The best time ever to be an individual investor
The average piker would be better off in a savings account, but it has never been easier to be an elite investor.
A haphazard approach to investing is the default among the public. Investors see an array of options from individual stocks and sector funds to annuities, real estate, collectibles, and private businesses, all promoted by middlemen with compelling narratives. It’s easy to throw some money here and some money there, and maybe keep some under the mattress. The results are on average terrible and at worst, devastating. The table below from JP Morgan (individual investor data from Dalbar) shows that even when good returns are available, few actually get them. Led astray by narratives and emotions, most investors mis-time their allocations, and on par realize net returns barely above inflation.
The passive investing doctrine is solid advice This is why sages like Warren Buffett* and the recently departed Jack Bogle tell us not to try to time the stock market, but to invest regularly and hold on no matter what. For the mass of investors, for whom a message must be simple and consistent, out of all the advice they commonly receive, this will always be among the best. Save as much as you can, take advantage of retirement plans, and don’t sell a share until you’re 65. The most nuance the public can handle is to own more stocks when you are young and more bonds as you get older (100 minus your age is a prudent guideline). Clearly, few investors are content to take this advice, because if they were it would show in their returns. Many simply haven’t heard the gospel of passive investing, but others are betrayed by an impulse to achieve better than average results. In light of the above, why do we bother with value and momentum? Are alternative assets like gold, REITs, or foreign stocks worth the complication? Objectively, yes. A plan that takes advantage of uncorrelated return streams and adapts to changing environments is inherently more robust than a vanilla stock and bond portfolio. It isn’t active investing itself that is inherently hazardous, but unstructured investing - buying gold because you are suddenly worried about deficits, selling stocks because you don’t like the new president, or getting aggressive when the economy looks rosy and then bailing out in the next recession.
If active investing were inherently hazardous, the fund managers with the greatest long-term records wouldn’t overwhelmingly be value investors or trend followers. Haphazardness is our enemy, because an investor without a plan is at the whim of his emotions and whatever narratives resonate with him. A passive indexer may experience volatility in his account, but the discipline to keep adding to his account through drawdowns will keep him on track. Clearly, if we are going to stray from Bogle’s advice, we had better know what we are doing.
Stay humble
We start with the same assumptions as the indexers: we can’t trust our whims and leave our nest eggs to chance. Our approach must be grounded in intuition and empiricism. This means defining objective rules, because only rules can be tested, and only rules can keep us on track. The purpose of this letter is to illustrate some basic rules that go a step or two beyond 100 minus your age, because despite what the gospel of indexing says, it is not always a great time to invest. Indexers acknowledge that individuals are fallible, but they turn a blind eye to the aggregate effects of that fallibility. We may go mad singly, but more often en mass.
Now that a century of data can be dropped into a spreadsheet, we can eliminate the mystique of value investing and trend following. It turns out that the greatest investors of older generations weren’t wizards after all, that is, if you consider complexity a requirement for wizardry. What they were was disciplined, and to be fair, their discipline was all the more impressive given that they couldn’t tap a few keys and see a 100-year backtest. They simply had intuitive conviction in the respective wisdom of paying low multiples for steady cash flows, or buying leaders and selling losers. Few are blessed with such abilities, hence the sagacity of Mr. Bogle, and the value of his invention, the index fund.
Embrace better rules
Those reading this letter understand that there are good reasons to take a more active approach, and that we can apply the same conviction and discipline as indexers. The strengths of an index are no mystery. They are diversification (among stocks at least), a minimal value screen (the Dow and S&P 500 have earnings requirements), and a momentum filter (stocks that decline have their weights reduced and are finally dropped). These rudimentary rules are enough to keep the indices trending up on a long enough timeline, but there is nothing magical about them. Anyone today can create and deploy rules that better suit their needs. Many of these rules are best applied directly to an index, and if indices themselves are the result of rules, at what level do we consider a process active as opposed to passive?
For example, if we invest in the S&P 500, but only when it’s priced at under 20 times earnings, we are remedying a serious deficiency of this index from the investor’s point of view: it makes no consideration for price. All of the major indices were designed for tracking and reporting, not investing, and as such they will ensure that an investor behaves only as sanely those around him. Surely we should embrace a mechanical process that protects us from the brunt of crashes and compels us to invest when the crowd is selling cheap. In the year 2000, investors were sanguine about high valuations, and in 2009 most were bearish when valuations were much lower. Now again, most are comfortable paying nearly 30 times a trailing 10-year average of earnings. Clearly, individuals can benefit from passive processes that cannot be applied in aggregate.
That’s what we do as tactical allocators. We aren’t building indices for tracking and reporting, but rule sets for investors who desire better performance, whether that means higher returns or steadier growth with less downside. Today, the investable universe has expanded far beyond US stocks, transaction costs have dwindled, and computing has made it easy to define and follow an optimal process. As an insider, we can tell you that few professionals even attempt to do this, as gathering and retaining assets is actually easier when you follow the crowd. Thus, individuals who have the conviction and discipline to follow different rules will find themselves at the top of the ranks. It truly is the best time in history to be an individual investor.