“There are no right answers to wrong questions.” – Ursula K. Le Guin
With the demise of most workplace pensions, investing has become an incredibly important job for most Americans. Yet, we’re never taught how to do it. In high school and college, we learn about geometry, ancient Greece, the internal organs of a frog, accounting, you name it. But we’re never taught how to do the one thing that we desperately need to do: Invest our money.
As a result, people muddle through life grasping at straws. But without some basic knowledge on how investing works, you might as well pick a strategy out of a hat. In this article, I hope to shed a little light on what to look for in an investing strategy and how to evaluate them.
The first thing to look for in a strategy is an overall theory of why it works. What makes this investment strategy tick? Too many investment firms simply tell their clients that they’re moving money from Investment A to Investment B because their economists believe that it’s the right thing to do at this moment.
Well, why is it the right thing to do?
Any changes to your portfolio should fit a larger overall strategy that an investment advisor has spent time explaining to you.
For instance, my overall investment strategy involves “Factor” investing – attempting to capture premiums such as small, value, momentum and quality – in addition to the overall the market premium. (See here, here and here for a primer on Factor investing.)
Recently, I’ve been shifting some of my clients’ portfolios from one mutual fund company to a different fund company. Why? Because I believe the other fund company does a better job of capturing these factors (or premiums), and I can show my clients why.
That move fits my overall strategy and is easily understood by my clients.
Investors should look for advisors who are very clear about their strategy and explain the theory behind why that strategy should work. Indeed, an investor should be able to explain to a friend the basics of their investment strategy. If they can’t, they don’t understand it well enough, which will lead them to give up on the strategy at the first sign of trouble.
Do not trust any “black box” strategy where an advisor basically says, “Trust us. We’re really smart.”
There should be reams of studies, papers and journal articles examining your investment strategy. Your investment strategy should have gone through the meat-grinder of open debate among academics and investment practitioners outside of the investment firm that you’re using.
Don’t trust a strategy that has been vetted only by economists and finance experts at one firm. Maybe they used flaw statistical analysis, maybe they cherry-picked their data or start dates, maybe they only examined one market. There are limitless ways that their conclusions could be wrong.
They should be publishing their work for the world to see and pick apart. You should be able to read about the merits of the strategy from people outside the firm.
Real World Implementation
Just because an investment strategy makes senses and looks good on paper, it doesn’t mean that it will work in the real world. Many strategies fail in the real world due to high implementation costs or capacity issues.
Demand that an investment firm or advisor show that a mutual fund or ETF has been able to capture the returns of the strategy in a cost effective way. However, be very careful here, because many investment firms use short-term records to tout funds and strategies. Don’t buy it. You’re being tricked.
Which brings me to the final thing that an investor needs to evaluate an investment strategy. Indeed, this may be THE most important lesson any investor can learn.
I’ll let you in on a little secret: Investors are human beings.
It’s true. And, unfortunately, human beings are evolutionarily designed to be terrible investors. We are our own worst enemy, and if we don’t take steps to stop ourselves, we will sabotage our investment returns.
Now, the list of ways that we hurt ourselves as investors could fill a library wing. (I know because I’m looking at row after row of such books in my office right now.) But perhaps our single most harmful behavior is having too short a timeframe for evaluating an investment strategy.
Investors typically judge a strategy or fund on one to three years performance. And why wouldn’t they? I mean, in the real world, you pretty much know whether a new employee hired will be any good after a year or two. They’re not likely to get a lot better – or worse. The same is true for machines. If my washing machine hasn’t been working that great for the past month, there’s almost no chance it will just get better.
But that’s not the way investing works. Even the best investing strategies of the past have had long periods of horrendous underperformance. For example, from 1998 to the end of 1999, the greatest investor ever – Warren Buffet – saw his Berkshire Hathaway stock fall 49%. Over the same period, the S&P 500 grew 56%. Buffett underperformed the market by more than 100 percentage points over two years!
You can’t judge an investment strategy on one to three years performance. You can’t judge an investment strategy on five years performance. You can’t even judge an investment strategy on ten years performance.
It’s just noise. I realize that this is hard to accept, but it’s a statistical fact.
So how many years do you need to judge an investment strategy? Fifteen years.
Yes, 15 years. Really, you should judge a strategy on 20-year performance, but I’m willing to go with 15 years.
Therefore, anyone showing you 1-year, 3-year, 5-year, or, even 10-year performance numbers is either trying to trick you or doesn’t know what they are doing. And any investor that judges an investment strategy on anything less than 15 years of past performance is using nearly worthless data to make an extremely important decision.
So, what does needing such a long timeframe mean to investors?
First, you have to trust that your strategy will work, and that trust comes from understanding the strategy and knowing its history, i.e. seeing other periods of time where it was struggling but eventually rebounded.
Second, you should consider diversifying so that you’re not relying solely on one asset or stream of returns. For example, with my clients, we diversify by asset class (stocks, bonds, real estate), by factors (small, value, momentum, quality and trend – see here and here for a primer on trend following) and by geography (United States, international developed and emerging markets).
Of course, diversifying means that you never hit the home run. It also means that you will trail more known benchmarks like the S&P 500 periodically, sometimes for many years.
Investing isn’t easy. But you if you look for a strategy that has a transparent, understandable theory behind it, that has been tested both academically and in the real world and that has a solid, long-term track record behind it, you should be in good shape.