Homo economicus likes to imagine himself as a clever being. And in some respects, he’s right. But when it comes to investing, even the most intelligent minds in the universe can be hornswoggled. Mr. Market, someone once told us, is a tricky nemesis.
With a new year standing before us, and an old one behind, this is the traditional moment to reassess, review and make a guess at what’s coming next. That includes deciding how to tweak the portfolio, if at all. The challenge, for our money, is now and forever at the center of success, or failure. Strategy, in other words, trumps all, even though the outcome may not be obvious for years or even decades. Nonetheless, the choices we make today, tomorrow, next year and beyond for building a portfolio–overweighting this, underweighting that–ultimately dictate results, for good or ill.
On that subject we’re routinely impressed by how difficult it is to reengineer betas to suit our investment needs and claim victory. Indeed, a popular if not universal goal is reducing risk while maintaining return. No easy trick, although it’s tempting to think that any one can do it. The proliferation of ETFs, to take an obvious example, provides a broad and ever-expanding palette of betas to play with. Surely an intelligent strategist can choose a mix of betas, from stocks to bonds to commodities and beyond, and craft a winning portfolio that delivers superior risk-adjusted returns.
While such a goal isn’t impossible, it’s devilishly difficult to achieve for the long run. Ironically, most investors probably have no clue just how difficult the task. Why? Because one can only recognize the depth of the challenge by routinely analyzing a living, breathing portfolio over the course of time. Daily analysis is ideal, although weekly or even monthly data will suffice over long periods. In any case, unless you’re crunching the numbers regularly, and comparing your results to a benchmark, it’s easy to overlook just how elusive successful investment strategy can be.
Consider that for most investors with a long-term horizon, equities are the primary risk factor. Looking out 10 or more years, it’s a reasonable assumption that equity risk will deliver superior returns compared to bonds, cash and perhaps even commodities and real estate. The risk of underweighting equities over time, therefore, can be thought of as the primary risk.
But ours is an age of clever strategists armed with access to inexpensive betas, in both conventional and alternative forms. As such, there’s a strong temptation to craft a portfolio that will is expected to enhance what can otherwise be had by mindlessly buying the major asset classes in something approximating their market weights on a global basis.
No, we’re not saying that it’s always best to buy and hold the market-weight portfolio, although as a long-term proposition you’ll probably do pretty well with that mix. For those who aspire to more, we recommend at least keeping in mind that playing with asset allocation far beyond Mr. Market’s recommendations invites additional risk in the form of trailing what you could otherwise obtain quite easily. On the other hand, if you’re not going to choose an asset allocation that’s materially different than the global market portfolio, what’s the point? Modest deviations won’t do much to alter the risk-reward profile of the market, although such tweaks may raise the risk of underperformance.
But don’t take our word for it; run the numbers on your own portfolio and see for yourself. As a simple example, calculate the total value of your investment portfolio at the end of each week and compare its performance to, say, the S&P 500, or a balanced mix of 60% stocks/40% bonds. Even better, create a custom benchmark of global stocks (50% S&P and 50% EAFE) that adds up to 60%, with the remaining 40% in Lehman Aggregate Bond Index. You might add in commodities and foreign bonds to the benchmark too in their proper market weight to build a relevant benchmark of what’s available. Over time, you’ll discover if you’re adding or destroying value, relative to what you can earn on a globally weighted index fund comprised of ETFs.
For most of us the lesson will probably be that second-guessing Mr. Market incurs an opportunity cost. The reason boils down to the fact that Mr. Market doesn’t bite his nails when prices sink, nor does he celebrate when prices soar. Emotion, in short, gets in the way of even the most disciplined investors. Some of us will be able to beat the odds and improve risk-adjusted returns relative to the true world portfolio; most will fail.
Perhaps, then, the most important investment decision is deciding if you’ve got what it takes to compete in the arena on a long term basis. History is quite clear on the stakes: if you’re wrong on this all-important issue, you’ll pay a price, and perhaps a heavy one, albeit 10 or 20 years from now. Like cancer and inflation, such a risk will be almost invisible in the short term. On a day-to-day basis, it’s easy to assume that all’s well and that your decisions are top rate. But taxes, commissions, and the accumulation of minor mistakes take their toll as the years roll on. Alas, only a relative few of us are up to the task of successfully evading what is otherwise fate for the investment masses. What’s more, many if not most of those who pay an opportunity cost may not even know that they’ve underperformed. Ignorance may be bliss, but it still has a price.