Investors are bound by the common decision to make money in the stock and bond markets. And from here we diverge in a thousand and one ways. Any investment decision we make should be based on information, but the information that can direct our actions is varied and various. This greatly disperses our behavior. Still, strong forces, often outside our control, work on the investment decision-making process. In particular, transaction costs and risk considerations each greatly influence the investment choices we make.
As for the costs, if we don’t believe we can afford or overcome the fees related to certain investments, we will steer clear of those investments. At other times, the costs attached to certain investments will simply restrict our access. Linked to this, if we feel that certain investments are too risky, we will avoid them.
In life, we often act based on deep-seated ideas of who we are and what we believe we can be. Every investor wants to maximize his or her returns while taking into consideration the risk or volatility attached to those returns. But some of us stick to the safer routes to what we deem acceptable returns. Others of us throw caution to the wind in the pursuit of break-out gains. And many more of us fall somewhere in between, walking both the safer and riskier paths that lead to the return.
The question is, as an investor, who are you and what do you want to be?
To help you answer this, I have classified the predominant investor types in relation to the most common investment vehicles available today. The parallel between energy generation and return generation continues, and here it enables me to show how investors embrace different levels of risk and cost—sometimes with full knowledge and other times not—in pursuit of their returns. As you will see, this pursuit can be quite primitive. It also can be very sophisticated. It can be relatively cheap. It also can be costly, in terms of both fees and risk. Ultimately, however, I believe this pursuit can be well balanced as well as flexible.
By your nature, you might fall in with one of the following groups, or you might gravitate toward several. In the end, I hope that each serves as a reference point for distinct types of investor behavior. Although the following investor types are presented in an absolute sense, I believe that each of their functionalities has value when accessed at the appropriate times.
Wood always will keep you warm. It is a renewable resource that can be counted on to be available in good times and bad. The cost of entry to wood burning is low; you can perform this function by way of an impromptu fire pit or a built-in fireplace. Wood burning might not be the most efficient way to generate warmth, particularly on a large scale, but it is the old standby that will do the job when you need it done.
The investing equivalent to this is bond investing—more precisely, money-market investing. Just as wood will be the zero-risk fuel as long as there are trees, money markets always will be the low-risk investment alternative. Not surprisingly, when America has grappled with oil and natural-gas shortages, there has been a spike in old-fashioned wood-fired home heating. Comparatively, when the stock market has entered periods of decline, investors have flocked to money-market instruments, such as “cash” positions or short-term government securities.
A well-diversified portfolio should always have some exposure to short-term instruments, but for this discussion, we’re dealing in absolutes: The wood-burning investor is the one who makes a career out of investing in short-term fixed-income securities.
Treasury bills, as you might know, are debt securities; they are I.O.U.s whereby you lend money to the government at a predetermined rate of interest for a short period of time, such as three months. Given the brief duration of the loan, it is more convenient for the government to sell these securities at a discount equivalent to current interest rates. For example, if the annual interest rate is 4 percent, then the 3-month interest rate on the T-bill is 1 percent. In this case, a bill that pays $1,000 at maturity will sell for $990. Investors receive a certificate for that loan and cash it in at maturity. Because the loan is only for three months, the risk of setting the rate too low in relation to the level of economic activity or the underlying inflation rate is well below that of longer-maturity instruments. In addition, T-bill rates are reset every three months. So in effect, the borrower (the government) refinances every three months.
This is all low-risk stuff. In contrast, the rates for ten-year Treasury bonds are set for ten years. If the market interest rate changes during that time, the price of the ten-year bond must adjust to reflect the new rate. Longer-maturity bonds are thus subject to principal risk, or the fluctuation in the price of the bonds.
Just as many types of wood will burn well in the fireplace, a variety of dependable short-term fixed-income vehicles are available to investors. Risk does fluctuate across this menu, with the short-term debt of businesses and corporations (or commercial “paper”) typically promising higher returns along with higher risk, and lower-yield T-bills offering the converse. Yet, as a group, the returns promised by short-maturity fixed-income instruments usually do not approach the potential gains offered by stocks.
This is how the money-market investor becomes the wood-burning investor: Burning wood will provide you with warmth, but many of your potential BTUs will escape out the chimney. (Modern high-efficiency wood stoves are not part of this comparison.) Likewise, the wood-burning investor will enjoy low risk and, for the most part, guaranteed returns, but also will exhibit low return-generating efficiency relative to the overall market.
