It’s an ancient problem, although as “problems” go it’s one of the better ones to have since it implies that you have money to manage. But it’s a problem nonetheless, and it becomes increasingly obvious as an investment portfolio grows.
Reviewing the nest egg of yours truly over the weekend revived the challenge anew of how to keep the growth relatively high in relative terms without assuming an imprudent amount of risk. Like many investors, your editor has done quite well since 2002. So it goes when bull markets bloom like weeds. Buy now what? The portfolio’s bigger, and so is the hurdle to keep up the momentum.
It should come as no shock to learn that growing a fund of, say, $100,000 at 10% per annum is far easier than keeping a $1 million fund rising at the same rate. Yes, it can be done, but it requires increasing amount of skill, luck or both.
The problem is further compounded at this juncture in the investment/economic cycle, or so we believe. There are more than a few risks swirling about the capital markets these days. The fact that most markets are at or near all-time highs suggests one or two things to the jaded mind producing the text before you.
The point being that reaching for the extra return at this point may be dangerous, perhaps more so than usual. Yet the incentive for reaching today is probably higher than it’s been in some time. Given the capacity for bull markets to lift all boats and raise expectations, most investors have portfolios that are materially larger compared to, say, five years previous. Some of that can be attributed to skill, but most of the growth was no doubt spawned by the genius of a bull market.
Whatever the reason for the growth, investors who take the time to analyze their portfolios and properly calculate trailing performance will realize that the rate of growth has, most likely, declined as the bull party has marched on. This is the nature of growth. If an investor mints $100,000 of growth from $1 million of assets this year, the return is 10%. Producing another $100,000 of growth next year naturally leads to a lesser relative return (9.09%) because the portfolio begins with at $1.1 million.
The temptation, of course, is to find a way to produce $110,000 of growth on that $1.1 million portfolio, which would again deliver a gain of 10%. But the task becomes progressively tougher as the size of the portfolio increases. There are natural constraints on returns under conditions of rising assets. If the laws of investing were otherwise, the most skilled managers might sit atop portfolios larger than the GDP of entire nations.
But this is not how the world works. If we consider the distribution of returns over time for, say, domestic equity mutual funds, it’s clear that a bell curve generally applies. In other words, the great majority of returns are middling, either slightly above or below average. The extreme returns, either far above or far below average are the exception.
Something similar applies to individuals as well. The range of returns would likely be more extreme in the negative and the positive, but only because individuals are more likely to go off the deep end in terms of investing strategies relative to conventional professional money managers, who generally think in herd-like terms.
The lesson is nonetheless the same for everyone: maintaining a portfolio’s rate of return requires greater inputs of skill or luck. Luck being what it is, we can all agree that skill is really the only game in town. With that in mind, we’re reminded of Grinold and Kahn’s fundamental law of active management, which quantitatively asserts that the productivity of money management is a function of skill and so-called breadth, or the opportunities for applying that skill.
In other words, a great investor can only become greater if he has more chances to make decisions. Alternatively, if an investor can’t increase his skill (which generally applies to most of us), then the only way to improve investment productivity is by expanding the opportunity set of investments. For instance, assuming a given level of skill, an investor who limits his worldview to domestic stocks and bonds has X opportunity. But if he begins considering foreign stocks, his opportunity becomes X+Y. If he adds foreign bonds to the mix, the opportunity becomes X+Y+Z. And so on.
Theoretically, the opportunity to be a more productive investor is unlimited. In addition to adding asset classes, there’s the potential to trade securities within those asset classes, along with a myriad of factor exposures to embrace, such as exploiting the so-called small-cap effect by going long a small-cap index and shorting a large-cap index.
But the physics of investing invariably steps in to spoil the fun. Increasing one’s investment breadth inevitably leads to rising pressures on skill. Indeed, the broader your investment horizons, the greater the need for skill to manage the expanding roster of assets and strategies. You may be an authority on stock picking, but how do you fare in choosing bonds? Or currencies? Or commodities? And while the demands on skill can be muted by sticking to asset classes, the issues of rebalancing and asset allocation become more taxing on an intellectual level as the assets under management rise and the embrace of asset classes broaden. Short of a brain transplant, the only way to materially improve skill (assuming a sophisticated investor) is to tap additional resources, i.e., hire an advisor or build your own research team.
In short, there’s no free lunch. Winning the money game comes at an intellectual cost and/or a willingness to embrace greater risk. Even then, there’s no guarantee of a payoff. As we’ve learned over the years, some of the smartest investors can suffer the biggest losses. Perhaps they weren’t so smart after all, lending support to the counsel dispatched years ago by Charles Ellis: Investing is a loser’s game eventually. Avoiding big losses, in other words, tends to yield more productivity than running after big gains in the long run.