Friday, November 8, 2024

How Investing Has Changed Over the Past Century

Benjamin Graham is widely considered to be the “father” of value investing, the process of finding individual stocks whose businesses offer the prospect of future price gains while offering reasonable protection against future losses.  Graham co-founded Graham-Newman Corp. nearly a century ago.  Stock markets have changed drastically since then.

Early in Graham’s investing career, his approach was to buy stock in companies that were out-of-favour and severely undervalued.  He described these methods in his 1934 book Security Analysis.

But Graham’s investment methods were never static.  As Jason Zweig explained in Episode 75 of the Bogleheads on Investing Podcast:

“People criticize Graham all the time for being old-fashioned, for having these formulaic techniques for valuing stocks, … and then people say these things are all out-moded.  Nobody invests like that any more.  Nobody should.  And that completely misses the mark for two reasons.  First, during his lifetime, Graham revised the book [The Intelligent Investor] several times, and every time he revised it he changed all those formulas.  He updated them to reflect the new market realities at the time the new edition of the book was coming out.  … If he were still around today, he would update all those formulas all over again, and they would look nothing like what’s in the books.  … The second objection is much more basic, which is: that’s not Graham’s message.  … Graham’s message is that if you try to play the same game as Wall Street itself, you will lose.”

Graham recognized that markets change over time.  To keep beating the market averages, as he did for many years, his investment methods had to change over time.

However, in Graham’s last version of The Intelligent Investor in 1973, he wrote

“We have some doubt whether a really substantial extra recompense is promised to the active investor under today’s conditions. But next year or the years after may well be different. We shall accordingly continue to devote attention to the possibilities for enterprising investment, as they existed in former periods and may return.”

Graham expressed optimism that conditions might change so that some version of his investment approach might beat the markets.  However, that hasn’t been the trend.  Markets have become ever more competitive with each passing decade.

Another quote from Graham in the same 1973 book:

“Since anyone—by just buying and holding a representative list [a market index]—can equal the performance of the market averages, it would seem a comparatively simple matter to ‘beat the averages’; but as a matter of fact the proportion of smart people who try this and fail is surprisingly large.  Even the majority of investment funds with all their experienced personnel have not performed so well over the years as the general market.”

By 1976, Graham become more pessimistic about beating markets:

“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook ‘Graham and Dodd’ was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.”

Graham remains a hero to many value investors, despite the fact that 48 years ago he doubted whether analyzing businesses to find good value worked any more.  Graham’s methods worked from 50 to 100 years ago because of the ample dumb money flowing in stock markets.  For superior investors making excess returns to exist, there must be many inferior investors performing worse than market averages.

The proportion of money in stock markets controlled by individual investors has declined steadily over the decades.  Investors who knew little used to buy their own stocks.  Now, many such investors use mutual funds and exchange-traded funds to have their investments controlled by experts.  Dumb money has shrunk as a percentage, and the competition among investment professionals to exploit dumb money has become so sophisticated that few understand it.

Markets have reached the point where many smart investment professionals seem like dumb money when compared to their competition.  In this environment, individual investors have little chance as stock pickers.  In the third edition of The Intelligent Investor, Jason Zweig wrote

“Millions of investors spend their entire lives fooling themselves: taking risks they don’t understand, chasing the phantoms of past performance, selling their winning assets too soon, holding their losers too long, paying outlandish fees in pursuit of the unobtainable, bragging about beating the market without even measuring their returns.”

Markets have changed dramatically over the past century.  Simple methods of beating markets stopped working decades ago.  There may be some brilliant investors, such as Warren Buffett, who can still beat markets, but most investors actively investing their own money are just fooling themselves.  We could make the case that if Graham were around today, he might be a passive index investor.

Monday, October 21, 2024

Passive Investing Exists

Many people like to say that passive investing doesn’t exist.  However, these people make a living from active forms of investing and are just playing semantic games to distract us.  Active fund managers and advisors who recommend active strategies are the main people I see claiming that passive investing doesn’t exist, but what they say isn’t true.

There is a continuum between passive and active investing; they are not absolute properties.  We can reasonably call an investment approach passive even if it involves some decisions, just as we can call a person thin even if their weight isn’t zero.  We may disagree on the exact threshold between passive and active investing, but the concept of passive investing still has meaning.

By “passive investing,” most people mean some form of broadly-diversified index investing with minimal trading.  Although passive investing usually requires substantially less work than active investing, passive investors still have decisions to make.  They need to choose an asset allocation, funds, accumulation strategy, rebalancing strategy, decumulation strategy, etc.  The term “passive” comes from the fact that there is no need for day-to-day or even week-to-week decisions.  It’s possible for passive investment to run on autopilot for a year without adjustment.  In contrast, more active strategies need closer attention.

