3 lessons to incorporate into your investment approach

He who loves practice without theory is like a sailor who boards ship without a rudder and compass and never knows where he may cast.

- Leonardo da Vinci

The Oxford Dictionary defines an ivory tower as “a state of privileged seclusion or separation from the facts and practicalities of the real world.” Teddy Roosevelt famously told us that “it is not critic that counts” but that “the credit belongs to the man who is actually in the arena.”

I talk to a lot of investors and there is almost universal disdain for academic theories of investing. Many of these critics touch on the same points outlined in both the definition of an ivory tower and Roosevelt’s view that what counts is the practitioner in the trenches.

I am always struck that while discounting the value of investing theory these same investors pepper their own views on investing with bits and pieces of disparate theories. Some foundational theories about investing have subconsciously worked themselves into our thinking.

This is not necessarily a bad thing. But understanding the basis of these theories and the inherent contradictions can help clarify our own investing approach and how we deal with the inevitable challenges we face as investors. What we want to avoid is selectively choosing parts of theories that conveniently justify whatever action we wanted to take anyway. That may work in political campaigns but it isn’t going to help you achieve your investing goals.

Today we are going to take a journey from the ivory tower into the real world and back again.

Efficient market hypothesis

We will start in the 1960s. The decade is popularly portrayed as a time of disorder stemming from colliding social and political movements. Yet in the investing arena it was a time where the animal spirits of the investing world were papered over in a theory known as the efficient market hypothesis which is often associated with a University of Chicago Economist named Eugene Fama.

The gist of the theory is prices will always reflect values. As each new piece of data or news becomes available investors will interpret it and instantaneously adjust the prices of securities to reflect their new value. At the heart of this theory is the notion that we are all rational.

Our rationality is centred around our desire and ability to always act in a way that maximises our wealth. Maximising our wealth entails selling overvalued investments and buying undervalued investments. As we collectively continue to do this it will adjust prices to match their value.

The implication of an efficient market is that an investor cannot beat the market. If an investor happens to achieve returns higher than an index it is a result of luck. This random occurrence of beating the market is the equivalent of buying a lottery ticket. And since buying a lottery ticket is not a great strategy for financial success an investor should simply buy an index fund.

Naturally many investors who take a passive approach cite the efficient market hypothesis as a justification. And fair enough. Yet the dirty little secret of ‘passive’ investing is that most investors that use passive investments don’t invest passively.

Buying and selling different passive investments is not passive investing. Stretching the boundaries of what is considered passive to narrower and narrower indexes that promise exposure to a compelling theme is not passive investing. Investing in products that follow an index with high turnover through constant rebalancing is not passive investing.

The efficient market hypothesis does not just mean an investor is unable to pick individual shares that will outperform. It also means that an investor is unable to select a market, index or theme that will outperform. An index is simply an aggregation of security level prices. If the underlying security prices reflect their value the index does as well. It also means that market timing won’t work. Going to cash when a market is overvalued and reinvesting when it is undervalued can’t work if a market is always appropriately valued.

Behavioural economics

In the 1970s a new investing theory became popular based on the work of a future Nobel prize in economics winner named Daniel Kahneman. An interesting fact about Kahneman is that he never took an economics class. Yet it didn’t take in-depth study of economics for Kahneman to conclude that there are many instances when humans don’t act rationally.

According to Kahneman it isn’t just a few outliers that don’t act in wealth maximising ways. Instead, most of us use short-cuts or heuristics to make decisions. This flies in the face of classic economics and the underpinning of the efficient market hypothesis which relies on the notion that investors are rational.

The implications of the body of research under the moniker of behavioural economics is that an investor can beat the market. If security prices are not necessarily representative of their value an investor that can rationally assess value can buy underpriced securities and sell overpriced securities.

Perhaps more importantly, an investor can beat the market if they make fewer poor decisions than the average investor. Kahneman introduced the concept of behavioural risk. Minimising behavioural risk or gaining a behavioural edge is a pathway to better outcomes.

