Investing Demystified

by Lars Kroijer

  The absence of an edge does not mean that you should avoid investing. Doing so would exclude you from potentially exciting long-term returns in the equity markets, or benefiting from the security of highly rated government bonds. By embracing the fact that you do not have an edge or advantage to consistently outperform markets I will help you understand how to benefit from a simple and cheap portfolio construction that, despite its simplicity, is very close to the best both from a practical and a portfolio theory perspective. I call it the rational portfolio and those that implement it are rational investors because once you realise that you do not have the edge to beat the markets, I hope you will agree that what I suggest is the rational way of investing.

  While most people would obviously rather have the magical ability to pick the market’s winning stock every year, and soon be richer than Bill Gates, reality is that a vanishingly small number of people can consistently beat the markets or know others who can do it for them, and most are far worse off for trying. It’s a huge positive step forward if you can embrace the fact that you do not have the edge to beat the markets. It will make you a better investor and leave you wealthier in the long run while spending less time worrying about your investments.

  The rational portfolio that I’m going to propose is much simpler, yet more theoretical and practically robust than what most investors have today. Even before considering its massive fee advantage over more conventional investment portfolios this portfolio offers investors a superior risk/return profile because of its greatly diversified and optimised investments. Other advantages include excellent liquidity, ease of tailoring risk to suit individual needs and tax efficiency. So you are getting something better at a far lower cost.

  Lower costs are possible because the rational portfolio is implemented through cheap index tracking products (investment products that try to mirror the performance of an index). Particularly in the equity part of the portfolio you can save about 2% a year in fees and expenses compared to many typical investment products that actively seek to outperform the market. To put this in perspective, if you have an income of £50,000 a year and save 10% a year from the age of 30 to 67 (so £5,000 at age 30, and every year thereafter going up with inflation at 2%), and the market gives you a return of 7% a year before fees, then at 67 the difference in your portfolio from the yearly 2% saving on fees is staggering (see Figure 1.1).

  Figure 1.1 Fee-saving example

  You are set to benefit from an increased wealth of £403,000 and retire as a millionaire! The money saved up every year amounted in total to about £281,000 at age 67, but the investment returns took your savings up to £1.06 million because you invested in the rational portfolio along the way.

  You can re-run the example with other levels of savings or returns, or with just one investment. While you will be changing the numbers, the conclusion remains the same: unless you have an edge in the markets, the benefits from cheaply constructed rational portfolios are hugely significant over time. Remember this and act on it.

  Where do we hope to end up?

  There are three main themes to take away from this book.

  1 We embrace that we do not have an edge

  Investors who embrace that they do not have an edge are not necessarily unknowledgeable or naïve about the world of finance. In fact they might be the smartest person in the room. But they know something much more important: they do not think that they have the informational, analytical or other advantage to outperform the markets. Edge may exist in the finance world; we are simply acknowledging that we neither have it nor know someone who does.

  Far too many people think that they have an edge, and far too few people have an incentive to tell them otherwise. Certainly not many you meet in the finance industry will do so. People working in banks, insurance firms, brokerage firms, media outlets, etc. get paid in many direct and indirect ways as a result of the fees paid to the finance industry. They have the backing of all sorts of marketing professionals who persuade investors that giving them money is the right thing to do, and the forceful backing of conventional wisdom that they are probably right. They are not.

  Most of us are rational investors, and it’s actually a pretty tall order to claim an investing edge. I hope that your reaction as we proceed will be, ‘OK. Got it. I see why it’s important. What’s next?’

  An immodest claim

  A large majority of investors will make more money over the long term by investing as suggested in this book and by embracing the fact that they do not have an edge in the financial markets.

  2 The components of the rational portfolio

  The rational portfolio consists of the lowest possible risk investment combined with a portfolio of world equities, and potentially other government and corporate bonds. Adjusted for a few individual elements like risk and taxes, over the long term it will be very hard to outperform.

  ‘If I don’t have an edge, why invest at all?’ That’s a fair question that may be best answered by asking what the alternative is. Is it to put your cash under your mattress or buy jewellery that you can hide in the garden? What does ‘not investing’ actually mean? Leaving your money in the bank will yield little interest income and may mean taking credit risk with that bank. To put it simply, your money will not grow and its value will be eroded by inflation. In the example above, ‘doing nothing’ meant savings of £281,000 while the same savings invested with pretty reasonable assumptions in the rational portfolio meant savings of £1.06 million.

