Focus on what you can control
In this week's Investing Compass episode, Shani goes through her investment strategy.
Shani provides the perspective that successful investing does not mean constantly searching for new investment opportunities.
Most investors believe that investment success requires finding the best investments. The foundation of this belief is that at any particular moment there are investments that are good and will outperform in the immediate future and ones that are bad that will underperform. This view is reinforced and encouraged by professional investors who are selling investments and their ability to navigate markets to find opportunities.
She's come to an approach that flips this conventional wisdom around. Selecting individual investments for her portfolio is not her primary concern. She start with other factors such as achieving a sustainable surplus and prioritising asset allocation.
She goes through the academic and circumstantial reasons why she has come to this approach.
You can read the full article here.
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You can find the transcript below:
Mark Lamonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.
So, Shani, we have – you've told me to make an announcement. We have a survey.
Shani Jayamanne: We do. We want to know what you think.
Lamonica: We do want to know what you think. So, there's a couple of questions. This shouldn't take more than five minutes.
Jayamanne: Definitely. There's 10 questions and most of them are multiple choice.
Lamonica: So, yeah. So, this should be easy. And if you take the survey and the survey is in the podcast notes, if you take the survey, we will do a random drawing of somebody who's completed the survey and has decided to leave their email address, we promise we won't.
Jayamanne: Not a portrait. We will draw the winner. Wow.
Lamonica: Yes. Would you like to tell us the prize, Shani?
Jayamanne: It is a $250 Visa gift card.
Lamonica: Yes. Which is available to use to take us out for drinks.
Jayamanne: Yeah.
Lamonica: Or anything else you want to spend it on.
Jayamanne: I mean, that would be nice, but whatever you like.
Lamonica: Yeah. We'll see who wins. But should we get into the episode?
Jayamanne: Yes.
Lamonica: We did a very long Preamble last time.
Jayamanne: We did. So, we got to cut to the chase this time.
Lamonica: Yeah. But I'll insert some stuff about your book. Nobody's requested an excerpt from your book yet.
Jayamanne: One person has. Lisa requested some quotes from my book and I'm glad you didn't give them to her.
Lamonica: No. I just haven't gotten back to her. She only emailed yesterday.
Jayamanne: Okay.
Lamonica: So, I'll work through that, Lisa. But today's episode is going to be a little bit of a different take on something we've done before. So, we've gone through several episodes, where I go through my investing strategy and we've talked about income, using that to fund my goals and how I'm approaching retirement. But today we're going to put the spotlight back on you, Shani, where it belongs.
Jayamanne: Well, I'm going to say right now mine is definitely less sexy.
Lamonica: Less sexy than income.
Jayamanne: Yeah. That's not much more sexy than income, Mark.
Lamonica: That is true. That is true. But some of the most boring investment strategies, I'm not calling yours boring, Shani, but some of the most boring investment strategies are the most successful. Long-term, buy and hold strategies work, but they're not exactly groundbreaking. It doesn't really give you a lot of ammunition at the barbecue when you're talking to your mates.
Jayamanne: I'll take boring, but that's basically what I'm going to describe today. So, thank you for ruining my punchline.
Lamonica: Yeah. Yeah. No worries. I think there is a little bit more than just that line that I gave Shani. So, if your rationale for buying me a multi-level marketing company for Christmas, which we got in trouble for calling it that, is anything go by your strategy is very well-thought through?
Jayamanne: Thank you, Mark. So, for those that missed our Chrissy episode, I bought Mark a share in a multi-level marketing company because it shares the same initials as his nickname, MLM. So, let's see if my actual strategy is more thought out than that.
Lamonica: Okay. Well, one thing to note is Shani has published an article on morningstar.com.au that goes into not her Christmas gift for me, but the strategy in depth. And it's titled My Disinterest in Investments as an Investment Specialist. And that's actually Shani's title, Senior Investment Specialist.
Jayamanne: I know. There you go.
Lamonica: Crazy. So, why don't you go on and talk a little bit about this to the podcast listeners?
Jayamanne: Okay. So, you can certainly add to this, but when we write our pieces, we have a reasonable idea of how popular they'll be. The list of the most popular articles on morningstar.com.au is predictably filled with pieces on shares. And given our audience, this makes a lot of sense. We have self-directed investors that are largely invested in equities and are hobbyists.
Lamonica: And we are an equity research house after all, and our readers enjoy the art of investing. And we like providing in-depth analysis on companies. The readers enjoy picking winners and investing towards their financial goals. So, sometimes we spend days on articles that we're really proud of, but no one else thinks so. And not a lot of people read them.
