Background

Academic theory about investing in stocks is a lot like a map of the London Tube. The map can get you from Point A to Point B, but it is not actually an accurate map of the rail line underground. It is only an easy-to-read, simplistic version of what is really going on.

What this means is that just because the map shows a 90° turn, it doesn’t mean that the rail line actually makes a 90° turn at that specific point in the line. The academic theories behind investing are a lot like this, in the sense that they can often get you to where you’re going over the full route, but if brace yourself for stocks to make a specific turn at a specific time based on the theories, you’re likely to lose your balance, look like a fool, or both.

When I speak to clients and friends about the latest investing fads making the news, I often wind up sounding ambivalent. No, I don’t care about most of what is said on tv, and I don’t have an opinion on whether something is going up or down in the near future. It’s an incredibly good feeling to be able to say, “I don’t know, and I don’t care.” Check out the book, The Intelligent Investor, by Benjamin Graham if you want to know more about where that quote comes from.

But sometimes, “I don’t know, and I don’t care” is not what people want to hear from the person or firm that is managing their money. While one of the biggest benefits an investment advisor can provide to their clients is the dampening of emotional investing, it is still sometimes jarring for a client to hear that their advisor doesn’t have an opinion or even doesn’t “know” what’s going to happen next.

Because of the dissonance that the “I don’t know, and I don’t care” mentality can create between a professional investor and our clients, I’m writing this blog to provide as context when these discussions come up.

Philosophy

“Investing” is a long-term endeavor. When you invest in something, you are expecting a return from that same something over time. Critically, this is quite different from expecting a return because the next person to buy it will pay a higher price, otherwise known as The Greater Fools Theory. The latter is known as “trading”, and it’s not what we do.
Markets may be efficient over the long-term, but markets are comprised of people, and people can do dumb things in the short-term. For those old enough to remember the movie Men in Black, Tommy Lee Jones’s character, Kay, summed it up nicely: “A person is smart. People are dumb, panicky dangerous animals and you know it.” People are people. And even in a world of algorithmic trading, it is people that program the algos or train the machines. And even if machine learning powers AI, it will be people that write the headlines or give the press conferences that help inform the machines. Markets can do dumb things sometimes, for extended periods of time. And when they are behaving that way, they can make smart people look dumb instead. Being smart does not always mean being right when it comes to investing.
“The market can remain irrational longer than you can remain solvent” is a favorite quote, often attributed to the economist John Maynard Keynes, but it’s not so clear he ever said it. I wish I had said it. The point of this notion is that even if you know that the markets are being irrational, you’d be wise not to try to explicitly bet against them. This doesn’t mean you can’t implicitly bet against something by simply avoiding it. In fact, I’d argue that it’s not betting against something at all if you’re just avoiding it. If that were the case, then anybody that didn’t own everything would be betting against something. Avoiding the hottest investment trend may well be the best way to express a negative view on something. Betting explicitly against something can cost you dearly if that something continues to rise in value, despite the “clear” evidence that the trend is a bubble waiting to burst.
There is no such thing as “the market”. People and media will often refer to “the market” in an effort to summarize and/or dumb down a complex set of often divergent movements in global securities (stocks, bonds, etc.). The S&P 500 Index is not “the stock market” any more than Toyota is the auto market. While they are both large, established, respected, and even good barometers of what may be happening in their respective fields, it is simply inaccurate and misleading to reference them as the entirety of those respective fields. Depending on your goals and preferences, the S&P 500 may be as relevant to you as Toyota is to a submariner.
There is no such thing as “investors” in the context of, “The markets did X today because Investors thought Y.” The global securities markets are comprised of investors of all types, with varying motivations, varying levels of sophistication, and varying stakeholders. A pension plan in the US did not buy or sell ABC stock for the same reason that a college student in Frankfurt bought or sold ABC stock. And while the pension plan may have bought or sold much more of ABC stock, do not underestimate the combined power of individuals coalescing into groups as their motivations align.
People whose goal it is to have higher returns compared to a market benchmark will be forever disappointed, forever searching, and forever chipping away at their wealth. They will walk in circles without realizing that their own path is digging them into a hole. The truth is that benchmarks are better suited to measure the performance of professionals that have no endgame for their portfolio beyond gathering more assets in it and have little to do with investors that are investing with a purpose beyond collecting management fees.
After doing a profoundly serious amount of research and training, pick an investment strategy and stick to it. The nature of the global securities markets means that no strategy will “work” all the time - but many will work over time. This is especially true if you have made sure that your investment strategy is aligned with your own goals and preferences, rather than focused on being the highest returning strategy when compared to anything else.