  I hope to convince you that the rational portfolio suggested in this book is as close to theoretically and practically optimal as you will find and is how you will make more money from your investments over time. So the ‘rational investing philosophy’ is not the brainchild of yet another investment professional you may never have heard about (me), but instead is a practical and cost-efficient implementation of decades of work in portfolio theory by the sharpest minds in finance. While the benefits from the rational portfolio start accruing immediately, this is a long-term investment philosophy with a strategy and individual securities that you can hopefully keep for years or even decades.

  Combining highly rated government bonds in the right currency, broad index-tracking products of world equities and possibly other government and corporate bonds in the right proportions through the best and cheapest products is core to rational investing (see Figure 1.2). I will quantify the risk/return profile of this portfolio and explain why low fees and expenses are core to long-term investment success. You may get bored with me talking about fees, but if you get expenses right you’ll have come a long way.

  The combination of the three asset classes that is best for you depends on your specific circumstances, particularly your attitude towards risk. I will give you the simple building blocks and help you to combine them. I will also discuss why some asset classes do not fit in the rational portfolio, including popular ones like property and commodities.

  Figure 1.2 The core of rational investing

  3 To get the full benefit of rational investing you should tailor your portfolio to your specific needs and circumstances

  To start with you need to think about the risks of investing in the financial markets, and how that risk fits with your personal attitude towards risk. Add to this the fact that you should try to be as clever as possible about your tax situation, so that as tax regimes or your personal circumstances change you are in the best position to benefit. Getting all this right is no small task.

  You need to consider your investment portfolio in the context of all your assets and liabilities, and how all of those interact. I will touch on what investing looks like in complete calamity situations, and also on the role that pensions and insurance play in the rational portfolio.

  Finally you need to implement all this. I’m wary of suggesting specific products to buy as the development in index tracking moves so fast, but I will discuss a couple of offerings with the characteristics discussed above. These pass the ‘what should
I tell my broker’ test; or, more likely these days, the ‘what should I tell my internet browser’ test.

  The 60-second version

  There are four things to take away from this book:

  You almost certainly do not have an edge in the financial markets. That’s OK. Most people don’t, but you should plan and act accordingly.

  There is an easy and cheaply constructed portfolio which is close to optimal. It combines the highest-rated government bonds with a world equity portfolio, adding other government and corporate bonds if you have the appetite for a bit more complexity. Get close to that in the right proportions, stick to it and you should do very well.

  Your specific circumstances do matter a great deal. Think hard about your risk appetite and optimising your tax situation, but also pay attention to your non-investment assets and liabilities.

  Be a huge stickler for costs, don’t trade a lot and keep your investments for the very long run. Over time you will be far better off for having implemented the rational portfolio.

  chapter 2

  * * *

  What is an edge over the markets and do you have it?

  A key premise of this book is that we can’t legally beat the markets consistently, or indeed know of an investor that can. It concedes having an edge over the markets. But what is meant by this?

  Consider these two investment portfolios:

  A: the S&P 500 Index Tracker Portfolio

  B: A portfolio consisting of a number of stocks from the S&P 500; any number of stocks from that index that you think will outperform the index. It could be one stock or 499 stocks, or anything in between, or even the 500 stocks weighted differently from the index (which is based on market-value weighting).

  If you can ensure the consistent outperformance of portfolio B over portfolio A, even after the higher fees and expenses associated with creating portfolio B, you have gained an edge by investing in the S&P 500. If you can’t, you don’t have an edge.

  On first glance it may seem easy to have an edge over the S&P 500. All you have to do is pick a subset of 500 stocks that will do better than the rest, and surely there are a number of predictable duds in there. In fact, all you would have to do is to find one dud, omit that from the rest and you would already be ahead. How hard can that be? Similarly, all you would have to do is to pick one winner and you would also be ahead.

  While the examples in this chapter are from the stock market, investors can have an edge in virtually any kind of investment. In fact there are so many different ways to have an edge that it may seem like an admission of ignorance to some to renounce all of them. Gut instinct may tell investors that not only do they want to have an edge, but the idea of not even trying to gain it is a cheap surrender. They want to take on the markets and outperform to make money, but perhaps also as a vindication that they ‘get it’, are street smart or somehow have a superior intellect.

  The competition

  When considering your edge who is it exactly that you have an edge over? The other market participants obviously, but instead of a faceless mass think about who they actually are, what knowledge they have and what analysis they undertake.

  Imagine Susan, the portfolio manager of a technology-focused fund working for a highly rated mutual fund/unit trust (let’s call it Ability) who like us is looking at Microsoft.

