
An expensive, active choice
Patience
Believing in an edge can be expensive
14 Products and implementation
Total expense ratio tells you the cost of owning the product
The best ETFs: liquid, tax efficient and low cost
Index-tracking funds
Comparison sites
Execution
Trading is expensive
Rebalancing your portfolio
Summary
part 4 Other things to think about
15 Pension and insurance
Defined contribution pension plans
Annuities and insurance
16 Apocalypse investing
Gold as security
If not gold, then what?
How could 2008 and 2009 have happened?
17 A wish list aimed at the financial sector
Enhanced independent comparison sites
Risk expertise
Tax advice
Customisation
Do you need a financial adviser?
18 Conclusion
Index
Acknowledgements
Since this is my first time writing about investments in a semi-technical way I have needed more help than the professors or personal finance professionals who often write about this topic. I am thrilled and honoured that such an accomplished and insightful group of people spent their time helping me. To start, I want to thank my wife, Puk Kroijer, for continuously supporting this project from the stage when it was still rumbling in my head. Soon after the rumblings were verbalised the publisher of my first book, Chris Cudmore, encouraged me to write a book and he and the team at Financial Times Publishing were again excellent at seeing the project through to conclusion.
A number of friends were also instrumental in the book’s completion by giving comments on early drafts as I stumbled towards a coherent argument: Steven Felsher with his extremely thorough system of numbering each paragraph (there were 8001 in one draft), former office mate Edwin Datson, Mark Hunter, Stuart Hamilton, Chris Rossbach with his sharp pencil, Paul Amery from Index Universe, Coenraad Vrolijk from Blackrock, Morten Bech from the Bank of International Settlements, Stéphane Guibaud from London School of Economics, and my former professors Andrei Shleifer from Harvard University and Jay Light from Harvard Business School.
Finally, I would like to thank all those in and around the finance industry who consistently encouraged me to write about this subject and helped in various ways. While the book in general suggests investing in ways that lead to lower fees to the financial industry, the people I talked to had their customers’ interests as their first objective. This kind of honest objective bodes well for the future of finance even while it is generally vilified in the popular press and is perhaps in for a rough ride in the years ahead.
Finally, this book is dedicated to Puk, Anna, Sofia and Sydney the dog; my four girls.
Lars Kroijer
About the author
Lars Kroijer graduated Magna cum Laude from Harvard University with a degree in economics and received a MBA from Harvard Business School.
Lars is the author of Money Mavericks – Confessions of a Hedge Fund Manager (second edition, 2012, FT Publishing). He currently serves
on the Board of Directors of OVS Capital, Linden Grove Capital, Northlight Capital, Steadview Capital and Maj sinAI (London, Mumbai/Hong Kong and Copenhagen-based hedge funds), and ShipServ Inc. (the leading online platform for shipping supplies with annual sales of about $4 billion). He has frequently appeared as a finance expert on a broad range of media, including the BBC, CNN, CNBC, Bloomberg, the New York Times and Forbes magazine.
Lars was the CIO of Holte Capital Ltd, a London-based, market-neutral, special situations hedge fund which he founded in 2002 before returning to external capital in the spring of 2008. Prior to establishing Holte Capital, he served in the London office of HBK Investments focusing on special situations investing and event-driven arbitrage. In addition, he previously worked at SC Fundamental, a value-focused hedge fund based in New York, and the investment banking division of Lazard Frères in New York. Whilst at graduate school, he held internships with the private equity firm Permira Advisors (then Schroder Ventures) and management consulting firm McKinsey & Co.
A Danish national, Lars Kroijer lives in London and is married with twin daughters.
Foreword
Today, most literature or other media on finance tell us how to make money. We are bombarded with stock tips about the next Apple or Google, read articles on how India or biotech investing are the next hot thing, or told how some star investment manager’s outstanding performance is set to continue. The implicit message is that only the uninformed few fail to heed this advice and those that do end up poorer as a result. We wouldn’t want that to be us!
This book starts with a very different premise. It starts with the idea that markets are actually quite efficient. Even if some people are able to outperform the markets, most people are not among them. In financial jargon, most people do not have an edge over the financial markets, which is to say that they can’t perform better than the financial markets through active selection of investments different from those made by the market. Embracing and understanding this absence of an edge as an investor is a key premise of the investment methods suggested in this book, and something I will discuss at length.
Who is this book for?
It is for investors everywhere who have several things in common:
They feel that they are not getting value for money from the finance industry and find it opaque, but realise how important investments are to their lives. They read about phenomenally wealthy finance types, but feel that in paying fees, for example, the results are poor. Thinking about the great phrase ‘Where are the customer’s yachts?’, they don’t even have a rowing boat.
Ideally, they would like a simple portfolio of investments, but also want to feel that they can expect the best possible return for the risk they are willing to take.
They may well have investments with typical investment managers as (despite themselves) they fell for the snazzy ads that showed great historical performance, which perhaps wasn’t matched post-investment.
They may have shares in blue chip companies like Google, Apple, Exxon or Vodafone, but at the same time recognise they are not expert stock pickers and consider that is something best left to the professionals.
They may also know a lot about finance and have a genuine interest in it, but with a busy day job are unable to devote a lot of time to their personal portfolio. They need a portfolio that helps them sleep better at night, knowing that their savings are well looked after without having to spend too much time on it.