Most of us know someone who has said something to this effect: “If I only had bought such-and-such stock 20 years ago, I’d be sitting pretty right now.” The ones we hear from less, if only because they have little to boast, are those who might say, “If I hadn’t put all my money into such-and-such back then, my current financial situation wouldn’t be so dismal.”
These statements are based on extremes, but either might be attributed to single-hook-up investors, those who specialize in a single investment or investment style.
These are the investors who would put all their investment eggs in one investment basket, presumably with the intent of turning a good profit. Such a basket might include multiple shares of the stock of one company or a group of stocks in one industry. It also might include shares of one or more funds that are biased toward a group of stocks, shares that tend to move together (or behave in the same manner) as a result of the preferences of a fund manager toward certain size, style, and/or location characteristics (or other asset attribute).
For instance, if you owned shares of a fund that invested in, say, all growth stocks during the latter half of the 1990s, you probably did very well. However, if you held shares of a value-biased fund during that period, you likely did poorly. Or maybe you owned a 401(k) that was invested entirely in the stock of the company you work for. If that company was Microsoft or Google, you probably did very well. On the other hand, if your company suddenly went belly-up, your retirement nest egg dissolved. (Many an Enron employee can explain this heartache.) Such is the ultimate downside of investing in a small number of stocks or single-interest funds.
Single-hook-up investors are not uncommon, and they are bound together by the common trait of being undiversified. As the BTU story teaches us, this is a position fraught with risk.
For example, if in the 1970s you lived in the northeastern U.S. and your house was hooked to a natural gas line, you likely experienced a disruption in the flow of your BTUs when you needed them most. In the same way, the risks for single-hook-up investors always will be elevated. In the absolute sense, this practice is best suited to the extreme risk taker and well-informed market dabbler, both of whom are poor models for the responsible investor. However, when you believe you have excellent information on the direction certain assets will move and have a high degree of confidence in the certainty of your forecast, you might have every reason to put all or most of your eggs in one basket—but only if you are willing and able to remove them at the appropriate time.
Unfortunately, being confident does not mean you will be correct. Investors who make allocation decisions with conviction but do so without the guidance of an appropriate time-tested framework for making those decisions almost always pay a high price for their mistakes in the long run. It’s like playing Russian roulette: You might win a round or two, but someday you’re going to end up on the floor.
Single-hook-up investors who own only a handful of stocks or single-interest funds might see high returns when things go their way, but they nevertheless expose themselves to high risk and the potential misfortunes of individual companies.
Do you know these people? There are a few in every neighborhood and probably a lot more.
The oil truck used to come to their houses before they had lines put in for natural gas. Since that time, they grumble that they should have stuck with oil, which currently is the cheaper fuel in their state, although they hope their investment in clean and efficient natural gas will at some point pay dividends. In the meantime, they attempt to take the edge off their high natural gas bills by firing up their wood stoves on those not-too-cold winter nights. In the summer, they seek out fuel economy as well. When the mercury climbs, they often cook outside on their propane-fueled grills, enjoying the “free” cooling breezes and bypassing the need to turn on their air conditioner and natural-gas oven. They’re the kind of people who prepare for emergencies, too. In their garages, they store gasoline-run generators, which sit beneath the shelf that holds the kerosene-fueled lanterns. They sleep well at night knowing they can rely on alternative fuels when warranted by events.
These people manage their own portfolios of fuel-burning strategies. They can predict which fuels they will burn based on the recurring weather cycles, and they take advantage of the random variations in temperature day to day. In this way, they perform two types of fuel management: long-term and passive, based on the cyclical fluctuations of the seasons, and active, based on the randomness of the weather. By storing portable generators, they also lower the potential high cost of their energy supply ever being interrupted. But because they understand that producing BTUs in this way is a relatively expensive proposition (due to economies of scale), the generator is but a last resort.
These people have spread risk around nicely, although they have done so in a very hands-on way. Similarly, spreading investments across many companies and/or funds is a common way investors mitigate risk and lower the costs associated with disruption.