This is a theory that is consistent with Ben Graham’s famous parable of “Mr Market”. Charlie Munger summed this up when he said the following about Graham. “Instead of thinking the market was efficient, he (Graham) treated it as a manic-depressive who comes by every day. And some days he says, ‘I’ll sell you some of my interest for way less than you think its worth.’ And other days, “Mr. Market” comes by and says, ‘I’ll buy your interest at a price that’s way higher than you think its worth.’ And you get the option of deciding whether you want to buy more, sell part of what you already have or do nothing at all. To Graham, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time. That was a very significant mental construct.”

My view

Eugene Fama and Daniel Kahneman both won the Nobel Prizes in Economics. The prospects of picking one up myself are not looking good. Yet I still have an opinion on the merits of their respective theories.

I do not believe markets are efficient. I do believe some markets are more efficient than others. I believe that any investor can develop a source of edge enabling them to outperform the market. In fact, I’ve incorporated behavioural and structural edge into my investment strategy. Yet this is not an easy thing to do and shouldn’t be pursued lightly.

More importantly I have other beliefs that may be more relevant. I’ve taken three lessons from this academic debate. All of them are related to how we think about success as an investor which will influence the way we approach investing.

Success is achieving a goal and not beating an index

The return on my portfolio has significantly exceeded the return on the ASX 200 for more than 15 years. Does that make me a genius? Of course not. The driver of this success is that most of my portfolio is invested in US shares.

This wasn’t a result of an astute assessment of the relative merits of different markets. It is because I spent most of my life in the US and like most people I invested my portfolio in my local market. And the US market has significantly outperformed the Aussie market since the GFC. Now that I’m an Australian citizen and intend to stay here I measure my portfolio in Australian dollars. This added another boost since the Aussie dollar has been so weak lately.

The larger point is that ‘beating’ the market implies there is an index return that corresponds with my goals. This is a nonsense. The return of a global index, the S&P 500 or the ASX 200 has nothing to do what I want to accomplish in life. I can say that with absolutely certainty even while acknowledging that earning returns on my portfolio is the enabler of the life I want.

I’ve become a better investor since I’ve started ignoring returns relative to an index and measuring success against a personal benchmark. And that benchmark is the required return needed to get me from where I am to the goal I want to accomplish. Spending time looking at my returns in relation to an index was not only a waste of time but it also encouraged bad behaviour.

Knowing I was trailing the market elicited the desire to do something. It made me search for ‘better’ investments that would keep pace with the index. That is a natural human tendency.

We are hardwired for fight or flight. Most of the time in the investing world more action leads to less success. Don’t focus on wealth maximising behaviour. Focus on achieving concrete goals. The added bonus is ignoring indexes will likely result in more wealth in the long-run anyway.

Success is focusing on the returns that matter

Applying any piece of academic research to solve a real-world problem requires an assessment of the underlying assumptions of the theory. In both the efficient market hypothesis and behavioural economics the underlying assumption is that an investor is trying to maximise their wealth by beating the market.

In some senses this is valid. In a world of cheap index funds an investor needs to decide if they will invest passively or will select individual securities – whether on their own or by using an active manager. However, for many investors ‘beating the market’ in an academic sense is false measure of true success. In the real world what an investor cares about are after-tax and after-fee returns in excess of inflation.

Investing is a means to an end. What matters is how much money you have after you pay taxes and after you pay any fees associated with earning those returns – management fees, account-based fees, financial advice fees and transaction fees to name just a few.

When the goal is to eventually spend the money inflation matters as well. We give up consumption today to save and invest to earn a return so more can be consumed in the future. A return in excess to inflation is needed to enable more consumption in the future.

The way we invest contributes significantly to the taxes and fees we pay. Trading frequently with short-holding periods increases taxes and transaction costs. Ongoing management fees are higher if ETFs and funds are used over individual shares. Some funds and ETFs have higher fees than others.

Over the long-term inflation impacts the returns on specific types of investments more than others. Cash and bonds often experience negative real (inflation adjusted) returns during periods of high inflation regardless of the level of interest rates. Bonds and cash may seem more attractive when interest rates are higher. Yet in many cases interest rates are high because inflation is also high.

