Monday, February 25, 2013

Think, Act, and Invest Like Warren Buffett

Larry Swedroe is well-known for explaining the science of investing, but his latest excellent book Think, Act, and Invest Like Warren Buffett is decidedly less technical and much more accessible to a broad range of readers. The title suggests that the book is about beating the markets with superior stock selection, but it’s really about following Buffett’s advice rather than his actions.

The first couple of chapters contain numerous Buffett quotes that make it quite clear that he thinks most investors would be best off investing passively in low-cost index funds rather than attempting to beat the market. With this approach as a starting point, Swedroe uses the rest of the book to explain how to execute this plan. The focus on concepts rather than technical detail makes this book an easy read while still being very useful.

One thing that prevents investors from improving is that most have no idea how badly they are performing. A study by Glaser and Weber “found investors overestimated their own performance by an astounding 11.5 percent a year.”

Swedroe is big on having a plan in the form of “an investment policy statement (IPS) laying out the plan’s objectives and the road map to achieving them.” He thinks that you should even sign your plan as a kind of contract with yourself. The idea is to prevent you from deviating from the plan in a moment of fear or overconfidence. I’ve definitely seen many investors desperately searching for rational-sounding justifications for their emotional desire to change their plans.

Swedroe gives some simple examples to show how mixing different investments together can increase expected returns and lower volatility. He even suggests that lowering expected returns can be justified if volatility is also reduced. This is what happens when he mixes commodities into a portfolio. I’m not sold on the virtues of mixing in commodities, but that discussion will need more space.

The book contains a section on rebalancing portfolios based on some rules of thumb for how far a portfolio can get away from its targets before it’s time to rebalance. I find these hand-wavy rules unsatisfying. Some time ago I worked out a sensible set of thresholds based on trading costs and expected rebalancing profits and coded them into a spreadsheet I use to track my portfolio.

With the current debate in Canada about whether financial advisors should be held to a fiduciary standard, it’s interesting that the top of Swedroe’s list for what to look for in an advisor is one who meets “a fiduciary standard of care.”

Swedroe closes his book with a point that has meaning for me: “the truly great tragedy is that [active investors] miss out on the important things in life in pursuit of what I call the ‘Holy Grail of Outperformance.’” I used to waste hours each week poring over company financials. Now I have more time for other things I enjoy far more.

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