They may have been directed by an adviser who they had retained to help simplify the jungle of investment products and were left unable to understand their portfolio mix. Perhaps without knowing if the adviser took a share of the high fees they were paying.
They probably also think about investing longer term. While this book certainly has many immediate action items it is the opposite of the ‘Spot the next hot stock’ or ‘Make $10,000 a day without getting out of bed’ genre.
They want a book on how to do a little bit better every year financially, with a big cumulative impact over time. If a hedge fund manager is a turbo-charged Ferrari, this book is akin to the grey Volkswagen that is a far better bet to get you safely to your destination in one piece.
So this book is about taking something as opaque and impenetrable as the financial market sector and demystifying it; thus Investing Demystified. Once investors realise that they do not have the investing edge to outperform the markets, and know that this is perfectly acceptable, the rational next step is quite logical and simple. I call this next step being the rational investor and the portfolio for that investor the rational portfolio.
So what is a rational investor?
The rational investor
The rational investor does not seek to outperform the financial markets, pay few fees and get higher returns for any level of risk, while incorporating individual tax and non-investment asset factors. He or she is rational about the low probability of having an ‘edge’1 in the markets and because of this insight will have a much improved financial performance.
1 The markets talk about investors ‘having edge’ – rather than ‘having an edge’ – or ‘edging the market’ but in the interests of legibility and understanding we have kept jargon to a minimum.
While I’m not expecting readers to know about finance, some basic knowledge is helpful. Someone without any finance knowledge may find it harder to distinguish between an unglamorous book that promises improved risk-adjusted performance over the long term and other appealing-looking products from the well-marketed finance industry that tell us we can all be Warren Buffett – or at least that we should try. No wonder that most people would rather aim to be a billionaire superstar.
However, to keep it an easily readable finance book, we will be relatively light on theory and complex maths. They play a central role in supporting the arguments made in this book as I’m keen that you understand that what I suggest is a practical implementation of the best theory on getting the optimum portfolio. But in the interest of readability I have tried to keep theory and maths to a minimum, and put some of it in boxes that you may choose to skip; likewise there are a limited number of footnotes and references for those who want to explore further.
This book uses words like estimate, guess, approximately, around, roughly, fairly, reasonable quite a lot. This is because the discussion is often about what will happen in the future and claiming certainty would be misleading. Most points are fair estimates of what we can expect and hopefully a framework of how to think about the issues. Reality will almost certainly turn out differently from what we forecast here, and perhaps even make a mockery of our logic if we try to be too exact. I use £, $, €, etc. interchangeably in the examples and discussion. This is deliberate as most of the topics discussed do not depend on currencies. Investors obviously care a lot about their specific currency exposure, but the issues faced by a sterling investor are very similar to those faced by a euro-based one.
Who am I to write this book?
This book draws heavily on my experiences managing a hedge fund and practically implementing investments, but also relies on academic research in portfolio construction. A one-time hedge fund manager writing a book about investments without edge may seem like a priest writing the guide to atheism. In my view, however, it is not at all inconsistent. The fact that some investors have an edge on the market does not mean that most people have it. Far from it. ‘Edge’ is confined to a very small minority of investors who typically have access to the best analysis, information, data and other resources. Most other investors simply can’t compete, and would be worse off trying.
Paradoxically, for those who know me as a hedge fund manager (I wrote a book called Money Mavericks about my experiences of starting and running a hedge fund), I was interested in optimal portfolio theory before I even really knew about hedge funds. For a while I planned to get a PhD in the field and perhaps teach. As it turned out, I graduated from university with a lot of debt and had a lucrative offer from Wall Street. From
there, I got my MBA and ended up being interviewed at a hedge fund. Events happened, as they say. So I have a lot of experience with optimal portfolio and general financial theory, but also experience operating in the financial markets. Since I stopped running my hedge fund in early 2008 (fortuitous timing) I have mainly focused on investing my own money along the lines discussed in this book, and have extensive experience of trading the products discussed.
part one
Introduction
chapter 1
* * *
Introduction to markets and portfolios
Our objective
This book will help you – the rational investor – create a portfolio that will have the best returns for any risk level. You will think about risk, taxation and incorporating other assets in your portfolio. This approach will result in more cash being available in the future through better investment returns than other investment methods. This book is about sleeping well at night, confident that you have the best possible investment portfolio for someone who can’t consistently outperform the market – and this covers the vast majority of investors.
This is perhaps an unusual book about investments. I will not tell you how to analyse company accounts, spot economic trends, identify great products, recognise the next hot stock or anything like that. Instead, I will try to convince you that you are probably among the vast majority of investors who are better off not trying any of that complicated analysis and then I’ll tell you what to do with your investments on the basis of that premise. In other words, this is a book for investors who have no ‘edge’ over the markets.
In reality, very few investors have the edge to outperform the financial markets, where many thousands of investors with access to the best and most timely information, analysis and financial models compete. Those investors speak to companies, research analysts, economists, traders, customers and so on. Then they read any report, web-chat, filing, news piece, etc. before they analyse the information using the most sophisticated systems and financial models. Only then do they buy or sell. Despite that level of insight, it is not clear that professional investment managers as a group outperform the markets. We as investors are probably unable to consistently pick the winning managers among them, just like we can’t consistently pick winning individual investments. But in both cases we can be sure that fees and expenses make the task of outperformance much harder. We are left with a realisation that we are far better off taking a step back and not competing in the financial market circus.