The rise of passive investing is a threat to active fund management.  Even factor-based investing that leans toward the passive end of the continuum is threatened by more passive forms of investing.  It’s hard to argue against the success of broadly-diversified index investing with minimal trading.  So, rather than trying to argue in favour of more active strategies, it’s easier to meander into a pointless discussion about how passive investing doesn’t really exist.

“Why should I pay your high fees instead of just owning a passive index fund?”  Active fund managers have a very hard time with this question.  A few meet it head on, but most can’t.  Advisors could launch into a discussion of the value of their services beyond portfolio construction, but some find it easier to launch into “well, you know, passive investing doesn’t really exist, because …”.

We could flip the argument against the existence of passive investing to prove that active investing doesn’t exist.  You’re idle for at least part of your day, so no investment strategy is purely active, and all we have is degrees of passive investing.  More absurdly, there is no pure form of red, so all we have is degrees of blue.  We need to see this claim that passive investing doesn’t exist for the distraction it is.

There is nothing wrong with explaining that even passive investors have to make important decisions.  However, phrased this way, active fund managers would have to explain why their products and services help investors make these important decisions.  It’s easier to deny the existence of passive investing and conclude “you see, there’s not much difference between the investment approach you want and what I offer.”  In reality, there are important differences that should be discussed.

Friday, September 27, 2024

Book Review: Simple but not Easy

Richard Oldfield was an investment manager for three decades, and he evaluated and appointed investment managers for a decade.  His book, Simple but not Easy: A Practitioner’s Guide to the Art of Investing, was first published in 2007, and his second edition, that I review here, came out in 2021.  The quality of the writing makes it a pleasure to read, but it comes from a time when “investing” meant stock picking, and few doubted that active investing based on star managers was the best approach.  For those who still think this way, this book offers many useful lessons, but others might see it all as advice on traveling by horse-drawn carriage.

The 2007 edition of the book is left intact with a new preface and a lengthy new afterword added for the second edition.  The new afterword provides interesting commentary on the modern investment landscape, but I still can only recommend this book to those dedicated to trying to beat the market.

Many themes in this book might have been controversial back in 2007, but seem well accepted today, at least by me: active managers are bound to make mistakes, “in aggregate, hedge funds are a con,” “leverage and illiquidity are the kiss of death,” fees drive down returns, investors need to avoid managers who are closet indexers, benchmarks are tricky, a manager’s approach can go in and out of style, forecasts are random at best, and valuations matter.

Some claims are a blast from the past.  Investors “can get almost all the diversification there is to get with a portfolio of as few as 15 stocks.”  No.  The author claims that ignorance and distance from the investing action are advantages for amateur investors.  “Investors in places remote from the City frenzy are arguably at a huge advantage.”  This idea that DIY investors can easily beat the pros used to be very popular, but it isn’t true.

The afterword written in 2021 is more interesting to me.  On bonds, “it is hard to justify using bonds as the counterweight to equities when they now yield almost nothing.”  This would have been written 3 or 4 years ago, and I certainly agreed at that time in the case of long-term bonds.

On electric cars, “there is no obvious reason why the traditional carmakers should not succeed with electric cars.”  To me, the obvious reason is engineering.  Tesla was hugely devoted to advanced engineering, to an extent that traditional car companies have had challenges matching.  U.S. car companies have covered up poor engineering with marketing for decades.  The author’s discussion of safety problems with self-driving cars left out the fact that human-driven cars kill people at a frightening rate.  We don’t need perfection to justify replacing the status quo.  Continued improvement can come later.

On the subject of the rise of passive investing, the author convincingly explains why active managers, on average, must trail passive investment returns by roughly their additional costs.  But he goes on to say “I think that it is possible to choose a group of active managers the majority of whom will outperform for the majority of the time.”  Oldfield’s own arguments make it clear that only a small minority of investors can hope to do this.

“The next ten years could … be a golden decade for active managers because the trend away from them has been too strong and is due for a large dose of reversion to the mean.”  This is just hopeful thinking from a former investment manager.  Active managers can only make up for their costs by exploiting other investors.  If the only other investors to exploit are index investors, the pickings are very slim.  Perhaps if 99% or more of investors were passive, there would be room for active managers to live off these pickings, but the proportion of investor money that is indexed is nowhere near that level yet.

This book is well written, and I would have enjoyed it back in 2007 when the first edition appeared, but now that I’m solidly in the index investing camp, I find its focus on trying to beat the market less compelling.  Investors who are still trying to beat the market with their own stock picks or who seek investment managers who can beat the market are its best target audience.

