Lee Eisenberg, in his strangely titled book “The Number” (strangely titled, because it actually has very little to do with calculating your Number and reads more like a rollicking yarn … if traveling around the country investigating the financial planning industry seems ‘rollicking’ to you) provides the following ‘memo’ as an example of good financial advice …
… surprisingly, it is good advice – mainly for those in their Making Money 301 ‘wealth preservation’ phase!
It reads like a memo from a junior member of a financial advisory firm to one of their reasonably well-heeled clients:
Dear [Your Name Here],
I wanted to take a moment to outline a few thoughts and ideas before our meeting Friday morning. Some of this may seem old and redundant, but I would like to present this in the context of of your upcoming asset allocation decisions.
1. Overdiversification – This is the single biggest mistake made in managing assets. Once you get beyond three or four funds, you might as well index the whole pool of your assets. If you have more that one bond fund and two or three equity funds you are not really doing much to increase your return expectations or diversification.
2. Value investing works better. Almost all great long-term investors are value investors. Growth investing in the public market works for moments in time but typically does not produce investment results that hold up over longer time periods (i.e. ten years).
3, Don’t be afraid of volatility. If you get your mix between stocks and bonds right, you can use volatility as an opportunity – especially if you are a net buyer of stocks. Your fixed income allocation should meet your cashflow needs and spending plans for the next five years in any environment. So, knowing that your lifestyle needs are met, you can operate as a long-term investor if you have a comfort level in your manager’s investment style. That way you don’t need to be concerned with volatility in the equity market in any given quarter or year.
4. Fees can kill you. In any given year an extra 1% in fees is no problem, but when you get into allocation of large amounts of money to fund low volatility products, arbitrage strategies, and other “alternative” asset class vehicles, you will be spending 2 – 4% of your expected return of 8 – 10% every year in order to achieve the “Holy Grail” of low volatility.
5. If you don’t believe in the fundamentals of any given investment, don’t invest in it. The quickest way to get into trouble is to be seduced by past returns. When you hit the first significant bump, you’ll pack up and get out – this is not a good prescription for long-term investment success.
6. Low turnover is key. Almost no one has made a lot of money engaging in high turnover strategies. It may work for a year or two but the ability to actively trade your way to wealth is all but impossible. When you incorporate the impact of short-term tax rates into the equation, the mountain you need to climb to achieve successful results gets a lot higher. I would be hard-pressed to ever buy a mutual fund with an annual turnover north of 50%. (I make this comment knowing that the average fund manager has turnover in excess of 85% a year, according to the latest studies).
I look forward to seeing you at 10.00 on Friday Morning.
Over the next few weeks, I will try and dissect this advice for those of you in (or contemplating) Making Money 301 …
… for those of you still trying to make your money, heed the advice on overdiversification (better, yet, read my posts on the myth of diversification), the impact of fees (even 1% is too much!), and the benefits of Value Investing over Growth Investing.
This part interested me the most:
“1. Overdiversification – This is the single biggest mistake made in managing assets. Once you get beyond three or four funds, you might as well index the whole pool of your assets. If you have more that one bond fund and two or three equity funds you are not really doing much to increase your return expectations or diversification.”
The reason it interested me was that the author made it sound like overdiversifying was really bad…but then basically says overdiversification really just provides little additional benefit, i.e., increased returns or reduction in risk attributable to diversification. I really doubt that the “single biggest mistake” I could make in managing assets would be to add a couple of extra funds.
Any thoughts on this AJC? Also, do you have 2-3 equity asset classes that you use or that you would recommend?
@ Jeff – I think ‘he’ means what he says … but, I agree he doesn’t really explain why [answer: ‘forcing’ yourself to the mean i.e. market average returns].
I can’t comment re funds (I don’t – and probably will not – invest in funds due to the overtrading / overdiversification / fees issues), but I do agree in general: I hold very few stocks at a time: perhaps only 1 or 2 … never more than 4 or 5 (and, I can’t even recall ever holding that many at once) in one market (e.g. USA).
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Diversification has become the holy grail for financial planners. Devised by mathmaticians it revolutionized the sales and marketing of equities, specifically mutual funds. It is probably the most misunderstood concept in finance. Here is how it works. It is simply a system to lower expected variance. If you own stock in 25 companies it is extremely unlikely that all 25 would go out of business. It is also extrememly unlikely that they would all have great growth. So instead of a range of -100% to 450,000% (Berkshire Hathaway over 43 years), your range of possibilities are -80% to 7000% (S & P 500 Index over 43 years). So you reduced your range of expected returns from 450,100% to 7080%. Note the skewed pattern of reduction; for a decrease of 20% on the downside you give up 443,000% on the upside! Once you reach a certain level of diversification (generally around 15-25 stocks) you no longer reduce the expected return variability. So there is no risk reason to continue to diversify beyond that point. Now of course they suggest diversifying different asset classes and different markets. Again this is only a way to reduce overall variation of a portfolio.
