Some lessons in the world of investing and finance are more valuable than others. They rang true in the past, still do so today and will continue to do so in the future. But not everyone pays heed to them. Therefore in today's post I will be touching upon some of these lessons. I will also be highlighting the essential teachings we should be taking away from each of them.
None Of Us Are Smarter Than The Market. Don't Try To Beat It
Beating the market over the long term (10/15/20 years or more) is near impossible. Short term outperformance is attributable more to luck than skill. It is not hard to see why. The market represents the collective knowledge and insight of all investors in a particular region. So we would beat the market when we know something that the rest of the investor population does not. This implies that we enjoy an advantage in terms of information and insight over the rest of the market.
Today information is freely available across a variety of platforms. Dissemination of information is extremely quick. Therefore all available information on any given security in the market is made available to all investors at the same time. Therefore no investor can claim to enjoy an advantage in terms of information or insight over investors. As a result, all the available information is factored into the market value of the securities immediately.
This means it is virtually impossible for any investor to beat the market over the long term. The best that investors can therefore hope for is to match and earn the return offered by the market over the long term. This principle is captured in a concept of personal finance known as the Efficient Market Hypothesis (EMH). I have discussed the EMH in greater detail in an earlier blog post Defensive Investing Decoded - I : Conceptual Framework
Robust Investment Returns Cannot Compensate For A Low Savings Rate
Individuals may try to make up for not saving enough for their goals with a higher allocation to growth oriented assets like equity. This may increase expected returns from the portfolio. But a subsequent market crash and/or prolonged bear market can decimate the portfolio. Most individuals may not be able to psychologically cope with such an eventuality. They may then reduce their growth oriented assets. They are therefore likely to generate lower investment returns over the long term.
We must remember that investment returns are not under our control. Our savings rate is completely under our control. Chasing returns only distracts us from what is actually important when managing our money. Our income and savings rate provide the fuel which can be used to achieve our financial goals. Therefore our focus must be on increasing our income and savings rate. A substantial income and robust savings rate would allow us to achieve our goals even with moderate returns.
Effective Portfolio Management Cannot Compensate For Ineffective Financial Planning
Portfolio management is a solitary aspect within the broader exercise of financial planning. Our portfolios are simply the vehicles which carry us towards achieving our goals. This implies that understanding ourselves and our needs are important prerequisites to defining our goals. Without this, our portfolios and the returns they achieve would be of little consequence. Our financial plans are ultimately meant to help us live a fulfilling life. This means that the focus of our financial plans must primarily be on the aspects given below.
Our portfolios must be built in alignment with these aspects. Blindly trying to build the so called 'perfect' portfolio without a clear understanding of these aspects would be pointless. This is because we would not know what our portfolios are ultimately meant to achieve. From this point our portfolios are virtually guaranteed to drive suboptimal outcomes regardless of how well we manage the portfolio.
No Investment Strategy Is A Silver Bullet
The search for a silver bullet investment strategy is a constant endeavour for most investors. But we must realise that no investment strategy would ever work as such. Every investment strategy would go through periods where it performs better or worse compared to other strategies. What ultimately makes the difference is the discipline and consistency with which we follow the strategy we have chosen.
Therefore the best investment strategy for each of us is the one we can stick to for long periods of time. Sticking with an investment strategy during a period where it does slightly worse than other strategies is key to experiencing its benefits. The investment strategy we pick for ourselves should therefore be simple, reasonable and rational. This increases our chances of sticking to the strategy for long periods of time.
No Investment Approach Is Purely Active Or Passive
Most investors today are overly concerned over the choice of active versus passive investment approaches . There are constant debates between investors aimed at proving the superiority of either approach over the other. Each of these approaches certainly comes with its distinct benefits and drawbacks. But it is also a fact that each of these approaches carry elements of the other.
The active approach to investing places focus on researching, selecting and managing an optimal set of investment products in a portfolio. But once these products are chosen, they need to be held patiently over long periods of time. This is akin to what we see with the passive approach. This proves that there is a passive element to the active approach to investing.
The use of index funds and index like products are central to the passive approach to investing. So the need for product research and selection is mitigated. But within market indices and index funds, stocks are included based on a specific set of rules. Weightages of each stock are also predetermined and maintained accordingly. Asset allocation decisions are central to the passive approach. The asset allocation of a portfolio is changed and reset whenever required as per the nuances of each goal. This shows that there is an element of active management involved when following the passive approach. This shows that neither approach is exclusive of the other.
Defensive Investing Has More To It Beyond Holding Index Funds
I have been a vocal advocate for the defensive or passive approach to investing across a number of past articles. The defensive approach to investing is one that emphasises keeping the portfolio simple and free from clutter. It aims to achieve adequate diversification while keeping investment costs low. The use of index funds for the equity component of portfolios is therefore central to the passive approach. But a common misconception that index funds and defensive investing are synonymous.
There is more to defensive investing beyond the use of index funds. It also aims to keep credit risk and interest rate risk low in the debt component of portfolios. This is achieved through the use of liquid funds, overnight funds and government sponsored savings schemes. It emphasises the use of sensible asset allocation strategies in line with an individual's goals. It focuses on the importance of increasing the individual's income and saving capacity. The use of index funds is therefore only a tool that facilitates passive investing.
Diversification Is The Only Free Lunch In Investing
The law of No Free Lunch is central to investing. The law states that there is no optimal solution that is universally applicable in investing.
Portfolio diversification offers us the rare opportunity to reduce portfolio risk without affecting the expected return of the portfolio. This is an ideal solution in terms of optimising the risk and return of a portfolio. And it works for all investors regardless of market conditions and locations of the investor. This means that portfolio diversification is the only exception to the law of No Free Lunch. All investors would therefore benefit from adequately diversifying their portfolios within and across asset classes.
Evaluate Portfolios On The Basis Of Process, Not Returns
Portfolio return is the most common benchmark used to evaluate the performance of an investment portfolio. But returns do not always provide a true and fair view of the effectiveness of the portfolio. The underlying process based on which the portfolio is built is a much better judge of any portfolio. Therefore it is vital to consider the following questions when evaluating a portfolio :
What would be the ideal asset allocation strategy for the portfolio?
How much is the current portfolio worth with respect to the target corpus?
Am I on track to achieve the goal in light of the intended deadline?
Am I able to invest as much as I need to for the goal?
If not, how well am I able to cover the deficit?
Is there a need to change my asset allocation?
The answers to these questions provide a much better reflection of how well the portfolio has been built and is doing. Having the answers readily available is therefore of vital importance. Optimal portfolio returns are a natural byproduct of having the appropriate answers to each of these questions.
Each of the lessons discussed above have valuable teachings for all of us. Some of them may look familiar and sound repetitive. But the fact that these teachings are still relevant today are testament to their importance. It truly shows that these lessons have stood the test of time. We would therefore benefit in paying heed to each of them. Here are a list of all the lessons discussed today :
None Of Us Are Smarter Than The Market. Don't Try To Beat It
2. Robust Investment Returns Cannot Compensate For A Low Savings Rate
3. Effective Portfolio Management Cannot Compensate For Ineffective Financial Planning
4. No Investment Strategy Is A Silver Bullet
5. No Investment Approach Is Purely Active Or Passive
6. Defensive Investing Has More To It Beyond Holding Index Funds
7. Diversification Is The Only Free Lunch In Investing
8. Evaluate Portfolios On The Basis Of Process, Not Returns
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