Tuesday, September 24, 2024

Indexing of Different Asset Classes

When it comes to stocks, index investing offers many advantages over other investment approaches.  However, these advantages don’t always carry over to other asset classes.  No investment style should be treated like a religion, indexing included.  It pays to think through the reasons for using a given approach to investing.

Stocks

Low-cost broadly-diversified index investing in stocks offers a number of advantages over other investment approaches:

  1. Lower costs, including MERs, trading costs within funds, and capital gains taxes
  2. Less work for the investor
  3. Better diversification leading to lower volatility losses

Choosing actively-managed mutual funds or ETFs definitely has much higher costs.  For investors who just pick some actively-managed funds and stick with them, the amount of work required can be low, but more often the investor stays on the lookout for better funds, which can be a lot of work for questionable benefit.  Many actively-managed funds offer decent diversification.  Ironically, the best diversification comes from closet index funds that charge high fees for doing little.

Investors who pick their own stocks to hold for the long-term, including dividend investors, do well on costs, but typically put in a lot of work and fail to diversify sufficiently.  Those who trade stocks actively on their own tend to suffer from trading losses and poor diversification, and they put in a lot of effort for their poor results.  Things get worse with options.

Despite the advantages of pure index investing in stocks, I make two exceptions.  The first is that I own one ETF of U.S. small value stocks (Vanguard’s VBR) because of the history of small value stocks outperforming market averages.  If this works out poorly for me, it will be because of slightly higher costs and slightly poorer diversification.

One might ask why I don’t make exceptions for other factors shown to have produced excess returns in the past.  The reason is that I have little confidence that they will outperform in the future by enough to cover the higher costs of investing in them.  Popularity tends to drive down future returns.  The same may happen to small value stocks, but they seemed to me to offer enough promise to take the chance.

The second exception I make to pure index investing in stocks is that I tilt slowly toward bonds as the CAPE10 of the world’s stocks grows above 25.  I think of this as easing up on stocks because they have risen substantially, and I have less need to take as much risk to meet my goals.  It also reduces my portfolio’s risk at a time when the odds of a substantial stock market crash are elevated.  But the fact that I think of this measure in terms of risk control doesn’t change the fact that I’m engaged in a modest amount of market timing.

At the CAPE10 peak in late 2021, my allocation to bonds was 7 percentage points higher than it would have been if the CAPE10 had been below 25.  This might seem like a small change, but the shift of dollars from high-flying stocks to bonds got magnified when combined with my normal portfolio rebalancing.

Another thing I do as the CAPE10 of the world’s stocks exceeds 20 is to lower my future return expectations, but this doesn’t include any additional portfolio adjustments.

Bonds

It is easy to treat all bonds as a single asset class and invest in an index of all available bonds, perhaps limited to a particular country.  However, I don’t see bonds this way.  I see corporate bonds as a separate asset class from government bonds, because corporate bonds have the possibility of default.  I prefer to invest slightly more in stocks than to chase yield in corporate bonds.

I don’t know if experts can see conditions when corporate bonds are a good bet based on their risk and the additional yield they offer.  I just know that I can’t do this.  I prefer my bonds to be safe and to leave the risk to my stock holdings.

I also see long-term government bonds as a different asset class from short-term government bonds (less than 5 years).  Central banks are constantly manipulating the bond market through ramping up or down on their holdings of different durations of bonds.  This manipulation makes me uneasy about holding risky long-term bonds.

Another reason I have for avoiding long-term bonds is inflation risk.  Investment professionals are often taught that government bonds are risk-free if held to maturity.  This is only true in nominal terms.  My future financial obligations tend to grow with inflation.  Long-term government bonds look very risky to me when I consider the uncertainty of inflation over decades.  Inflation protected bonds deal with inflation risk, but this still leaves concerns about bond market manipulation by central banks.

Taking bond market manipulation together with inflation risk, I have no interest in long-term bonds.  We even had a time in 2020 when long-term Canadian bonds offered so little yield that their return to maturity was certain to be dismal.  Owning long-term bonds at that time was a bad idea, and I don’t like the odds any other time.

Once we eliminate corporate bonds and long-term government bonds, the idea of indexing doesn’t really apply.  For a given duration, all government bonds in a particular country tend to all have the same yield.  Owning an index of different durations of bonds from 0 to 5 years offers some diversification,  but I tend not to think about this much.  I buy a short-term bond ETF when it’s convenient, and just store cash in a high-interest savings account when that is convenient.

Overall, I’m not convinced that the solid thinking behind stock indexing carries over well to bond investing.  There are those who carve up stocks into sub-classes they like and don’t like, just as I have done with bonds.  However, my view of the resulting stock investing strategies, such as owning only some sub-classes or sector rotation, is that they are inferior to broad-based indexing of stocks.  I don’t see broad-based indexing of bonds the same way.

