Embracing Prejudice

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If there’s one quote that I’m really a sucker for it is this one;

“This above all: to thine own self be true.”

That Shakespeare was quite a fellow.

In this one simple line he captures so much essential wisdom.

Off the top of my head this truism suggests that we should all aspire to :

  • Truly get to know ourselves as individuals.
  • Spend time considering difficult truths about ourselves that are as inescapable as they are frightening.
  • Understand the difference between trying to embellish ourselves into something that we are not, and trying to simplify ourselves into something that we already are.
  • Live our lives in a way that is consistent with our own essential natures and morals.
  • Turn away from the ideals of artifice and perfection, and towards the ideals of honesty and acceptance.

Which all sounds a little bit touchy feely, I will admit.

But this idea of self acceptance, warts and all, just has the ring of truth to me.

(I imagine this process of self-learning to be similar to looking at oneself with the cool and calculating eye of a casting director who knows that it would be as fruitless for Woody Allen to try to play Arnold Schwarzenegger, as it would be for Arnold Schwarzenegger to try to play Woody Allen.)

Sleeper“I’ll be back”

And one of the areas where the search for my own authenticity has been most rewarding has been in the designing my own investment strategy.

I’ve already sung the praises of reading investment books.

Is important to understand the basic vocabulary of investment before you can make an intelligent choice about what you should invest in, after all.

And it’s also important to read different authors so that you can recognize the logic and style that conforms most to your own worldview.

But once you’ve read a few books it becomes possible to perform some amateur self-analysis using the vocabulary of the economy.

So let me pull back the curtain and allow you to peer at me lying on my self analysis couch going through economic concepts and sorting through them based on nothing more than my own inescapable prejudices and proclivities.

Active vs Passive Investment

The evidence is in, and it’s clear. Passive investment beats active investment 80% of the time over long time periods. (And being in the Lucky 20% of over-performers ((and I mean “lucky” quite literally, here)) does not pay you commensurate with your actual risk of underperformance.

My take: I’m an absolute sucker for data-driven conclusions, and evidence-based practices, and the scientific method, and most other things that I suspect to be useful in predicting outcomes.

Take home: I’m all passive mutual funds and ETFs all of the time.

Beta 

This term describes the inherent relationship between risk and return in the market. The entire market, by definition, has a beta value of 1. So any asset class with more volatility/risk than the market as a whole will have a beta value higher than 1, and any asset less volatile or risky than the market will have a beta value of less than one.

My take: although I consider myself a realist who understands that risk and return are related, I’m frankly not a huge fan of risk. I don’t like gambling. And I’m not much of an adrenaline junkie.

So I hold my nose and accept beta by investing broadly in stocks. But I’m not trying to hit homeruns, and I’m not willing to borrow money in order to invest “harder” in the market. (I don’t use leverage to chase higher returns in exchange for higher risks.)

Take-home message: My base portfolio is 75% stocks and 25% bonds. (My beta is less than one.)

Value

The value factor states that cheap companies will perform better in the long term relative to expensive companies.

Cheap can mean that the price of the stock is low relative to its assets, or that the price of the stock is low relative to its earnings.

And this cheap price means that the market as a whole thinks that this stock is worth less than other stocks of similar assets or earnings.

In other words, these are “bad companies.”

Academic research shows that “bad companies,” (value stocks) outperform “good companies,” (growth stocks) in terms of total returns over long periods and in all market types.

The two main explanations for this fact are:

1. Behavioral Economics: WHich posits that people have an irrational attraction to good companies (everyone likes a winner), which irrationally bids the price up.

2. The Efficient Market Hypothesis: which posits that “bad companies,” are in fact more risky and more susceptible to the loss of value during price shocks and market corrections.

My take: I come from a long line of cheapskates, and I’m very attracted to this idea of value. I like buying things on sale and I can’t resist a good bargain. (Miles game anyone?)

Take-home lesson: I tilt my portfolio heavily towards value funds.

Size:

The size factor states that smaller companies have outperformed larger companies over long time horizons in the stock market.

Most agree that this is essentially a risk story. Smaller companies are more volatile and more likely to lose significant value during times of economic stress as they often have less ballast to survive in turbulent seas.

My take: I was one of the smallest boys in my class all the way through the middle of high school. So I love a good underdog. On the other hand I’m also somewhat risk-averse (see Beta.)

Bottom line: I tilt my portfolio towards small size but not as much as I tilt my portfolio towards value.

Momentum:

The momentum factor states that assets that have recently done well are more likely to do well in the near future, and that assets that have recently done poorly are more likely to do poorly in the near future. This factor has been demonstrated to increase returns in almost every market type and location.

The main explanation for this observation is behavioral, that people do not like to get rid of recent winners and do not like to buy recent losers.

There is also some recent research that suggests that the flow of institutional money in and out of funds plays an important role in generating price momentum.

My take: Momentum is a bet on the irrepressible irrationality of human beings. This is a bet that I am willing to make any day of the week.

I also love that momentum stocks tend to be growth stocks, so momentum funds are great diversifiers for value funds.

My bottom line: I don’t meaningfully tilt my portfolio towards momentum yet, mostly because of my limited access to momentum funds, (MTUM is an option available to most investors, but not an option my retirement accounts) but I’m strongly considering the momentum play in my future portfolio.

Quality:

This is the newest factor, and it’s observation is that the returns of the stock of companies with high cash flow relative to reported earnings outperforms that of companies with high reported earnings relative to cash flow.

My take: I don’t have one yet. More research is required on my part

(But I do like the name. )

Real Estate:

There is evidence that real estate is a good diversifier, and a reasonable hedge against inflation. On top of this, real estate likely represents about 10% of our economy and is not proportionally represented in the universe of publicly held companies.

My take: I’m a big fan of diversification in general, and aside from tilts, I like the idea of my portfolio reflecting the general composition of the economy. It just sort of feels right to me. I’m honestly don’t know why.

Take home: I keep 10% of my equity allocation in real estate investment trusts.

International Diversification

America makes up about 50% of the world economy. There is evidence to suggest that past investors have been rewarded over the long term with up to at least 40% international diversification in their Equity portfolios.

My take: In general I’m not a big proponent of American exceptionalism. There are few countries I’d prefer to live in, but I’m also a big believer in the “home-field bias” which states that people tend to overestimate the positive economic attributes of the place where they happen to live. (Who could’ve blamed a Japanese national for being bullish on the exceptionalism of the Japanese economy in the early 1990s?)

The bottom line: if it were every bit as cheap to invest in international funds as it is to invest in domestic funds I would probably be 50-50 between domestic and international equities.

Since domestic funds are a bit cheaper, apples to apples, I am 60% domestic/40% international funds in my equity holdings.

Tactical Asset Allocation

Research holds that stock valuations matter. Buying stocks on sale is more profitable, and buying them at a premium is less profitable. In general somewhere between 40 and 50% of ten-year returns are inversely correalated to the CAPE ratio alone at the time of purchase.

I particularly like William Bernstein’s description of tactical asset allocation as “over rebalancing:” When you rebalance you sell recent good performers and buy recent bad performers. (So this is a way of buying low and selling high.) With tactical asset allocation, you sell even more your good performers and buy even more of your poor performers based on some predetermined measurement of market valuations.

My take: I see this strategy as being very much one of a kind along with with tilting towards value and simple rebalancing. It is a way of automatically forcing yourself to buy undervalued assets and shed overvalued assets.

Bottom line: I decrease my stock exposure at very high levels of stock market valuation, and increase my stock exposure at very low levels of stock market valuation.

So there you have it: my investing philosophy.

anchorman

Woohoo!

The reason I share it with you is not because I believe it to be a generically good philosophy (aside from the preference for low cost passive funds), or because the particular make up of my plan is at all pertinent to you as an individual.

It will almost certainly be outperformed by many millions of other investment plans in the coming years.

My only contention is that this is the perfect investment plan for me. And my faith in this assertion lies simply in the fact that it conforms to my own specific biases, and way of seeing the world.

My central hope is that when the going gets tough, the fact that this plan is tailored to my own peculiar prejudices will make it easier for me to stick with it through thick and thin.

For this is another truth that I hold to be self-evident. That in investments (as in most things) stick-to-it-iveness is the ultimate determinant of success versus failure.  So authenticity and self-knowledge matter.

(Which I think is what Bill Shakespeare meant, in that little skit, Hamlet)

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2 Responses to “Embracing Prejudice”

  1. serdar July 9, 2014 at 10:35 am #

    There is a better way. Sell your stocks based on the 12 months moving average. If the stock market crosses the moving average going down, sell it and buy it when it crosses going up. If you do this based on monthly closes, you basically get the same returns, but drawdown goes down significantly. Instead of 50% max drawdown, you have 18% or something like that.

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