Academics (Without the Academics)

Stocks

Stock and Bond markets are not always efficient; people do not always act logically or in their own interest; and people do not always have all the relevant information they need. Specifically, I believe that transaction costs, information that is not freely available to all investors, and disagreement among investors about the implications of given information are sources of market inefficiency in the short-term. Importantly, this doesn’t mean stock picking is a good idea for most people saving for their financial goals.
Fundamentals matter over the long-term, but the long-term is a long time. In the meantime, “noise” can have a profound effect on returns and can last for years.
Tilting portfolios toward stocks that exhibit certain factors can be a source of long-term outperformance as compared to the broad stock market. This is a good long-term strategy, but investors should be prepared for extended periods of time where the noise is a more powerful force than the fundamentals.
Foreign stocks have foreign currency exposure. To the extent it is possible to mitigate that exposure without incurring undue costs, foreign currencies should be avoided. This is overlooked far too often and gives rise to myths such as “foreign stocks are riskier than U.S. stocks”.
Keep it simple, low-cost, and diversified.

Not Stocks

It’s amusing to me that I can organize things by “stocks” and “not stocks”, because the “not stocks” category contains some extremely important and sometimes overlooked securities, such as bonds. However, the reality is that the categories below are the way things are organized even by professional databases. Suffice it to say, each entry is a huge catch-all for a diverse set of underlying constituents with various characteristics.

Bonds - Bonds serve as ballast in a portfolio, tools used primarily for risk/volatility reduction, and secondarily for stable income. Overall return is a tertiary concern. Even if we believe the prospects for high future returns in bonds is nil, they still serve a valuable purpose as part of an overall portfolio. Additionally, attempting to wring out as much income as possible from bonds is a fool’s errand, and you will eventually get burned if you keep reaching for yield by investing in lower credit bonds, or by investing in bonds with excessive interest rate risk.
Commodities - This is an incredibly broad category. Corn is not the same thing as Palladium, and it’s strange to me that they are lumped together under the same category from an investment standpoint. In any case, I generally would prefer to own the actual commodity itself rather than try to get access through a fund that owns derivatives that may or may not exhibit the same risk and return characteristics as the actual commodity itself.
Real Estate - Similar as commodities above. Your house is different than a commercial building in London, but they’re often lumped together in the same bucket from an investing perspective. Where real estate differs from commodities is that I’m much more comfortable investing in a fund that owns real estate securities. Unless you can buy a diversified portfolio of actual houses, office buildings, warehouses, retail malls, etc., a real-estate focused fund is a fine option to get exposure to the asset class.
Private Equity and Private Debt - These sound fancy! Many people will espouse the non-correlated nature of private investments and the subsequent diversification benefits that come along with them. Some of it is probably true. However, the nature of these types of investments mean that they may also be illiquid (which is part of the correlation/volatility mirage), costly, opaque, and riskier than their public counterparts. As wealth grows, private investments may become increasingly relevant investment options. But like Commodities and Real Estate above, be wary when offered private equity and/or private debt exposures within easy to access, liquid, low-cost funds. The performance of such funds may be very different from the performance of true private investments.
Hedge Funds - Possibly the most egregious “catch-all” category of them all, hedge funds come in all shapes and sizes. While the term “hedge fund” usually applies to the legal structure of a pooled investment, many people also conflate it with higher levels of sophistication. I’m here to tell you that a hedge fund manager can mess up just as easily as a “traditional” manager, only hedge fund managers have fewer regulations and more tools of mass destruction at their disposal. A good way to think of hedge funds is just, “pooled investment vehicles with fewer regulations and higher barriers to entry.” This often results in funds whose managers will make non-traditional investment choices (i.e., not just be long-only stocks and bonds), but they don’t have to. A hedge fund could simply invest in a low-cost index tracking ETF from Vanguard and call it a day. But they probably wouldn’t do that. They’d probably lever up their investment in the low-cost index tracking Vanguard ETF to a point where it becomes a risk to their very existence as an ongoing concern. But that’s why they make the big bucks…All cynicism aside, true hedge funds can become more relevant to your portfolio of investments as your wealth increases, but be wary of the hedge fund “funds”.

Summary

I will undoubtedly update this blog post over time, if not completely destroy it and rewrite it every so often. It’s not that I expect my philosophy to change much, or that the academics will change much, but they may.

A critical part of investing is to not be dogmatic because investing punishes those that cannot adapt to change. One fascinating aspect of academic theory in investing is the phenomenon of winning strategies losing their effectiveness once the masses become aware of them.

In addition, I inevitably left some things out during this stream of conscious session and will want to further clarify or adjust my points. You, the reader, are likely an expert in your field, your hobby, or something else you are passionate about. You know that attempting to consolidate all you know and believe into a series of bullet points can be impossible, particularly when you reach the stage of knowledge where you realize that “experts can disagree”. The more experience, training, and education you have the more likely it is for that to happen!

Therefore, a key takeaway I want you to have is to recognize when a supposed guru comes to you with absolute certainty, and after you recognize it - run the other way!

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