It’s only natural that investors have a preference for focusing on the positive. Everyone wants to earn higher returns and excel in all things financial. But for most folks, there’s more opportunity on the negative side of money management: reducing if not eliminating the mistakes. It’s easier to add value by pinching errors vs. trying to emulate Warren Buffett. But this subtle but powerful truism is too often overlooked, which probably explains why market-trailing returns are the rule rather than the exception.
It’s no secret that the average investor fares rather poorly in matters of earning a risk premium. What’s true for individuals applies to professionals as well, as a recent New York Times story reminds. We’ve seen this picture before, but the message resonates anew, month after month, year after year: market-beating results by way of active management are the exception, perhaps to the point of being extremely rare. It’s all about the numbers, and they speak loud and clear on this point.
Most of the attention, of course, is directed at the handful of winners, which delivers exactly the wrong message for the overwhelming majority of investors. For the truly gifted among us, focusing mostly if not exclusively on the positive constitutes a prudent strategy. For everyone else, sidestepping mistakes and ill-conceived pursuits is the priority, at least in the beginning.
If and when we beat the errors down to a relatively small headwind should we consider ambitious plans to enhance returns above and beyond what’s available in low-cost market betas? Most of us will never reach this tipping point, largely due to behavioral issues. But fret not, since there’s an abundance of opportunity waiting in the wings by focusing on the negative.
Where to begin? Ditching active management in favor of index funds is a good start. Shedding funds that charge higher fees for what tends to end up as middling to below-average results is a no-brainer. Imagine an asset allocation strategy with ten active funds, each charging 80 basis points, which is actually a pretty good deal in the grand scheme of actively run mutual funds. As an alternative, you can replicate virtually the same asset allocation by way of index funds and reduce the fees by, say, two-thirds. Congratulations–you’ve just boosted performance. There’s also a strong chance that you’ll add value over a full business cycle or two by choosing to capture market performance, which is to say eliminating the active funds that will trail their benchmarks. How much will this one-two punch add over the active portfolio? The answer depends on the funds you’re replacing and the asset allocation details, but it’s reasonable to project a modest premium gain—courtesy of focusing on the negative.
There are lots of other examples for nipping the dark aspects of our investment strategy into a net positive. Abandoning a reluctance to rebalance or hold a portfolio invested across the major asset classes, for instance, can strengthen an investment strategy over the long haul.
At some point, if you’re diligent and disciplined, you’ll run out of road in the cause of boosting results by focusing on the negatives. If you reach that point of financial nirvana, you’re in the sweet spot. At that point, you can shift your focus to the positive. Having picked the low-hanging fruit, it’s reasonable to wonder if it’s time to start planting trees to grow your own alpha. Perhaps it’s time to tweak the rebalancing strategy with a more aggressive overlay. Or maybe your research inspires an extreme position in one corner of the asset allocation. Another possibility: adding an alternatively managed portfolio with exotic beta. Be careful, however, as there’s a danger that you could slip back into old habits and end up back where you started.
For some ears, this all sounds like a radical idea, and one with no prospects for success. In fact, the notion of prioritizing efforts to trim the dead weight from an investment strategy is no spring chicken. Charlie Ellis first explored the idea back in the 1970s, framing the concept as the enduring plan of Winning the Loser’s Game. The basic principle is that quite a lot if not most of success in investing is about avoiding mistakes vs. hitting home runs. Embracing this view is still the exception in the grand scheme of money management, which probably explains why subpar results remain pervasive.
The “system”, remember, has a bias for separating you from your money. Slowly and on the sly, but the bias is there — Where Are the Customers’ Yachts? The natural order of Wall Street is to enrich the few at the expense of the many. The primary tool for this devious little plot: persuading the masses to focus on the positive without first excelling with the negative. It’s a clever game, rife with plausible denial among the usual suspects. After all, they’re only trying to help. But in the end, they’re only helping you to leave a fair amount of money on the table. Fortunately, there’s an effective, easy solution and its starts with a simple idea: First, do no harm.