Smarter Investing 2 – Smarter Thinking

Today’s post is our second look at Tim Hale’s book Smarter Investing. The section we’re going to look at today is called Smarter Thinking.

Smarter Thinking

Tim’s objective in this section is that you should think about investing, and about your own behaviour, before doing any investing.

He wants you to come up with a set of rules for investment decision making before you get into the practicalities.

• You can’t control the markets, but you can stop throwing money away.

You also need to learn to curb your emotions, so that you can stick to your plan when times get tough.

Investment philosophy

In this section, Tim recaps some of the things we learned in the first section of the book, and that we have covered elsewhere on the blog:

1. you need a plan of what you want to achieve with your money
2. you need an asset allocation plan
3. you need to cut out the noise that leads to emotional pressure
4. you need to keep your costs low (and your taxes low)
5. it’s hard to pick a winning manager in advance

As an example of crazy investor behaviour, Tim tells the story of the CGM Focus Fund, a commodities fund that was the top performer in the US during the “lost decade” of 2000-2009.

• The US stock market ended the decade pretty much back where it started, but CGM made 18% pa.
• At the end of the decade, a $1K investment would have turned into more than $5K.

Yet the average investor in the fund made minus 11% pa.

• The fund’s big year was 2007, when it gained 80%.
• The following year, $2.6 bn went into the fund.
• In 2008 the fund fell 50% and investors withdrew $750M of the $1.3 that was left from the previous year.

As Tim points out, this is classic “Buy high, sell low”.

Developing a philosophy

Tim’s foundation is that the goal is not to win the most points, but to lose the fewest.

• This is similar to Buffet’s Rule Number One: don’t lose money.

But Tim means something more – he means that you shouldn’t try to beat the market.

• Beating the market is attractive – we all want to be “winners” rather than “average”
• But the key thing is to avoid being a loser.

I think this approach is valid in most situations, but not all.

• You can outperform the market by using proven “factors” (momentum / trend following, value, small caps etc.)
• And you can – subject to your own personality and psychology – actively manage a portfolio of stocks from your home country to beat the index.
• In addition, active managers can outperform in less liquid markets.

So we won’t end up with exactly the same philosophy as Tim.

Tim also stresses the asset allocation mix, and here I agree.

• Along with costs and taxes, this is the most important thing to get right.¹

Active strategies

Investors can’t in aggregate outperform the market, since they are the market

• the average performance is the market return, minus costs
• since passive funds have lower costs than active funds, the average passive fund will beat the average active fund
• so will the active fund’s benchmark, which has no costs at all

Every time you buy or sell, someone else takes the opposite side of the trade

• you can’t both outperform as a result
• one of you has to win, and the other lose
• it’s a zero-sum game

So if you want to include active investing in your philosophy, you have to believe that you are better than the average investor.

• this is actually not as hard as it sounds, as demonstrated by the CGM story above

Tim outlines the three main active strategies available to “non-believers”:²

Moving between asset classes according to their short-term prospects

• Generally this is referred to as market-timing, or a top-down approach
• A technical or charting approach could also be used to reach similar conclusions
• Philosophically, it has a lot in common with portfolio rebalancing, which also involves selling “expensive” assets and buying “cheap” ones
• It’s also the process by which an investor takes advantage of proven outperforming factors (eg. by buying value shares when they are cheap)
• So in general, I don’t think it can be excluded from your investment philosophy
• On the other hand, I agree with Tim when he advises investors to ignore fund manager marketing that asks whether “now is the time to invest in Japan?”

Picking better stocks (and / or funds)

• This is usually known as bottom-up investing, or fundamental analysis
• But of course, a technical approach using something like the momentum factor would result in similar decisions (though over a shorter timescale)
• With the largest and best analysed stocks, this approach seems like an uphill struggle, but with stocks too small for fund managers to buy, I believe there are opportunities here
• So once again this is not an approach that I would exclude

Picking better (active) fund managers

• It is probably accepted by most that superior managers can be identified in hindsight, if only mathematically from the performance numbers
• Since some managers must outperform, there is an argument that this outperformance is a matter of luck rather than skill, though this is a debate that cannot be resolved
• So the real question becomes whether it is possible to identify outperforming managers in advance
• I would argue that it is not, or at least that I can’t do it
• I would further argue that many investors choose managers with a proven track record to reduce risk – to minimise the chance of future underperformance – rather than guarantee more outperformance
• It follows that these investors would do better to buy cheaper index-tracking funds that guarantee there will be no significant underperformance, and charge less for the guarantee³
• Active funds tend to have bigger marketing budgets than passive funds (they charge more, after all) and so many investors are initially drawn to them.