  Susan and Ability have easy access to all the research that is written about Microsoft including the 80-page, in-depth reports from research analysts from all the major banks, including Morgan Stanley and Goldman Sachs, that have followed Microsoft and all its competitors since Bill Gates started the business. The analysts know all Microsoft’s business lines, down to the programmers who write the code to the marketing groups that come up with the great ads. They may have worked at Microsoft or its competitors, and perhaps went to Harvard or Stanford with senior members of the management team. On top of that, the analysts speak frequently with their banks’ trading groups who are among the market leaders in trading Microsoft shares and can see market moves faster and more accurately than almost any trader.

  All research analysts will talk to Susan regularly and at great length because of the commissions Ability’s trading generates. Microsoft is a big position for Ability and Susan reads all the reports thoroughly – it’s important to know what the market thinks. Susan enjoys the technical product development aspects of Microsoft and she feels that she talks the same language as techies, partly because she knew some of them from when she studied computer science at MIT. But Susan’s somewhat ‘nerdy’ demeanour is balanced out by her ‘gut feel’ colleagues, who see bigger picture trends in the technology sector and specifically how Microsoft is perceived in the market and its ability to respond to a changing business environment.

  Susan and her colleagues frequently go to IT conferences and have meetings with senior people from Microsoft and peer companies, and are on a first-name basis with most of them. Microsoft also arranged for Ability personnel to visit its senior management at offices around the world, both in sales and development, and Susan also talks to some of Microsoft’s leading clients.

  Like the research analysts from the banks, Ability has an army of expert PhDs who study sales trends and spot new potential challenges (they were among the first to spot Facebook and Google). Further, Ability has economists who study the US and global financial system in detail as the world economy affects Microsoft’s performance. Ability also has mathematicians with trading pattern recognition technology to help with the analysis.

  Susan loves reading books about technology and every finance/investing book she can get her hands on, including all the Buffett and value investor books.

  Susan and her team know everything there is to know about the stocks she follows (including a few things she probably shouldn’t know, but she keeps that close to her chest), some of which are much smaller and less well researched than Microsoft. She is one of the best-rated fund managers in a couple of the comparison sites, but doesn’t pay too much attention to that. After doing her job for over 20 years she knows how quickly things can change and instead focuses on remaining at the top of her game.

  Do you think you have an edge over Susan and the thousands of people like her? If you do, you might be brilliant, arrogant, the next Warren Buffett or George Soros, lucky or all of the above. If you don’t, you don’t have an edge. Most people don’t. Most people are better off admitting to themselves that once a company is listed on an exchange and has a market price, then we are better off assuming that this is a price that reflects the stock’s true value, incorporating a future positive return for the stock, but also a risk that things don’t go do plan. So it’s not that all publicly listed companies are good – far from it – but rather that their stock prices incorporate an expectation of a fair future return to the shareholders given the risks.

  When I ran my hedge fund I would always think about the fictitious Susan and Ability. I would think of someone super clever, well connected, product savvy yet street smart who had been around the block and knew the inside stories of success and failure. And then I would convince myself that we should not be involved in trades unless we clearly thought we had an edge over them. It is hard to convince yourself that this is possible, and unfortunately even harder sometimes for it to be actually true.

  You just have to pick your moment

  Warren Buffett is quoted as saying that ‘just because markets are efficient most of the time does not mean that they are efficient all of the time’. To quote Buffett about investing is like quoting Tiger Woods about golf. He is a world-famous investor with a long history of being right, so we are all bound to feel a little deferential.

  Buffett’s words might be right of course. Markets might be perfectly efficient some or even most of the time and horribly inefficient at other times. But how should we mere mortals know which is when? Can you predict when these moments of inefficiency occur or recognise them when you see them? Clearly we can’t all see the inefficienci
es at the same time or the market impact of many investors trying to do the same thing would rectify any inefficiency in an instant. But can you, as an individual investor, spot a time of inefficiency?

  I think that it’s incredibly hard to have an edge in the market even occasionally. Be honest with yourself. If you have a long history of picking moments when you spotted a great opportunity, moved in to take advantage of it and then exited with a profit, then you may indeed occasionally have an edge. You should use this edge to get rich.

  The costs add up

  On average individual investors trying to beat the markets would not systematically pick underperforming stocks – on average they would pick stocks that perform like the overall market. They would have a sub-optimal portfolio that would not be as well diversified, but in my view the main underperformance comes from the costs incurred.

  The most obvious cost when you trade a stock is the commission to trade. This has been lowered dramatically with online trading platforms but it is far from the only cost. A few others to consider are: