In this short note, we set out the evidence-driven approach that we use to invest our clients’ money. As you will see, it is widely supported by many wise and experienced people, from legendary investors like Warren Buffett and Jack Bogle to Nobel Laureates in finance and economics. Its not complicated, but it does require us to do a few simple things exceptionally well.
Being an investor is a necessity for most people
- Investing is simple but not necessarily easy: it is the task of building, or maintaining, reserves of wealth that can help fund financial and lifestyle goals, achieved by owning sensible financial assets that will provide greater future purchasing power than simply holding cash deposits. A well-considered approach leads to robust portfolios and favourable outcomes, overcoming whatever the markets may throw at them.
‘People outside the profession think it complicated. Generally speaking, it is not…On the other hand, though not complicated, investment is difficult. People on the outside think that anyone on the inside should be able to do better than the market indices purely by virtue of being a professional. Sadly not.’ Richard Oldfield, investment manager and author.
A good place to start is with the evidence
- Investing is more science than art: Nobel prize winning investment theory and academic evidence sit at the heart of our process. It is always evolving, which may, on occasion, result in incremental changes to our philosophy and portfolios structures over time. We go where the evidence points us. In reality, change tends to be a slow process. Its essence is captured in the formula below.
The evidence defines our guiding principles
- Have faith in capitalism: capitalism is an adaptive, robust economic system that has delivered incredible benefits to mankind. It may not seem to be the fairest system, yet it has lifted over 2 billion people out of crushing poverty and halved infant mortality over the past 25 years (Human Development Report, 2015: ‘Work for Human Development’, United Nations.). The profit motive gets people out of bed in the morning and makes the world go around. It is also resilient, bouncing back from set-backs and tough economic times.
‘When things are getting better, we often don’t hear about them. This gives us a systematically too-negative impression of the world around us, which is very stressful.’ Hans Rosling, Factfulness: Ten Reasons We’re Wrong About the World—and Why Things Are Better Than You Think.
‘Our system works. Over time, people will live better and better. We have a system that unleashes human potential, and now China has a system that unleashes human potential. We will have interruptions. We overshoot and undershoot sometimes, but your kids and grandkids will live better than you. Over time, we move ahead at a pretty damn rapid rate.’ Warren Buffett, Chairman, Berkshire Hathaway 2009
- Have confidence in the markets: capital markets are a reasonably efficient mechanism for allocating capital and rewarding those who take on the risks of company ownership (by owning shares) and lending money (by owning government or company bonds). We consider that they work pretty well, incorporating publicly known information into market prices quickly and efficiently. That makes them hard to beat.
‘Everybody has some information. The function of the markets is to aggregate that information, evaluate it and get it incorporated into prices.’ Merton Miller, Ph.D., Nobel Laureate in Economics, 1990, (2007) Investment Gurus by Peter J. Tanous
‘So, who still believes markets don’t work? Apparently, it is only the North Koreans, the Cubans and the active managers.’ Rex Sinquefield, Co-founder and board member, Dimensional Fund Advisors
- Let markets do the heavy lifting when it comes to portfolio returns: when investing, there are two main sources of returns: those derived from market risks taken on in portfolios and those that come from professional fund managers trying to second-guess the markets in an attempt to beat them. The evidence suggests that such talent is extremely rare and hard to identify in advance. So, capturing as much of the market return on offer becomes the rational goal for sensible investors. The evidence overwhelmingly supports our approach. It is evident that a keen eye on keeping investment costs low is important.
‘[Active] mutual funds are run by highly experienced and hard-working professionals who buy and sell stocks to achieve the best possible results for their clients. Nevertheless, the evidence from more than fifty years of research is conclusive: for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker.’ Daniel Kahneman, Ph.D., Nobel Laureate in Economics, 2002. (2011) Thinking, Fast and Slow
‘Unless an investor has access to ‘incredibly high-qualified professionals,’ they should be 100 percent passive – that includes almost all individual investors and most institutional investors.’ David Swensen, CIO, Yale University Endowment Fund speaking at the John C. Bogle Legacy Forum
‘The financial “elites” – wealthy individuals, pension funds, college endowments and the like – have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars. This reluctance of the rich normally prevails even though the product at issue is – on an expectancy basis – clearly the best choice. [Buffet is referring here to index funds]’ Warren Buffett (2016) Berkshire Hathaway Shareholder Letter
‘An investor doesn’t have a prayer of picking a manager that can deliver alpha [outperformance]. Even over a 20-year period, the past performance of an actively managed fund has a ton of random noise that makes it difficult, if not impossible, to distinguish luck from skill’ Eugene Fama, Ph.D., Nobel Laureate in Economics, 2013, (2012) CFA Institute Annual Conference
- Accept that risk and return are related: to achieve a higher return, you have to take on more risk. Unfortunately, you cannot escape this fact. If an investment looks too good to be true, it probably just means that you have not identified where the risks lie. The only opportunity to alter this relationship – at the margin – is through diversification. That is why it is an important feature of our portfolio construction.
‘In investing, what is comfortable is rarely profitable.’ Robert Arnott, Founder, Research Affiliates
- Be patient as the tortoise wins the race: accept that there is no easy or quick way to investment success. The longer you hold an investment for, the more it is likely to grow in value and act as it was expected to at the outset. Two steps forward, one step back, is the way of investing; it always has been, and always will be.
‘The stock market is designed to transfer money from the active to the patient.’ Warren Buffett.
‘There is something in people; you might even call it a little bit of a gambling instinct… I tell people investing should be dull. It shouldn’t be exciting. Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.’Paul Samuelson, Ph.D., Nobel Laureate in Economics, 1970 (1999) ‘The Ultimate Guide to Indexing,’
- Be disciplined and ignore temptation: discipline is the anti-dote to temptation and the siren calls of short-term market noise and emotions. When investing, activity such as chasing rising markets, employing ‘hot’ managers, and piling into enticing new products, is almost always in surplus. Short-term falls in value are part of the journey. Falls only become losses if you sell, which investors with a suitably structured portfolio should not need to do. Looking at your portfolio too often is not a good practice.
‘Individuals who cannot master their emotions are ill-suited to profit from the investment process.’ ‘The investor’s chief problem, and even his worst enemy, is likely to be himself.’ Benjamin Graham (1949) The Intelligent Investor; A Book of Practical Counsel
‘Investors, of course, can, by their own behavior make stock ownership highly risky. And many do. Active trading, attempts to “time” market movements, inadequate diversification, the payment of high and unnecessary fees to managers…can destroy the decent returns that a life-long owner of equities would otherwise enjoy.’ Warren Buffett (2014) Berkshire Hathaway Shareholder Letter
Portfolio structure drives success
- Structure drives success: a robust, well-diversified portfolio structure – usually balanced between growth assets such as equities, and defensive assets such as high-quality bonds – should help an investor’s portfolio weather any market storms that come its way. Our portfolios are widely diversified, holding several thousand companies’ shares across both developed and emerging markets. We tend to favour high quality bonds, as this is where scared money heads when markets get rough, which helps support (and sometimes even raise) their prices, providing a strong diversification benefit. We only take on risks that are clearly understood and which contribute something positive to the portfolio.
‘The safest port in a sea of uncertainty is diversification.’ Larry E. Swedroe, The Only Guide to a Winning Investment Strategy You’ll Ever Need
‘Investment success requires the conviction that comes from a fundamental understanding of the rationale for building the portfolio to certain specifications. Unless investors truly believe in the efficacy and validity of an unconventional approach to asset management, the end result almost certainly fails to withstand the wear and tear of market forces.’ David F. Swensen, Unconventional Success: A Fundamental Approach to Personal Investment
‘One cannot judge a performance in any given field (war, politics, medicine, investments) by the results, but by the costs of the alternative (i.e., if history played out in a different way).’ Nassim Nicholas Taleb, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets
- Keeping costs low is critical: relying on markets to deliver returns also implies a tight watch on product costs. Astute investors realise that a penny saved is more valuable than a penny earned, as the former are harvested year-in, year-out.
‘In investing, realize that you get what you don’t pay for. Whatever future returns the markets are generous enough to deliver, few investors will succeed in capturing 100% of those returns, simply because of the high costs of investing—all those commissions, management fees, investment expenses, yes, even taxes—so pare them to the bone’. John C. Bogle, founder – Vanguard
‘If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios [Ongoing Charges Figure or OCF – Ed.] help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.’ Morningstar (2010), How Expenses and Stars Predict Success, www.morningstar.com
- Maintenance is important too: maintaining the integrity of your portfolio structure – through regular review and rebalancing – is really important and something that we do for our clients on a regular basis. We spend considerable effort constructing robust portfolios, making sure that we identify which structure is suitable for each of our clients’ unique circumstances. It makes sense to keep your portfolio at the right level of risk over time.
‘Supremely rational investors take the further step of acting against consensus, rebalancing to long-term portfolio targets by buying the out-of-favor and selling the in-vogue.’ David F. Swensen, Unconventional Success: A Fundamental Approach to Personal Investment
Ongoing governance of our investment approach
- Keeping on top of the program: our investment approach is not a ‘set-and-forget’ process, but an evolving journey. Fortunately, the academic investment community prolifically publishes new peer-reviewed papers and evidence. Ongoing review of this new research may challenge our current thinking and lead to refinements to our investment approach. At the end of the day we go to where the evidence increases the chance of a successful investment experience for our clients. Keeping on top of the risks in portfolios – and the wider investment process – is the role of the Investment Committee. Change is not made for change’s sake but only when the evidence suggests that the portfolio can be improved. Don’t expect a surfeit of activity.
“The finance sector devotes too little attention to the search for new investment opportunities and the stewardship of existing ones, and far too much to secondary-market dealing in existing assets.” Professor John Kay (2016); Academic and author of ‘Other People’s Money: The Real Business of Finance’
Investing can appear complex, but by starting with the evidence we can identify a simple set of rules that allow us to structure your portfolio to navigate through the years ahead and the variety of markets we will undoubtedly encounter together. Stick to these rules, take a long-term view, and have the discipline and patience to see the plan through and you have every chance of being richly rewarded.