Tim also notes that a market timing approach can be dangerous:

• if you are out of the market on its best days, your returns will be significantly impacted
• this is the origin of the quote from Peter Lynch:

I’m always fully invested. It’s a great feeling to be caught with your pants up.

Investor behaviour

The second part of Tim’s section on Smarter Thinking is about investor psychology and behaviour.

• As Tim says, quoting Ben Graham:

You are your own worst enemy.

Simply put, investors follow a value-destroying fear and greed cycle.

• They buy when they are greedy (close to the top)
• They sell when they are fearful (close to the bottom)

As Buffett explained, you need to do the opposite:

Be fearful when others are greedy and greedy when others are fearful.

We have now entered the world of behavioural finance.

• For those who have not already read them, Thinking Fast and Slow by Daniel Kahneman, and anything by James Montier will provide useful background.

We have two systems for thinking – one fast and one slow.

• The fast one was useful when running away from a sabre-toothed tiger, but gets us into trouble when investing.
• You need to force your slow system to take charge.

Psychological blocks

Tim runs through a few of the classics psychological blocks that we face as investors:

1. overconfidence
   • “I am better than the others”
   • you are more likely to make a bad decision after a good run
2. over-activity
   • don’t trade too much
3. “I can see a pattern here”
4. probabilities, especially those involving multiple iterations (like compounding)
5. hindsight delusions
   • it’s much harder to actually predict the future
6. anchoring
   • for example, to the price you bought a stock
7. familiarity
   • the easier it is to imagine something, or the more that you see it in the news, the more frequent / likely you think it is
   • this contributes to the self-fulfilling nature of booms
8. we like stories
   • and therefore story stocks, and predictions from pundits
9. short-termism
   • stop measuring your performance every day
   • the more you check the more likely you are to see a loss
   • think long-term instead

Planning

The way to beat all these traps is to have a plan:

• know what your chances of achieving your goals are
• know what your expected range of returns is
• know what you will do when things get tough
• stick to your asset allocation by periodically re-balancing

Conclusions

That’s it for today.

• We’re now two-fifths of the way through the book, with another three visits to come.

It might seem that I am a long way from accepting Tim’s philosophy that passive investing is the way to go.

• But in fact we have a lot in common.

I agree that asset allocation – diversification – is the most important thing.

• Stocks are the key driver of returns, and I would expect the typical UK private investor to have the majority of his portfolio in stocks.

Based on UK house prices, and the amount of money needed to become financially independent (FI) in the UK, the typical UK private investor pursuing FI will have 25% to 30% of his final portfolio in property.⁴

Of the remaining 70% to 75%, at least 50% will be in stocks, with say 20% in cash, bonds and other diversifying assets.

• Of the 50% in stocks, 25% will be in the UK, and 25% will be international.

Here in the UK, you can safely track the mega-stock FTSE-100 with a passive fund.

• That might take up 15% of your allocation.
• The other 10% could be used actively – either via investment trusts, funds, or direct stock holdings – on smaller, less liquid UK stocks that are below the radar of fund managers.

Internationally, perhaps 15% of the 25% will be in developed markets like the US and Europe, where a passive approach should work well.

• The other 10% might be in less liquid and efficient Asia and Emerging markets, where an active approach – probably through investment trusts – is acceptable.

So across the typical portfolio, I am only suggesting a 20% allocation to an active approach.

• Tim and I are in agreement for the other 80%.

Advanced investors might choose to go active with a portion of their diversifying assets.

• You could try trend-following, or macro bets, or market-neutral pairs trading, or shorting.
• These techniques are not appropriate for most investors.

But even if you were tempted, that would only bring the active allocation up to say 30%.

• And you would still be 70% in agreement with Tim.

I also agree with Tim’s analysis of the psychology-driven failings in investor behaviour.

Where we disagree is in what to do about it:

• Tim thinks that the lesson to be learned is to avoid these traps.
• I think we need to go further and try to do the opposite, which should lead to outperformance.

This is obviously somewhat harder than buying a few index funds, but why not aim for the stars?

Until next time.

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1. Of course, you need to budget correctly, in order to save enough each year – a good asset allocation won’t bail out a bad saver [↩]
2. Or believers, depending on your own philosophy [↩]
3. These funds are generally known as passive, since they track an index; I have a problem with the notion of passive investing, since choosing which indexes to track is still an active decision – no-one tracks what Cullen Roche at Pragmatic Capitalism calls the “market portfolio” of all outstanding global financial assets [↩]
4. This assumption requires you to subscribe to the notion that property is a good investment, which I think that it is, in the UK at least [↩]