In 2014 Warren Buffett wrote:
My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard‘s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors—whether pension funds, institutions, or individuals—who employ high-fee managers.
I recently listened to a podcast that explored this statement and whether active or passive management is better. In our last blog we explained that we need to think differently when it comes to investing money. Cash, as an asset class, whether to provide “income” or “growth” is not really a viable long-term investment option.
In this blog I want to expand on how we approach investing money, and the theory behind what we do.
How do people think?
In previous blogs we have explained how we act as a barrier; we aim to take the emotional attachment away from investing.
If we expand further, in the past I have invested in direct shares. The problem then is that I became emotionally attached to those shares, and that meant I would make mistakes.
This is common with investors; there are many different mistakes we can make but one is that if the share price falls, we can become fearful, forget our original thesis and sell at a loss.
In the UK there are something like 2 million DIY investors; on average they tend to hold investments for about 12 months or less. Fundamentally investors are driven by greed and fear, and DIY investing heightens these emotions.
This means if we see something has done well then, we are likely to want to invest in it. Many DIY providers will promote this within their marketing. This often leads to chasing last year’s winner; therefore, we are likely to underperform whatever benchmark we set ourselves.
We feel, there is a strong argument that Warren Buffet is right. You buy the S&P 500 index fund and you leave it alone.
Even when we take the emotional side out of investing Warren Buffett’s theory has some holes. Firstly, as humans we will compare to other people and it is more likely we will underperform.
Even the portfolios we manage will underperform the “index” at times but there are two things that we aim to do; we look to find good consistent long-term investment managers and diversify assets. By taking this approach we believe we can deliver returns which clients will be happy with.
Secondly, it is important to understand that there are many different strategies when it comes to investing; in the recent podcast I was listening to, they stated there were something like 15 to 20 different strategies. Some will do better in rising markets, and some will do better in times of recessions. Passive falls into this grouping.
This makes it very hard to pick the best managers if we use active management. The key for us is consistency; we are not looking for the top manager. The second approach we adopt is to be careful that we don’t allow bias to come into our thinking; it is very easy to believe something to be true and seek evidence to support that.
The point of this is that if we adopt the theory of Warren Buffett, how can we be sure that putting our money in the S&P 500 is the best place to be over the next 10 years? Just because it has done well doesn’t mean it will continue to do so.
It is very easy to be swayed by what people say and/or do. The more we read, the more we listen, the more we tend to steer towards those with views like ours.
Personally, we have no view on whether active or passive is better; but it is important to understand that with passive you also need to be active.
These are some discussions we have had in the past to illustrate whether we use active, passive or do nothing.
Global bonds – it is very easy to buy a global bond index. If we think returns from global bonds will be low for a long period of time, then going passive might be a better route.
However, there is a school of thought that buying the index actually brings in greater risk than an active fund because you are buying the most indebted companies, and if there is a belief that we are in a bond bubble and things reverse then the index is not where you want to be. In this case you need to be active in your decision making, it could be that you hold the index for a short period of time but not as a long-term strategy.
Country specific – we can see why Warren Buffett prefers an S&P 500 Index Fund because in the US it is harder to beat the index. There are managers that do, but the US is perhaps one market that an index fund might be a better route. This may mean you blend it with an active strategy, or it is your only exposure to the US.
When we looked at the UK, if you wanted a pure All Cap Fund (this is a fund which invests in a broad universe of equities irrespective of the size of the companies) then actually there are very few strategies that do this and therefore an index again might be the best route.
However, we would argue that in more complex markets like India, China, Emerging Markets, Asia etc active management can provide significant benefits.
In all of this we must be careful not to be swayed. We can easily look at a good fund and say, “well it has done this because of this” and therefore we will try and second guess what it might do in the future. This can be crippling because we almost start to discount everything as we try to over analyse all the potential future outcomes. In doing this we get to a point where we just don’t know what the best route to investing is.
Sometimes, this approach is important. We have looked at country specific funds, and one region in particular; we don’t believe long-term passive is the right route. However, the number of active managers operating in this area are limited and although performance is okay, we have concerns. It is more about a gut feel than anything specific. For this reason, we may hold back in investing. That is not about over analysing it is about accepting that waiting might be the better option.
Therefore, we need to be careful when investing that we are not swayed by our own views and that we don’t over analyse to such an extent that we can’t decide. (Paralysis by analysis!)
What will work
It can be hard to beat an index. However, before everyone rushes to buy an index the next point is this. What are you trying to perform against? If we compare our balanced portfolio against the S&P 500 over ten years it would have significantly underperformed, the same would be true against the FTSE World Index but it would have outperformed the FTSE 100.
Fundamentally we are not trying to achieve that. Our aim has always been to deliver returns in the region of 6% to 8% p.a. depending on the risk profile of the client. We are not trying to guess which index is going to be best over the next ten years, but we are looking to diversify to provide consistency of returns. We are also not trying to guess which investment strategy is best, but we are trying to find good consistent long-term investment managers.
Unlike DIY investors, investment managers tend to hold investments for 3 to 5 years, and some much longer. In truth it is thought that only about 10% of DIY investors make good consistent long-term returns, on the other side good active managers get about 60 to 70% of their choices correct and this is what drives those returns.
Could we have periods when we underperform the index?
Of course, but which index? We have built a ‘model’ index to provide some comparison, but it is just a guide. If we can get the consistency of returns, then actually we believe we can take away the risk that an index can bring.
Just because we have seen strong returns from say the S&P 500, it doesn’t mean these will continue; if the index was full of heavily indebted companies that were being squeezed by technology, there is no haven when things go wrong.
And where does this all lead
In our last blog we stated that because we are investing in different times, we must look elsewhere as cash is not really a viable investment option.
Equally when we are looking at investing, building a diversified portfolio of assets is key. However, we need to be careful that we don’t allow our beliefs to cloud our judgement, and therefore look for evidence to support it. Fundamentally, we almost want to ignore the 15 to 20 different investment styles and just search out those fund managers who we believe can deliver those consistent returns. If we can deliver returns that are acceptable to clients, then we are doing what we set out to do.
The argument of passive vs active is almost irrelevant because both have a place, and both need fundamental research. But one truth for anyone investing client money is whether you would be happy to invest in what you recommend? If the answer is yes, then clients should have some reassurance that both parties are aligned in terms of the eventual outcome.
Note: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.