There is another mathmatical law that plays into this. The law of large numbers, which simply says that any subset of a population will, over time, return to the mean. So, mutual funds that do above the mean will, over time return to the mean, no matter what the strategy employed.
Now here is the assumption that never made sense to me. I willingly give up the ability to create wealth (mutual funds average around 7-8% returns over the last several generations) in order to avoid a total loss of capital instead of a loss of most of my capital. However, if you are selling people on being passive investors, then you probably should be selling the least risky products out there. Unfortunatly for folks, it isn’t mutual funds. And now most employees are forced into 401K wrappers that really limit choices!
No, people should become active investors like you and I. I own three equities covering 2 asset classes. The majority of my portfolio is in Berkshire Hathaway, I own significant shares of a REIT (HCN), and I own a small amount (very small now!) in a small bank that is well run and profitable. That’s it. Beyond that I invest in real estate and real estate development. Concentrated investments, bought fairly cheaply, like Warren Buffett advises.
@ ShaferFinancial – Thanks! For most people, owning their own home and holding a couple of bank accounts makes them well diversified even if they chose not to buy a single mutual fund (perhaps choosing to buy 2 to 5 individual stocks – as you have chosen to do – instead).
“So instead of a range of -100% to 450,000% (Berkshire Hathaway over 43 years), your range of possibilities are -80% to 7000% (S & P 500 Index over 43 years).”
Something looks wrong with these numbers. I understand your first range of numbers (although I usually annualize mine–yours annualized would be -100% to 21.61%). But the second range appears off. The SP500 has a historical variance of approximately +5.7 to 14.3% (annualized) when taking into account every 43 year period since 1871. Where did you get the -80% number from?
Your point still comes through either way–by diversifying you give up long term extreme upside for a better extreme downside.
If I was hoping for a return on the tail end of the upper extreme, I would want to know how likely it was for me to receive the extreme upside return (so I know what I was going to give up by investing the SP500). I would also want to know what returns are “most likely” to occur over the next 43 years–not just a comparison of the extremes.
Jeff, the -80% is from the worst possible 15 stock diversified portfolio or the worst possible mutual fund. I have no real figures to back it up, but I couldn’t find a mutual fund that did worse than that (even though I didn’t spend much time looking!) Feel free to adjust as you see fit.
“If I was hoping for a return on the tail end of the upper extreme, I would want to know how likely it was for me to receive the extreme upside return (so I know what I was going to give up by investing the SP500). I would also want to know what returns are “most likely” to occur over the next 43 years–not just a comparison of the extremes.”
That is of course the $20M question!!!! But, the skewed rates of returns means you have a much greater chance to outdo the index than to underperform the index!
I ask myself why, when you still have a chance to allow the worlds greatest investor to invest for you, at essentially no cost, you wouldn’t take that option? Every decade some yahoo says its over for Buffett, and he proves them wrong. For myself, I allow him to invest for me for the majority of my portfolio and then attempt to invest with my own ideas with the remaining 20%. So far he does better than me! But, I am doing OK with my share, and most importantly learning to be a more Buffett like investor. Next up, writing calls, once the market settles down. But, with only a very small sliver of my portfolio as I learn whether I am as good at that strategy as my test run (no actual investments) indicates!
If I had a financial planner that told me to invest in mutual funds when I could have invested in Berkshire Hathaway anytime in the last 20 years, I would be asking him/her what they were thinking about. Talk about a low fee, well diversified investment that has a history of great returns and is currently very cheap!!!!!!! But, then again no one could make a living off of advising buying BRKB’s!!!
@ ShaferFinancial – If you’re talking about writing ‘covered calls’, that can be a great strategy in a ‘sideways-to-steadily-increasing-market’ … but, you have to be prepared to sell out (and, back in) of a stock that rises ‘too much’ in a month.
On the other hand, in a volatile market as we have at the moment, for the brave, a naked options trading strategy is actually ideal (even though I would normally recommend against it).
Yes, you are right on writing convered calls. That is why I am waiting until the market volatility (casued by emotional responses)is wrung out of the market. High variability is good for naked option trading, but I am not comfortable with the risk/return ratio for my skill level. Meanwhile, I am pretend writing covered calls to gain skill and actually doing OK in this volatile market!
@ Shafer – There is an implied ‘risk’ in Covered Calls which makes them a little less suitable in an upwardly volatile market: the potential loss of upside gain … which makes them ideal for flat markets (of course, we only really know what market we are in in hindsight!)
Also, while the premium you earn protects you a little from very slight downward movement that – at least, to me – is hardly suitable for this market 🙂
I am having mixed success with naked PUTS and CALLS (buying, not writing) at the moment … but, I am ‘gambling’ very small proportions of my portfolio.