Jayamanne: Well, hopefully, they have a long tail, Mark, but most of these investors are looking to make well-informed and thoughtful decisions about investments that will impact whether they'll achieve their financial goals, whether that be a comfortable retirement or paying for education, purchasing a home or travel. Investment selection is important. I'm not trying to change the perspectives of that camp. I'm here to provide the perspectives that successful investing does not mean constantly searching for new investment opportunities.
Lamonica: Yeah. No. Absolutely, Shani. So, most investors believe that investment success requires finding the best investments. The foundation of this belief is that, at any particular moment, there are investments that are good and will outperform in the immediate future and ones that are bad that will underperform. And this view is reinforced and encouraged by professional investors who are, guess what, selling investments and their ability to navigate markets to find opportunities.
Jayamanne: And I've come to an approach that kind of flips this around. And this isn't revolutionary. It's not some secret strategy that I've been keeping close to my chest. It's what we talk about day in, day out. It's about prioritizing your goals over investment selection. So, at the center of this strategy, is that selecting individual investments for my portfolio is not really my primary concern.
Lamonica: And Shani lays out the technical reasons in her article and some circumstantial reasons. So, why don't we start with the technical? Because we all know that Shani loves to study.
So, in 1986, before Shani was born, Brinson, Hood and Beebower's paper, Determinants of Portfolio Performance, which sounds like a page turner, attributed 93.6% of investment performance to asset allocation. But it's important to note that the paper focus not on the return level, but on the variation of returns.
And in 1991, also before Shani was born, there was an update to the paper that concluded that active decisions on investment selection by pension plans, which were used as a basis for the study, made little improvement to performance over a 10-year period. The paper championed a focus on strategic asset allocation over the long-term to increase the chances of reaching successful outcomes.
Jayamanne: And there were several adaptations of this research by other academics, including Ibbotson and Kaplan's report in 2000. I was born then, Mark. Does asset allocation explain 40%, 90% or 100% of performance? And they focused on a key question for investors. What percentage of the actual return comes from the asset allocation decisions that they make? Ibbotson explains the results in a CFA Institute paper from 2010. So, Mark, since your voice is closer to Ibbotson's in mind, do you want to do the quote?
Lamonica: Have you heard him speak or this is just like a gender thing?
Jayamanne: I'm just assuming.
Lamonica: Okay. Ready for the quote, Shani? Asset allocation policy gives us the passive return, which is known as beta in finance jargon, and the remainder of the return is the active return, alpha or excess return. The alpha sums to zero across all portfolios before costs, because on average, managers do not beat the market. In aggregate, the gross active return is zero. Therefore, on average, the passive asset allocation policy determines 100% of the return before costs and somewhat more than 100% of the return after costs. The 100% answer pertains to the all-inclusive market portfolio and is a mathematical identity at the aggregate level.
Jayamanne: So, if anyone's still listening…
Lamonica: I almost fell asleep reading that quote.
Jayamanne: Yes. In plain English, Ibbotson's point is that because most investors can't put together a portfolio of individual investments that beat the index, the only driver of returns is the asset allocation of their overall portfolios.
Okay. So, let's move on to the second guiding principle of my investment strategy. And that's really to focus on factors that are in my control as I try to build wealth and achieve my goals. And something that is very much in my control is savings. Minimizing taxes, fees and limiting the impact of poor decisions on my investments are also relatively within my control. So, I have rigid savings goals that are governed by my investment policy statement or IPS and I try to consider those as non-negotiable fixed costs.
Lamonica: And we're talking about technical justification because of the 18 papers that Shani cited, but there aren't going to be any academic papers on the importance of savings. It is pretty simple math. We contribute $1,000 a month and are able to contribute $100 extra. That's the equivalent of a 10% monthly return. Of course, there are caveats to this. There's an opportunity cost attached to extra contributions. You don't get to spend the money. You don't have the same cost with investment returns.
Jayamanne: I'll touch on my experience with savings and how it's formed such an integral part of my perception of successful investing a little later on.
Lamonica: All right. So, we've covered all the academic justifications and arguments for asset allocation and savings. Why don't we talk about this in practice, Shani?
Jayamanne: Okay. So, I've got a little bit of a Preamble to this and that's kind of looking at the other side of the coin. There are two types of investors that prioritize security selection. There are investors and then there are speculators. New investors tend to attack security selection first. Strong returns are often an inducement to get into the market. And we saw this with the influx of new investors in 2020 and 2021. And these investors rode the wave of COVID market returns and gained premature confidence in their investment selection capabilities. It was a momentum-fueled rally and buying shares, which have done well, paid off. A large cohort of these entrants, I would classify as speculators making tactical allocations based on recent performance.
Lamonica: And this was a perfect example of riding the asset class wave and mistakenly attributing it to the prowess of the individual. Since then, there's been more volatility, but markets continue to climb and reach new highs. A contraction, which is basically a reality check, is inevitable. We've historically had a bear market every 3.5 years and it's folly to think that we will continue to avoid one going forward.