Buying stocks, company to company, requires great diligence if diversity is to be achieved, making it an activity best suited to the most hands-on investors. However, many multiple-hook-up investors strive to achieve diversity by buying mutual funds that are invested in a range of stocks and bonds, and/or exchange-traded funds (ETFs), which mimic the performance of individual stock indexes. Such funds do lower risk, although investors need to choose these vehicles with care.
ETFs are baskets of securities traded, like individual stocks on an exchange. They can be bought or sold throughout the day, they tend to have lower expenses than mutual funds, and they can be bought or sold on margin.
As mentioned in the single-hook-up example, mutual funds tend to have mandates whereby they purchase “like” assets, such as mostly value, growth, small-cap, large-cap, or international stocks. Mutual funds, which are active investment vehicles, also can be attached to high management fees that must be hurdled before even a dollar in profit can be counted. Meanwhile, because ETFs aim to replicate the performance of stock indexes, they can be biased toward the “like” assets contained in the individual indexes. (In Chapters 14, “Ending the Never-Ending Debate: Active vs. Passive Investing and Why You Can Take Both Sides,” and 15, “A Rational Walk Down Wall Street: Darting Between Passive and Active When the Odds Are in Your Favor,” we investigate whether actively managed mutual funds are superior to passive ETFs.)
ETFs and mutual funds also buy assets in bulk; thus, a “herd” or “all-aboard” characteristic can arise that reduces the potential diversity of these funds. Logically, when people in a group all do the same thing, diversity of action ceases to exist. That said, because mandates are attached to mutual funds and ETFs (making them analogous to the different fuels), combining them based on the cyclical nature of the economy becomes a viable way to maximize long-run returns while minimizing the risks or volatilities associated with those returns.
In terms of achieving diversification that maximizes returns for a given level of volatility, the best multiple-hook-up investors are those who are most diligent about identifying the characteristics of the stocks, bonds, and funds they place in their portfolios.
In the cellars of old homes, you can still sometimes find those rooms where the coal was stored before it was fed into the furnace. For many years, coal was king of the cellar, the workhorse of home heating before cleaner-burning oil and gas nudged it aside. But coal as a fuel source did not disappear; in a way, it concentrated on bigger things.
Today, although coal represents only about 20 percent of the fuel used in the U.S., it is by far the number-one fuel source for the nation’s industrial boilers and electricity generators. In electricity production, coal fires the enormous boilers that create the high-pressured steam that powers the giant turbines that create the electricity. That’s not the kind of thing that goes on in today’s cellar; because of economies of scale, coal-burning is an activity best suited to the biggest of burners. Likewise, the relatively low energy needs of most houses are not compatible with the economies of scale offered by the giant coal burners.
In this way, hedge funds are analogous to big-time coal-burning facilities. Hedge funds are unregulated, highly autonomous vehicles that invest in just about anything—stocks, bonds, futures, etc.—but often by way of high-risk techniques, such as short-selling (the practice of trading in unowned securities with the expectation that they will decline in price) and the use of leveraging techniques (or borrowing). These are highly managed investment vehicles that are designed to be uncorrelated with the market and seek to outperform the market. And they are very restrictive, partly because of government regulations: Each fund sets limits on the number of investors it allows in (typically less than 100), requires high minimum investments (normally more than $250,000), mandates that investors meet net-worth requirements (often $1 million or more), and sometimes, largely as a result of the nature of the investments, does not allow investors to redeem the value of their shares all that frequently.
Related to this, just as the coal-burning industrial boiler is costly to operate, hedge funds are attached to high fees: Hedge-fund managers characteristically claim 20 percent of profits in addition to management fees of 1 or 2 percent. But just as coal-burning facilities can generate a massive amount of energy, hedge funds can produce lofty returns.
For most investors starting out, hedge funds are off limits. But in time, as their net worths grow, they can and should look to hedge funds as viable and high-powered sources of returns. The golden rule, however, is to look hard before committing: The big-burner hedge fund can be a risky place to put your money. (In Chapter 16, “Alpha Bets: The Case for Hedge Funds and a Greek Letter You’ll Want in Your Portfolio,” we more formally weigh the pros and cons of hedge-fund investing.)
For a very long time in investment history, an asset was simply a stock or bond. But in the latter part of the twentieth century, investing underwent an information revolution. At this juncture, all available assets began to be grouped into asset classes.
