“Philosophical” thoughts about investment

Sonnie Bailey

25 September 2015

I’m starting a role in a law firm soon. I’m really excited to be joining a firm that appears to have a great culture, where I’ll have an opportunity to work in areas of the law that I enjoy and am passionate about. 

Prior to accepting this role I had been entertaining setting up my own financial advisory business.

I’m *this* close to going through the formalities of becoming an Authorised Financial Adviser here in New Zealand. And my mind has been boiling in recent months with thoughts about investment philosophies, portfolio construction, and the like.

I’m likely to be giving a lot less direct thought to these in the coming weeks and months and years. In light of this, for my own benefit as much as anyone else, I figure that now is a good time to share some of my high-level thoughts on the matter.

Note that this is not intended to be advice. You should seek personalised professional advice before making important decisions that will impact your financial future.

1. Underlying investments are only a very small part of the puzzle.

If you’re agonising over whether to invest in this stock of that stock, you’re likely to be agonising over the wrong thing. Unless you’re investing in your own business, or you have a unique reason for investing heavily in one particular investment, your investment in any one individual asset should only represent a small part of your wealth. Diversification (not putting all of your eggs in one basket) is important.

It’s easy to go down the rabbit hole of trying to work out which stocks that you like and that you think will make money for you over the long run. If you’re going to do it in your own time, my advice is to treat it like a hobby – and, like a hobby, expect that on balance it will lose you money. As I mention later on, if you play this game, you’re playing with big boys in zero-sum transactions. Anything less than full commitment is not likely to be effective. 

2. Asset allocation, on the other hand, is a huge part of the puzzle.

Asset allocation relates to what proportion of your assets you put into cash, fixed interest, equities (domestic and international) and property (domestic and international).

Asset allocation is really important. It should reflect a number of things, including:

  • your cash flow needs over the coming years; and
  • your personal risk profile, taking into consideration: 
  • your psychological tolerance for increases and decreases in the value of your investments – what will allow you to sleep at night, if sleeping at night is important to you;
  • your capacity for dealing with volatility, particularly sharp decreases in the value of your portfolio; and
  • to a lesser extent, the amount of risk that you need to take on in order to achieve your financial objectives.

3. Fees are a really big deal.

If you invest in a managed fund, it’s easy to think of the fees that you pay to the investment manager and associated parties as rounding error. It’s tempting to think: what’s a percent or two going to matter?

Over the long-run, a lot. Fees are the reason that the majority of professional investment managers don’t outperform the market as a whole.

A provocative article published on a CFA Institute site explains that “Investment management fees are (much) higher than you think”:

“When stated as a percentage of assets, average fees do look low — a little over 1% of assets for individuals and a little less than one-half of 1% for institutional investors. But the investors already own those assets, so investment management fees should really be based on what investors are getting in the returns that managers produce. Calculated correctly, as a percentage of returns, fees no longer look low. Do the math. If returns average, say, 8% a year, then those same fees are not 1% or one-half of 1%. They are much higher — typically over 12% for individuals and 6% for institutions.

“But even this recalculation substantially understates the real cost of active “beat the market” investment management. Here’s why: Index funds reliably produce a “commodity product” that ensures the market rate of return with no more than market risk. Index funds are now available at fees that are very small: 5 bps (0.05%) or less for institutions and 20 bps or less for individuals. Therefore, investors should consider fees charged by active managers not as a percentage of total returns but as incremental fees versus risk-adjusted incremental returns above the market index.

“Thus (correctly) stated, management fees for active management are remarkably high. Incremental fees are somewhere between 50% of incremental returns and, because a majority of active managers fall short of their chosen benchmarks, infinity.”

4. For the most part, you shouldn’t aim to beat the market. You should make sure the market doesn’t beat you.

“The market” relating to investment assets represents the collective selling and buying activity of many people. The majority of trades are made by extremely intelligent, highly educated, hard working, incredibly well-resourced investment managers who are dedicating their professional lives to generating superior risk-adjusted returns for their clients.

To a large extent, even people with these huge benefits are playing a losing game. By definition, someone will ultimately win or lose in a trade. It’s zero-sum. They and their research needs to be paid for, so fees need to be charged from any returns they generate. These fees ensure that actively invested funds (as a whole) will tend toward underperforming the market as a whole. 

Too many people focus on trying to beat the market, when for most people, the better approach is to make sure that the market doesn’t beat you.

This point and the previous point (that fees are really important) lead me to believe that low-cost index funds (such as exchange-traded funds (ETFs)) tend to be great value for money. They usually have very low fees relative to actively managed funds. Because they are indexed to the market, your performance is almost certainly going to match the market. And on top of all this, depending on the fund, your investment is likely to be diversified across a large number of companies, which operate in different sectors and markets. So you don’t need to worry about the underlying investments you invest in at all.

5. How you invest your money is only a part of building your wealth

Before you can invest, you need to have assets to invest. Unless you receive a windfall, this is usually by saving money – spending less money than you earn over an extended period of time. Having a healthy income, and spending your money prudently, is an essential part of building wealth.

Being mindful in relation to debt is important, both in terms of what you go into debt for, and how you repay your debt. Borrowing too much (or at all) for vehicles is not generally prudent. Buying a house that’s too expensive can also have a really profound impact on your long-term financial outcomes. When you have debt, especially “bad debt” like high-interest debt or debt relating to “fun” or depreciating things, it’s often valuable to focus on paying that debt off before trying to invest. Think of it this way: debt repayment is the same as wealth accumulation. And in most cases, paying off a debt represents a guaranteed, risk-free, after-tax return that you probably wouldn’t get by investing it in any other way.

And if you’re serious about accumulating wealth, protecting it, and ensuring appropriate succession for that wealth, there a number of strategies for doing this well. Which is something I’ll probably be focusing on in a legal capacity in the coming weeks, months, and years.

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