Exactly five years ago I started this blog, an eternity in the blogging world. I follow dozens and dozens of value investing blogs, but most of them disappear just as fast as they appear. I guess everybody has different goals and expectations when they start a blog. My main goal of starting a blog was to become a better investor. I thought that writing down why I make buy/sell decisions would force me to act more rational because I know that my reasons will be scrutinized by my readers. Writing something down while knowing that people will read it is useful in itself, but getting actual feedback is also quite valuable. I have changed my mind more than once on an investment thanks to readers knowing more than me.

A bit more unexpected is that I found the blog also a great tool to generate new ideas. A lot of the ideas that have been published on this blog have originated from like-minded readers that wanted my input on a certain idea, or were just happy to give a good idea as a sign of appreciation. So keep those idea’s coming, and I’ll continue blogging for another five years!

To take advantage of a small signup bonus at the Dutch insurance company “Nationale-Nederlanden” I applied for an account that would let them invest a bit of money for me. Based on a couple of questions they assign you to a model portfolio, and for doing this they charge a management fee of 1.0%. They assigned me to the “neutral 2” profile, that is pretty conservative with an allocation of 40% equities and 60% bonds. Since I don’t intent to keep this account strictly longer than necessary for the signup bonus, I don’t really care how they invest the money. Nevertheless, I was sort of surprised how crappy the portfolio is that you get:

As you can see they put my money in a bunch of random mutual funds that add another layer of expenses. In the case of my profile these funds add 0.66% in expenses, so you pay 1.66% annually (more if you don’t meet certain minima). Of course, they managed to tuck in some of their own funds in this list and then it’s just a crappy mix of overlapping funds. There are for example two global bond funds (and there is a third one with inflation protection) and also three European corporate bond funds. And that’s just the tip of the iceberg… Investing like I do isn’t an option for everybody, but this is without a doubt a terrible deal for anyone. Just buy some cheap ETFs! It’s really sad how the big financial institutions are mainly in the business of selling the biggest crap they can get away with. I can’t really complain, because I’m just in it for a small bonus, but imagine someone who’s putting his life savings in this…

Disclosure

I have invested a whopping 50 euro’s in this crap, and already lost 3.89 euro…

“It’s not supposed to be easy. Anyone who finds it easy is stupid.”
Charlie Munger

I started writing a post about how the recent market volatility provides a good moment to reflect on your skills as an investor, but I realized that the more interesting topic – that is somewhat related – is how easy or hard it is to outperform the market. I think this is really the most important question that every investor faces since the answer has huge implications on what kind of strategy you should follow. While this is a very fundamental question I don’t think there has ever been a good definitive answer. Are markets almost perfectly efficient and is your best bet an index fund? Do you need 150+ IQ points and read 500 pages/day to have a shot at out performance? Can you have an edge with an average or below average intelligence, but with a contrarian mindset and enough time? Can you be successful if you are really smart, but when you lack the “magic” psychological profile?

What kind of people should consider what kind of strategy?

Usually, this is a question that isn’t even asked when people ask for investment advice. Ask for investment advice on boggleheads.org and everybody is going to advise a portfolio of low-cost index funds. Ask the question somewhere else and they probably recommend their own strategy; which could be buying owner operators, compounders, cheap value stocks, magic formula stocks, swing trading, forex trading, and whatever else exists.

Some of these strategies are probably not a good idea even if you are a genius and have a massive amount of free time (hint: forex trading) while other strategies could be executed by anybody with little effort. But being able to differentiate between a good and a bad strategy is also a skill. Some people might stumble on CoBF.com when they start out as an investor and go for some value strategy while other might stumble on a forex trading site and go that route. If your process for choosing a certain strategy is flawed the possible alpha of that strategy is not really your alpha. And if you are really smart and could generate alpha, but go for a passive indexing approach because that strategy sounded more convincing it’s also proof that investing is hard (unless of course it’s a conscious decision but you, for example, go for indexing because you have a lack of time or interest in investing) .

When I started investing I wasn’t at all convinced about my ability to beat the market, but I knew that there was a large amount of evidence that retail investors underperformed their benchmarks by large amounts by structurally buying high and selling low. I figured if they are able to underperform by such a wide margin I should be able to do well by just trying to do the opposite. That’s easier said than done, but on a day like “black Monday” I thought that the correct course of action was pretty obvious: buy stuff when you see ridiculous trading activity. I bought, for example, some Retail Holdings – because that is a stock that I know – at ~$16 because someone was selling at any price and no-one was buying. In some ETF’s there were even bigger opportunities, but I was too late to that party.

