The Three Key Drivers of Investment Success in the Long Run
By: Tariq Ali Asghar
There has been a fierce debate going on recently whether Passive Investing Strategy such as “Couch Potato” (where you just sit on the couch and mimic the returns of an index painlessly) or Active Investing Strategy (such as investing in mutual funds and alternative investment strategies whereby the Fund Manager wants to compete with the Market Returns) are better to each other or not?
My view is that this is not a relevant debate. By the end of day, what matters most is answer to this simple question: Has the client been successful in realizing her objectives of investments in the long run? This success is attributable to three key drivers of value creation of the investment process in the long run. Whatever route you take on, passive or active, it is all about adherence to these three factors what determines the success of your portfolio. Like they say success is not just grounded on one milestone, it is a continuous and consistent journey over longer period.
The three key drivers of long term value creation of any portfolio, whether using passive or active investing, are the following:
Diversification across different Asset Classes (stocks, bonds, real estate, commodities, gold) and across geographical regions would hedge the risk against unexpected losses due to market volatility. Getting the right diversification balance is both an art and science. One main reason for the popularity of ETFs is their relatively low cost diversification.
It is not surprising that the imperative for diversification is far more pronounced today than it was a decade back. Why? My reasoning is as follows:
(A)-Modern Portfolio Theory (MPT) says that in the long run the value creation of any portfolio is not based on “what” constitutes the portfolio; but “how” individual securities or asset classes are combined in the portfolio. For example, your portfolio may have top seven technology stocks of blue chip companies, say Microsoft, IBM, Oracle, Apple etc. On the face, it looks to be a diversified portfolio, whereas the reality is that these stocks belong to the undiversified technology sector. Hypothetically if this sector performs slower in the next few years, this would have a relative negative impact on all of these stocks albeit varying degree. In contrast, if the Portfolio has been diversified across broader range of sectors and stocks like Financials, Real Estate, Commodities, this would internalize some of the unexpected downturns in one or two sectors. Therefore the “how” factor has become very important than the “what” factor in the portfolio optimization process.
(B)-Macroeconomic headwinds: Diversified Portfolios are better geared up to internalize the unexpected macroeconomic shocks and market volatility. This is true because the sensitivity of each security to market volatility varies quite a bit. Having a full blown diversified portfolio would probably net both positive and negative impacts of market volatility on the underlying securities. This paradigm of diversification holds stronger in the long run.
Emotional decision making in investments can derail your long term investment plan. Typically people cannot anticipate or correctly discern the changes in the business cycle…sometimes even expert economists cannot do this either. Generally people would buy securities at the peak of the cycle when realistically they should be selling the overpriced securities. In contrast, they sell their securities at the lowest downturn of the cycle (see diagram below) whereby they should be actually buying underpriced securities at this stage.
Worst of all, majority of investors are prone to switching positions during downturns of the economic or stock market cycle. This is driven by different emotional states captured in the diagram below. The frequent switching of gears derails the investment process and the investors deviate away from the optimal path. Keep your emotions in check and do not abandon your strategy unless you discover technical reasons to do this in a dispassionate way.
Some Advisors would argue that by the end of day it is all about risk adjusted and inflation adjusted returns. Who cares about costs, in particular if these have already been factored into the rate of returns? In my view this is an erroneous assumption as supported by the latest research done by Mebane Faber in his new book “Global Asset Allocation”.
Costs matter more than what we could imagine because no Fund Manager has a crystal ball to beat the market by a considerable margin over longer period of time. The competitive returns are highly concentrated across a wide range of spectrum of fund returns. It is quite interesting to note, says Faber in his latest book, that the long run competition among top portfolio managers is fiercely close. Faber further states that the difference between the best and worst performing portfolios was about 1.86% annually (in particular after you adjust for risks and inflation rates). Please see diagram below
In my view, this shrinking competitive edge amongst top portfolio performers is due to three main factors: (A)-Market Volatility and increased impact of market sentiments on the Portfolio Returns than it was existing a decade back; (B)-Increased Market Efficiency due to technology which is leading to quick wiping out of arbitrage opportunities across globe; and (C)-Exponential growth in the number of securities and stocks.
This cut throat competition on the spectrum spanning across 1.86% annually is an eye opener for all financial advisors and investors. Costs are the critical point to tilt the balance between the winners and losers. This is the one main reason that Venture Capitalists have invested massive amount of money into Robo-Advisors in the past few years because their whole investment philosophy is predicated on cost minimization. Big Banks are now following the Robo-Advisors in this race for capturing the emerging market trend of low cost investments. This mega trend also explains the sudden exploding of Exchange Traded Funds as alternatives to Mutual Funds.