Generally speaking, no longer were there merely different stocks and bonds to choose from, but different classifications of each based on their inherent and identifiable behaviors over time. The three major classifications became stocks, bonds, and cash. Within these breakdowns, important delineations were made. For instance, within stocks, modern portfolio theory gave us breakdowns by size (small-cap, midcap, and large-cap), style (value and growth), and location (domestic and international). These categories all seem rather intuitive, but once popularized, they transformed the way we invest.
In a way, we were presented with the distinct types of fuels that could power our portfolios, with all the fuels having predictable natures, insofar as they will very likely perform a certain way over a certain period of time. From this point on, we also could attempt to develop the “optimal fuel mix,” one that would deliver the highest possible returns for a given level of risk.
That optimal mix is partly based on mean performance—the long-term trend-line of asset classes, the future slope of which is predicated on past performance as well as on the historic correlation between the different asset classes. (An understanding of the latter enables us to reduce the chance that the flow of our returns will be disrupted.) Put in the simplest of terms, if an asset class performed a certain way over the past 30 or so years, it can be expected to perform in a similar way over the next 30 or so years (market conditions, in general, remaining the same). Under this assumption, the optimal mix of the past provides us with the optimal mix for the future.
When the financial community began targeting asset classes, the process known as asset allocation was born. And energy is to the return as electricity generation is to asset allocation.
By buying electricity, individual consumers indirectly burn the different fuels that will ultimately provide them with the energy they seek. The advantages of this are several. When buying electricity, consumers indirectly take advantage of the economies of scale of multiple fuel-burning processes and often extend their reach to the energy produced by the nuclear, hydropowered, and coal-burning processes. In doing so, consumers greatly reduce the possibility that the delivery of their BTUs will be interrupted for any prolonged period of time.
Meanwhile, the generating facilities can attempt to anticipate fluctuations in the prices and availability of the different fuels, a practice that reduces both risk and cost. They also can combine the use of different fuels to minimize the long-run cost of electricity generation. They also can take advantage of geographic differences on the fuel map, determining which fuels are easiest and most cost-effective to transport and which facilities are best suited to burn certain fuels. Clearly, electricity-generation facilities have many more fuel-purchasing and fuel-burning options at their disposal than any one end consumer.
Comparatively, by combining different asset classes and formulating alternative asset mixes, the process known as asset allocation could increase the chance that investors receive their returns in the amounts they desire and when they need them. The assumption, and a proven one, is that although asset classes at times deviate from their long-run trends, they will return to those trends. Investment managers call this phenomenon of returning to this long run trend mean reversion. Thus, by allocating to asset classes over a long period of time, investors reduce the chance that those temporary deviations will cause too much damage to their portfolios.
Electricity-generation investors are asset allocators, which is another way of describing many modern investors. They both have to develop a process of dividing the investment among the different kinds of fuels/asset classes to optimize the risk/rewards trade-off based on the institution-specific situation and goals. By purchasing and switching between asset classes, these investors mimic the functionality of the electricity-generation facilities that substitute between fuels. Importantly, the extent to which this substitution process occurs separates one asset allocator from the next.
As an investor, who are you, and what do you want to be? In the preceding classifications, you might find your answer.
Again, I believe there is value in each of these behavioral models, although I admit that I’m partial to the final classification—at least, as a starting point. Asset allocation is today an extremely viable way for investors to both lessen risk and meet their goals. The theory rests comfortably on the predictable nature of groups of assets over time. But I depart from a strict allegiance to static asset allocation: I believe asset classes diverge from their long-run trends in a predictable manner instead of only following long-run trends that are predictable.
In this way, cyclical asset allocation can offer an investor much higher returns than traditional asset allocation. The cyclical asset allocation strategy is a strategy that deviates temporarily from the long-run optimal allocations to take advantage of predictable fluctuations in the market. The former switches between asset classes periodically and when warranted by events, whereas the latter might switch only occasionally or never. The better or more reasoned those switches are, the better an investor will perform.
All endeavors, however, must have a starting point, or a point of reference. So before a cyclical asset allocation can be performed, a traditional asset allocation must be constructed. This allocation (should you choose to copy it, and I recommend that you do) is the starting portfolio from which you will switch, or tilt, throughout your investing career.