The following chart represents 30 year returns as of 30 June 2023 on different asset classes in excess of inflation.

When we start interrogating this chart using an investment approach that is not primarily concerned with maximising wealth but instead achieving a goal a couple things should become obvious. Achieving a certain return level in excess of inflation is less about how you invest within each of these asset classes and more about the asset classes you choose to invest in.

This is not a hypothesis. It is backed by academic research. Asset allocation or which asset class you allocate your portfolio to has a far bigger influence on overall returns than security selection.

Investing 101 calls for diversifying among different asset classes. This admonishment is the investing of equivalent eating an apple a day to keep the doctor away. In the real world we should only diversify to different asset classes if it helps us achieve our goals.

For instance, allocate part of your portfolio to bonds and it will lower the long-term returns you achieve and lower volatility or how much your portfolio bounces around. This is a great approach if lowering the volatility of your portfolio will help you achieve your goals. This is a terrible approach if lowering volatility doesn’t. I have 20 years until retirement and I have no allocation to bonds. Volatility is meaningless to me at this stage and keeping as much of my portfolio in asset classes with higher long-term returns is the best way to achieve my goals.

While the academic research is interesting and may inform if you invest actively or passively within an asset class this shouldn’t be your primary concern. If you want to achieve your goals get your asset allocation right. Focus on the only returns that matter. That is not what is published in the media and not what investment products tout. Worry about your after-tax, after-fee real (inflation adjusted) returns.

Stop investing like professional investors. The rules they play by and their incentives have little correlation with what you want to achieve. Focus on trading as infrequently as possible to minimise taxes and fees and the behavioural mistakes that all investors make.

Success is learning from your mistakes

In an article on Daniel Kahneman and his legacy, Jason Zweig a columnist for the Wall Street Journal had a really interesting way of describing his work. He wrote, “instead of using behavioural economics as a window, we should regard it as a mirror.”

And Zweig was pointing out that it is easy for us to use insights into what mistakes investors make to judge other people’s behaviour. It is easy to use this work as foundation for policy prescriptions. It is a lot harder to realistically evaluate our own behaviour with a goal of improving it over time.

One of the key lessons from behavioural economics is that our decisions are influenced by our view of the past. And that view is highly subjective. We tend to overestimate our own experience and capabilities. The good things that happen to us are a result of skill. The bad things are the result of bad luck – and that is if we even remember them happening in the first place.

Looking at our own portfolios exacerbates this human tendency of focusing on good outcomes and ignoring bad ones. The positions in your current portfolio reflect survivorship bias. Going into the global financial crisis I had a large position in a US bank called Washington Mutual. This turned out to be a huge mistake.

Yet looking at my portfolio today I’m not reminded of this mistake because Washington Mutual was seized by regulators and shut down. I lost my entire investment but it also meant the holding disappeared from my portfolio along with the constant reminder of my short-comings as an investor. The same thing happens when we sell an investment that hasn’t done well.

Looking at my portfolio I naturally focus on my largest positions. This can reinforce an internalised view that I am a great investor and know what I’m doing. My largest positions got there for a reason. Those are the winners. Those are the positions I’ve held for a long time. It is easy to draw the conclusion that I’m a successful long-term investor and forget about the mistakes I’ve made. This conclusion holds me back from being a better investor by not examining my mistakes.

To learn from mistakes, reflect on them without wallowing. We all make mistakes and the only benefit we can possibly get from those mistakes is to improve future outcomes. The GFC taught me some important lessons that I’ve applied to my own investing approach. In summary, I avoid investing in banks.

Their balance sheets are opaque. Their business models are complex and incentive structures often encourage risk taking that can turn excessive. This accounts for their historical propensity to blow up. Many bank investors like to cite the skill and competence of regulators as justification for investing in banks they don’t understand. Whatever gets your through the night.

I am not saying that anyone reading this shouldn’t invest in banks. I’m just saying that I don’t do it. Avoidance may not be a profound lesson to take from a mistake but it beats ignoring that it happened. The real lesson is investing within your circle of competence.

I would love to hear your thoughts at [email protected]