Over the years, my mentors have all told me the same thing. As they get older (and better), they've come to appreciate the importance of keeping it simple. Do the easy stuff and leave the hard stuff to someone else.
Warren Buffett talks about putting things in the "too hard" box.
There are several aspects to investing where I've made a decision to stay within my skill set and keep it simple. Maybe it's not easy, but it's easier.
Easy: Diversification
Hard: Getting in and out of the market
A diversified portfolio holds a variety of asset types and is exposed to different geographies, industries and company types. It derives returns from all forms of risk – interest rates, credit, equity and liquidity. Proper diversification won't avoid market downdrafts, but the ride will be smoother than the alternative.
Trying to avoid those downdrafts requires making two decisions – when to sell and when to buy. I've never seen anyone, professional or amateur, get this right consistently enough to make it pay. A myriad of economic, political and social forces make both decisions difficult. The second one particularly so because it comes with a lot of emotional baggage. Getting back in is the hardest thing an investor can do, especially if the market has been going up. Too hard.
Easy: Buying good companies at reasonable prices
Hard: Catching macro trends
It's called bottom-up investing – building a portfolio from the ground up, one stock at a time. Each company has its individual merits and trades at a reasonable valuation. There will be lots of small mistakes made along the way, which is why diversification is important.
Making the right call on an economic or market trend can pay off big time, but for me it's too hard. If you identify an economic shift, you must then determine if it's cyclical or secular (think the China resource boom versus online retailing). Then, you have to figure out how early you are. Are you getting on the wagon ahead of others and getting a good price as a result or are you paying up for a well-established, well-publicized trend?
Easy: Investor sentiment
Hard: Risk modelling
Investor sentiment is a contrarian indicator that is a valuable check and balance. If everyone around you is bullish, it's time to be careful. You want to be doing more selling than buying. And the opposite is also true. If everyone is running for cover, your bias should be to the buy side.
Reading sentiment can be done anecdotally (your cab driver or hairdresser) or through services that measure the mood of individual investors, portfolio managers, traders and strategists. I also look at the yield spread on high-yield bonds, which is a good indicator of investors' risk appetite.
Today, there are many brilliant minds working in risk-management departments at banks and investment managers. Using past data and fast computers, they develop impressive models that will generate higher returns with little downside risk. It's a beautiful thing until it doesn't work because correlations between asset classes change, risk premiums unexpectedly widen or something comes up that wasn't anticipated. Think back to 2008. Too hard.
Easy: Long only
Hard: Hedging
It's often forgotten, but the most reliable source of return is the market, or what investment professionals call beta. The market is volatile and unpredictable, but over time stocks go up and dividends accumulate. Being fully exposed to the market over the long run allows the power of compounding to kick in. For an investor who doesn't need the money in the near term, volatility and surprises should be irrelevant.
Strategies that hedge away all or some of the market risk are designed to limit the downside. They draw less return from beta and instead rely on added value generated by the investment manager, or alpha. It has the chance of working out brilliantly if the manager gets it right, but alpha can be expensive and unlike beta, it's unpredictable in the long term. It's not always there. Too hard.
We all have our skills and preferences. I'd encourage you to think about what you're capable of doing and the chance of success. If you aren't confident you have an edge and don't clearly see how your approach can work, then put it in Mr. Buffett's box and look for another, simpler solution.
Tom Bradley is president of Steadyhand Investment Funds Inc.
Tom Bradley