Jayamanne: And this situation is avoidable when building a portfolio from the foundations up. Anchoring your investments to a goal means that you'll have an intimate understanding of the purpose of each security in your portfolio. It'll be part of an allocation to an asset class that is connected to returns required to reach that financial goal. It will prevent poor behavior by selling at inopportune moments to try and time the market or because holding an investment you have surface-level faith in drops which makes you nervous.
Lamonica: What's also worth mentioning about bear markets is that tactical allocation of funds can severely rig the game against you. We did speak about this in our Timing the Markets episode. But over the last 30 years, if you miss the S&P 500's 10 best days, your return would be cut in half. You miss the best 30 days over the last 30 years, your returns will be a shocking 83% lower. This is why timing the markets is an issue, but also why an overreliance of tactical asset allocation in your investment strategy can also be an issue. Not being invested in the right securities means missing most of those days. 78% of the best days occurred in a bear market, which I think this informs your strategy, right, Shani?
Jayamanne: Yeah. I don't want to miss out and I'm perfectly content capturing the average return of the market.
Lamonica: And just as bull markets drive new investors, bear markets cause people to give up. Those that don't quit may find their way to adopting a strategy that focuses more on what they are trying to achieve rather than the vehicles to get there.
Jayamanne: I know this situation very well because I used to be one of these investors who focus more on investments than investing. When I first started investing, I purchased funds that had sex appeal with terms such as Pure Alpha, Long Short and Innovation in the name. I was extremely lucky that I invested during a very long bull run and didn't get badly burned. And the good times kept rolling as equity markets continued to trounce other asset classes. As my career progressed, I felt an obligation to start making direct equity investments to justify my work. I didn't get burnt, but I was sitting in a stock pot that was coming to a rolling boil.
Lamonica: I think it's interesting that you invested in a fund that had Pure Alpha in the title because you had a fish named Alpha.
Jayamanne: Yeah. Namesake maybe.
Lamonica: Yeah. And the fish died.
Jayamanne: Yes, it did.
Lamonica: So, maybe that was time to sell out of the funds. But all right, you put a lot of metaphors into that, Shani.
Jayamanne: Yes.
Lamonica: So, I guess what changed when you started investing in these stocks that you thought you had to?
Jayamanne: So, I guess I started understanding myself better as an investor through these holdings. So, I learnt two main things. I get incredibly nervous with direct equity holdings and I tend to spend a lot of time overanalyzing my decision and seeking information to confirm I made the right decision.
Lamonica: Something that you do with your own life as well.
Jayamanne: I don't need to do it for my investments as well.
Lamonica: Yeah. You apply this to everything you do in life.
Jayamanne: I do.
Lamonica: Anxiety and overanalyzing what you do.
Jayamanne: Yes.
Lamonica: Okay. That's good.
Jayamanne: And as you can imagine, it's incredibly exhausting. So, this was one less thing that I needed to be exhausted about. So, this is where I realized that a large part of investing is understanding what works for you and deeply understanding yourself as an investor. Investing was a means to an end for me and not a journey I would actively enjoy along the way.
Lamonica: Okay. So, how has this impacted the way you invested today? You were in a Pure Alpha fund. You had a fish named Alpha. Fish is dead; fund went away. So, what does your portfolio look like now?
Jayamanne: Okay. So, if we fast-forward to today, my portfolio outside of Super consists of cash and collective investment vehicles, so managed funds and ETFs. The investment vehicles are concentrated mainly in equities and my cash portion is held in my emergency fund.
Lamonica: Okay. Well, I mean, how has this changed your outcomes? I know you're not there yet, because you're still young. But yeah, what do you think these changes have done for you?
Jayamanne: Okay. So, I no longer feel the need to continually justify my investment decisions at every turn of the market. And my portfolio is connected to strong foundations to my goals. I have a strong understanding of why I hold each position and why it behaves the way it does through different market conditions.
This understanding and the connection to my goals means that I am not tempted by each new opportunity. I have a long time horizon for my capital to grow and compound. I've evolved my perception of investing from maximizing wealth to building a model that works best to maximize my outcomes.
Lamonica: And this has other flow-on effects for you and other benefits. So, you're more tax-efficient, I imagine. You've lowered your transaction costs. You're cost-conscious and you stay invested for the long-term.
Jayamanne: I try to.
Lamonica: Yeah.
Jayamanne: We'll see. Yes.
Lamonica: So, as part of this, you've also thought about investment structuring, so that your investments are in the most tax-efficient vehicles. And these benefits are hugely important as an investor because Shani has assessed the actual total return of investments. We did a podcast on this, and you wrote an article on it. It goes through how much, in real terms, these factors detract from your returns.