There is actually some research that suggests that intelligent investors are better at buying low and selling high. It doesn’t really sound like a surprising result, but it’s not easy to research since your broker usually doesn’t know your IQ. But in Finland nearly every male of draft age is IQ tested, making an interesting paper possible. Especially this graph that shows when people in the 1995-2002 period were buying tech stocks is pretty neat:

So I think if you are reasonable smart (maybe 120+ IQ?) and have enough time to research strategies and stocks active investment is perhaps worth a shot. I don’t really think that having the right mindset is extremely important because I think that is largely created by having the right knowledge (for example knowing that selling in a panic is almost the worst thing you can do). But I wouldn’t be surprised if many people think differently, and I also wouldn’t be surprised if I’m wrong about this. Anyway, enough rambling. To sum it up; I think that what people should do really depends on their intelligence, education, available time, their personality and probably other factors that I’m missing. There is no strategy that is a good fit for everybody. Indexing isn’t the right strategy for everybody, nor is value investing.

You have to be brutally honest with yourself about what is the right strategy is for you.

While browsing around on the web today I encountered an article from early 2009 that argued that most/many claims that are made in favor of fundamentally weighted indices are flawed. Before continuing reading this post, I would suggest reading the article. It’s just three pages in a large font, and I don’t want to repeat the complete argument :).

Intuitively the argument for fundamentally weighted indices is compelling. If the market is not efficient then stocks that are overvalued have a bigger market cap than they should have and stocks that are undervalued have a smaller market cap than they should have. If you now buy this market you must by definition underperform compared to the case where every security is fairly valued, right? Or perhaps wrong? Can you argue with the example below?

Consider a two-company world. Company A has a fair value of $10 billion with a market value of $9 billion, and Company B has a fair value of $5 billion with a market value of $6 billion. If we have a $150,000 market-capweighted portfolio, it will have $90,000 in Company A, the undervalued company, and $60,000 in Company B, the overvalued company. It will not have most of its money in companies that are above fair value—it will have most of its money in the company that is below fair value.

He is absolutely right that you have more money in the undervalued company in this example than in the overvalued company! But what is important to note that the undervalued company is less undervalued than the overvalued company is overvalued. The result is that the total market value of both companies remains equal and, as a result, both market efficiencies offset each other. If you would buy the complete market it would cost you $15 billion in both cases and in both cases you get company A and company B. Doesn’t matter if you overpay $1 billion for company B and underpay $1 billion for company A. The net result is exactly the same!

So when we add as a constraint that if the market as a whole is fairly valued the conclusion that the author draws is inescapable: there is no hidden performance drag by buying a market cap weighted portfolio. If you don’t overpay for the market as a whole it doesn’t matter that for some individual securities you overpay and underpay for others.

But this is of course only true if the market as a whole is correctly valued. Whether or not this is true depends on how market inefficiencies manifest themselves. Let’s take a look at a market with two companies, but to make things even simpler both companies have a $10 billion fair value. Let’s say that on a single day there is a 50/50 probability that a company drifts 1% away from fair value, either up or down. After one day the market is expected to look as following:

So it seems like everything is still well for the argument that market inefficiencies – represented by random movements away from fair value – don’t make a market cap weighted portfolio inferior compared to buying the stocks at intrinsic value. If you would buy the whole market you still get the same two companies at the same price!

While this model appears to be reasonable there is one major flaw, and that is the fact that these returns introduce a bias when we start compounding across multiple periods. A plus 1% return followed by a minus 1% returns doesn’t net out to zero. If we would alternate a long series of +1% returns and -1% returns the market cap of both companies would converge to zero. That wouldn’t make sense! To remove the bias from the expected returns we need to combine random movements of plus 1% with minus 0.9901%:

• $10.0 billion * 1.01 = $10.1 billion
• $10.1 billion * 0.990099 = $10.0 billion

What we are basically saying that market prices are log-normally distributed around fair value. The log-normal distribution is asymmetrical, as it should be because asset prices can’t go below zero. I think that by now you can guess what the impact will be if we redo our table:

Because of the small difference in the up- and down move we lose the result that the market as a whole remains fairly valued, and as a result, a market-cap weighted approach will be at a disadvantage compared to a fundamentally weighted approach. Buying these two companies at fair value is better than buying them at their combined market cap.