Real estate

Owning Real-Estate Investment Trusts (REITs) is certainly less risky than owning a property or two.  I’ve chosen to avoid additional real estate investments beyond the house I live in and whatever is held by the companies in my ETFs.  So, I can’t say I know much about REITs.  

However, I don’t think the advantages of indexing that exist with stocks automatically carry over to real estate without checking the details.  Someone would have to examine REITs to see if they can play a positive role in investor portfolios.  Do REITs have hidden costs?  Are other market participants able to exploit REITs when trading properties?  What are the costs of managing passively-owned properties?  Perhaps someone has examined these questions in sufficient detail, but I haven’t seen the analysis.

Some of these problems apply to stock indexing as well.  For example, there are circumstances where traders can exploit the way that index funds respond to changes in the list of stocks making up indexes.  However, major index ETF providers have responded with changes to how they do business that reduce such costs to low levels.  I don’t know if REITs are able to do the same.

Commodities, Hedge Funds, Venture Capital, Collectibles, Cryptocurrencies, other Alternatives

Any time I look at index-style investing in other asset classes, I find more questions than answers.  What answers I do find often keep me away from these asset classes rather than draw me in.  It would take a lot to convince me to make any of these asset classes part of my own portfolio.

Conclusion

I’ll never claim that how I invest is the best way.  I seek reasonable long-term results with a reasonable amount of protection against extreme events, such as stocks market crashes, high inflation, or outright corruption.  In some cases, I stay away from asset classes for well thought out reasons, and in other cases, I stay away out of my own ignorance.  I’m good with that.

Friday, September 6, 2024

Book Review: The Canadian’s Guide to Investing

Authors Tony Martin and Eric Tyson have updated their book, The Canadian’s Guide to Investing, but it certainly does not seem very up-to-date.  Despite a few references to ETFs and some updated examples, most of the text seems decades old and no longer very relevant.  There are some good parts, but there are better choices for investment books.

The book makes reference to many things that used to be true.  Extensive discussion about “funds” is almost exclusively about mutual funds with little about ETFs.  Buying stocks is “costly unless you buy reasonable chunks (100 shares or so) of each stock.”  You can “call the fund company’s toll-free number” and invest by “mailing in a cheque.”  “A great deal of emphasis is placed on who manages a specific fund” – this is mostly a thing of the past.  “Invest in a handful of funds (five to ten).”  There is discussion of real estate “declines in the late 2000s.”

There are repeated references to MERs of 0.5% to 1.5% as being “low.”  Even the ETF discussion on this point says index ETFs “typically have MERs of less than 1 percent.”  I suppose 0.05% is less than 1%.

The authors advise people to avoid limit orders and use market orders when you intend to hold for the long haul.  They seem to consider limit orders as being only for trying to get equities for cheaper than the current ask price.  A good use of limit orders is to offer a price higher than the current ask price (or lower than the current bid price when selling).  This will usually give you the market price, but will prevent the trade from executing if markets move quickly against you just as you’re entering the trade.

The book advises people to rely on credit-rating agencies for bonds, which is interesting in light of the abject ratings failures leading up to the great financial crisis.

On asset allocation, “playing it safe” is to use your age as a bond percentage, “middle of the road” is age minus 10, and “aggressive” is age minus 20.  They go on to break down the stock allocation characterizing owning mostly Canadian stocks as “play-it-safe,” and having half your stock allocation outside of Canada as “aggressive.”  I don’t see anything safe about avoiding U.S. and international stocks.

The authors tell investors “who enjoy the challenge of trying to pick the better [fund] managers and want the potential to earn better than market level returns, don’t use index funds at all.”  Chasing star fund managers is an old and losing game.

At one point, the authors promise to help investors in “spotting a greatly overpriced” market so you can “invest new money elsewhere.”  It turns out that this method uses price-earnings ratios.  Shiller’s CAPE10 measure of U.S. stock market price-earnings has been above 20 since 2010, a period where U.S. stocks have grown by a factor of nearly 6 (including dividends).  This is not a good period to have skipped.

On the positive side, the authors advise against buying expensive cars: “set your sights lower and buy a good used car that you can afford.”  When it comes to index investing, “you can largely ignore the NASDAQ.”  “To find a home that meets your various desires,” taking “six months to a year [to find the right house and neighbourhood] isn’t unusual or slow.”  “Begin your search without [a real estate] agent to avoid … outside pressure.”

The authors have some interesting takes.  “One of the best tactics is to focus only on [retirement saving and paying off your mortgage] and ignore [saving for university or college]” until later.  They also offer extensive advice concerning owning a small business and determining if readers are suited to it.

The authors would need to put extensive work into this book to bring it up to date.  As it is, I can’t recommend it to others.