Jayamanne: That's right, Mark. I've also prioritized savings. And this is a hard lesson to learn without experience. But I was fortunate to work early in my career at a fund manager where I could see the history of individual accounts. And this drove home the importance of contributions and compounding to building wealth.
So, I worked in client services and with transaction histories and account balances all day. And it was basically viewing a blueprint to building wealth. I saw how individual investors had built up their portfolios over time. And going into this job, I believed that investing was for the wealthy and had no exposure to it growing up.
Working in this role, it allowed me to see every type of scenario imaginable played out, including those that were contributing small amounts per week over a long time period. I have not had any lumpsum windfall, and I don't expect anything in the future. So, I know that for me, to build a comfortable life, I need to prioritize saving to build my capital base. And this approach resonated with me on a graduate salary, and it kickstarted my journey with investing.
I know that selecting investment spring, a lot of people enjoy, I'm much more focused on investing regularly in the right asset allocation and committing over the long-term. I believe that it'll provide more of a difference to my outcome than choosing between two stocks.
Lamonica: Well, there you go. And we've gone through this whole investment strategy. So, clearly, you have a very hands-off approach. I'm asking, and this may or may not determine if you have a job after this podcast, why would you decide to make your whole career about investments? Because as we mentioned before, your title is actually Senior Investment Specialist.
Jayamanne: Well, we just had my quarterly review, Mark. And before I joked, and I said, should I just clear out my locker now, and he said, no, security needs to watch you do that.
Lamonica: Yeah, no. And we should add one thing about your quarterly review. So, as part of this anxiety that Shani has for her investment, she also has it for quarterly reviews.
Jayamanne: Well, yes.
Lamonica: And how does your anxiety come out in reviews?
Jayamanne: I smile a lot.
Lamonica: Yeah.
Jayamanne: So, even during very serious conversations, I'm smiling quite broadly.
Lamonica: Yeah. It's kind of bizarre. It's like giving a review to the Joker. But...
Jayamanne: Well, I guess...
Lamonica: Yeah. Back to the question. How did you end up in this role?
Jayamanne: What was the question?
Lamonica: How did you end up in this role?
Jayamanne: Well, look, I guess my answer is that I didn't focus on investments. And during the story, where I had that light bulb moment at the fund manager, I asked myself, why doesn't everyone invest. And the answer is that some people don't know that it's a viable way for them to build wealth. And a lot of the people that could drastically improve their outcomes for themselves and future generations have not been exposed to their version of the blueprint. I think it's very fulfilling to be able to make this information accessible to everyday Aussies and all types of investors. I know that it's very fulfilling for you as well, Mark.
Lamonica: Yeah. No. Absolutely. I think the funny thing is that you spend a lot of time at the beginning saying that this is the way you invest and not the way I do. But ultimately, what I do is pretty boring, too. Like, I think I enjoy picking shares certainly more than you. But I generally don't ever sell them and just slowly try to save and invest more. I just like watching the income generated by them tick up. So, there are some similarities.
Jayamanne: Well, there you go.
Lamonica: Exactly. Mine meld.
Jayamanne: Yeah. Well, I guess I have one last comment. So, my investment philosophy, it is individual to me and it has evolved over time. I'll imagine it will continue to. I think that's the beauty of investing. It's being able to take on other perspectives, many of which I'm lucky to have shared with me by readers of the articles and listeners of the podcast. But it is understanding what works for you and understanding that all of this is really just a journey to create a better life for yourself and your loved ones.
Lamonica: Okay. I have one more question for you. Have you converted anyone to this approach?
Jayamanne: I have actually. Yeah. I have some friends that follow the same approach.
Lamonica: Now, did you convert them from something else or did they come to you before they started investing you? You said this is the approach to do. Or do you have like a friend that was a day trader and all of a sudden they're just following the Shani approach?
Jayamanne: Well, I have a few friends that come from all different types, like all of the ones that you mentioned. But I wrote an article recently called Transitioning to a Grown-Up Portfolio. And that was based on one of my friend's experiences. She came to me and she said, I've made a lot of mistakes and I just wanted to get invested in the market. I knew I had to invest and I bought really bad investments. She used another word for bad. And she's like, how do I get to a grown-up portfolio. So...
Lamonica: There we go. Yeah. I read that article and I was like, you've transitioned to a grown-up portfolio. I'm much older than you. I'm not a grown-up. I guess you don't have to be a grown-up to have a grown-up portfolio.
Jayamanne: No. I guess not.
Lamonica: But anyway, thank you guys very much for listening. We would love it if you could fill out that survey. It will be very, very quick and it will be helpful for us. And of course, you could potentially win this $250 gift card, which buys Shani approximately two drinks because she has very expensive taste. But anyway, thank you very much for listening, and we'd appreciate you filling out the survey.
(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)