Is this a reasonable result? Small-caps stocks are known to outperform large-cap stocks. The traditional academic view is that the difference in performance is the result of differences in risk between small and large stocks, and to some extent that is probably true. But a part of the performance differential could also be caused by the fact that undervalued companies have a smaller market cap than overvalued companies when they have an identical intrinsic value.

So, to summarize: I think that the intuitive idea that a fundamentally weighted index should outperform a market cap weighted index is actually correct. Whether or not it works in practice depends on how inefficient the market is compared to the added trading costs that will be incurred by a fundamental weighting.

At the end of the year, when people inevitably start comparing their performance with others one common theme usually emerges: every great stock picker runs a concentrated portfolio. When you “only” generate a 15% positive return while others are making 30%, 50% or even 100%+ it’s easy to envy those mind-boggling returns and start wondering what you should do to emulate those results. When you learn that those results were without exception generated by investors who had the balls to concentrate on just a few good ideas the implication seems obvious: time to bet big!

And as a matter of fact the undeniable truth is that the only way, to achieve those mind-boggling returns, is by having a concentrated portfolio. Intuitively concentration makes sense, but unfortunately everybody’s intuition sucks at statistics. What is ignored here is the base rate of people trying a concentrated strategy. How many shoot for the moon only to end up with an evaporated portfolio at the end of the year? Because that is the flipside of the story; the investors with the mind-boggling losses are also the concentrated investors! But that is, of course, a story that most people prefer not to tell (kudos to the few that do!).

Let’s believe for one second in an efficient market and imagine that 50% of investors are concentrated and 50% are diversified. Since the market is efficient no-one can generate any alpha, yet at the same time a large number of investors is expected to outperform the average. The diversified investors should generate a return that is close to the average, but approximately 50% of the concentrated investors – 25% of the total population – is expected to outperform the average while the other half is expected to underperform. Depending on how concentrated they are some could outperform spectacularly. A naive interpretation of the phenomenon would be that concentration would be the way to go while the opposite is true since it only increases risk in an efficient market.

If you are reading this you probably don’t believe in an efficient market. I know I don’t. But the reality is that most outcomes in investing are the result of random noise. You can’t know what will happen. No-one expected oil to drop from $80/barrel to less than $50/barrel in two months time. No-one expected that the Swiss franc would gain 30% in minutes yesterday. You can only expect the unexpected. And the only realistic way, to protect yourself against the unexpected, is to be diversified across industries, countries, and asset classes.

Another problem with the large amount of luck that is involved in investment results is that it is easy to look like a genius and think that you are while you aren’t. Even when you are a pretty good investor it is incredibly hard to be right consistently, and you are probably delusional when you think that you can outperform the benchmark by a large margin. But the bigger problem is – even when you are realistic about your skill – that there is a large amount of uncertainty about your skill level. There is always the possibility that you don’t add alpha.

If you concentrate and you are wrong about your skills it is almost inevitable that you will blow up at some point in time. Betting too big relative to the expected value of the bet will result in a suboptimal geometric growth rate: that’s what Kelly teaches us. Investing isn’t about hitting a great return in a single year. It’s not even about generating on average a great return: any series of returns, that includes a zero, has a zero as the final portfolio value! The geometric growth rate is the only thing that matters and if you keep everything else equal you maximize it by reducing variance.

To be fair: at the same time Kelly also provides a strong argument for concentration. If you find a great idea with limited downside and/or a small probability of a large loss and a large upside the formula is probably going to suggest that you put the majority of your portfolio in a single stock. But you have to account for the uncertainty in your estimates, including the unknowable, making a strict application of the formula unwise.

It is also only true when it’s the only good bet available. There are more than 100,000 listed companies worldwide. If you aren’t able to find a decent amount of reasonably comparable good bets your are probably lazy or the markets are incredibly efficient. But if they are so efficient is it reasonable to assume that there is somehow one overlooked huge opportunity? That’s not something I would want to bet on, and being lazy is certainly no excuse.

Disclosure

I consider myself to be concentrated and diversified at the same time. The fact that I’m writing this post with 50% of my portfolio in my top six positions is kinda ironic…