25IQ

Successful investors do not need to have above average intelligence.   What is required instead is the ability to control your emotions that will otherwise get you into trouble.  

To invest and earn more than what you would receive by purchasing index funds requires at a minimum that you devote a lot of work and time to the process.  If you are not willing to devote that time and do the work, then you should buy a index fund which charges you a very low fee.  More than 90% of people who read these words should invest by purchasing low fee index funds.

People will invest “actively” instead of buying index funds in no small part because humans are fundamentally overconfident about their abilities. There are other reasons why people invest unsuccessfully, but we will get to those reasons later.  You can also read about this source of human bias and oter topics discussed here in the quotations section of this site (which you can find by clicking on the links to the right of this text).  

People who are humble about their ability to invest and generate financial returns that are better than an index fund are rare. The odds are high that you are not humble in this aspect of you life.

One way to force yourself to confront whether you are actually willing to devote the time, do the work and successfully control your emotions is to adopt what is called a “barbell” strategy.  This strategy involves creating two buckets of investment capital.  The first  bucket  contains low risk investments that will enable to you capture what an index would earn less the fee you pay to the manager who does that for you.  The second bucket is for cash that you invest actively in an attempt to earn more than you will earn on cash put into the first bucket.

If you do adopt a “barbell” strategy, it is important that you keep clear and very current records of your investment performance. If you do not keep these records you will “fib” to yourself about how well you are doing with your second bucket of active investments.  There is nothing sinister about this “self-fibbing” because you are programmed by nature to do so.  You just need to recognize that you have a flaw in your mental software that you need to a tool to help correct so your bias, which is useful in other contexts, can be eliminated when you invest. 

If you do invest in index funds either as your exclusive strategy or as part of a “barbell” strategy, paying a high fee to (1) the fund managers (2) someone who sells the funds to you or (3) advises you on what funds to buy is like burning money in a fire.  It is a significant drag on what you will earn from your investments. 

Money paid as a sales, management or advisory fee would otherwise be in your accounts compounding its return over time. If you need advice, find someone who charges an hourly fee instead of a percentage of what you invest.  Managing an index fund is an that is all about process. You are paying a fee for an administrative function and that fee should be as low as that charged by the fund management firm like Vanguard, for example. Other firms that offer both actively managed funds and index finds are a problem for many investors since that firm often will never tell you the things you will read about here.  They do offer low fee index funds (because smart investors demand them) but they will never tell you to buy one since they would rather have you buy an actively managed fund on which they earn a high fee. 

If you read and understand what is written here you should be able to push past this conflict of interest and buy a low fee index fund even from a firm that really wants you to buy their high fee products.   In some cases this is important since your options where you work may require that you buy from a firm that offers both index funds and actively managed funds. When a fund management firm has conflict of interest like this it is more critical than usual that you think for yourself (actually you should always think for youself but people seem particularly inclined to delegate with regard to financial matters so it is worthwhile to state the obvious).

Understanding how a financial return compounds over time is vital to your financial success.  You may have read about or heard people debating about whether Einstein actually said: “Compound interest is the most powerful force in the universe.”  The important point is that regardless of whether Einstein made this remark or not, he should have said it.  Because it is true.  Amplifying the importance of understanding this phenomenon is the fact that humans have not been equipped by evolution to comprehend the power of a compounding financial return. 

Unless you take the time to understand the concept of compound interest and pay careful attention to its application in a range of scenarios you will not be able to take advantage of its powerful effects.  Even worse, you will suffer the consequences of this most powerful force in the universe working against you. The most common instance of fighting “the force” is debt such as credit card debt or a mortgage.

 If you owe $2,000 on a credit card which charges an annual interest rate of 19.6% “APR” and you pay the minimum monthly repayment amount it will take you 42 years to pay the card balance off.  Cards issued by stores under their own names typically have interest rates above 20%.

The best favor you can do yourself is to pay off credit card balances on time and in full. If you have a credit card balance, investing outside your 401k or other retrirement funds makes no sense since you won’t earn anything close to 19% or more that the card companies charge.

If you prove to a natural great active investor, earning 8-12% on your money is all you can ever expect over the long run.  Most hard working active investors can expect to earn 5-6% per year over time.

If you have decided to be an “active” investor then you must learn to think about probability in making your investments. You will never make an investment that will be 100% sure to outperform an index fund (such a superior return than can be earned by a index fund is known as ”alpha”).  Instead you will only find, after  putting in you time and effort and after keeping your emotions an investment in check once in a while where the probability that you will earn what is called “alpha” is substantially more than  50%.  Just a little better odds than 50% is not enough for it to be worth you making an investment.

Thinking about the “odds” of success, may seem strange to some readers, but when you think in terms of probability, it is indeed a bet you are making when you make an investment. And you want to make bets only when the odds are substantially in your favor.  It’s that simple.

How do you find a bet on an investment that is substantially in your favor? This is where you will need to devote the greatest share by far of the time and effort.

You may recall from an economics class or your reading that markets are “efficient”. This means that markets take all the available information and create a price for the good or service.  The market is often right about that price, but is not always right. It is possible, by finding an area in which you are particularly competent, to find an investment that is being offered to you for substantially less than it is worth. Not a little less than what it is worth mind you, but substantially less than it is worth. “How much is substantially less than it is worth?” you may ask.  The price should be so good  that it is screaming out at you to buy it.  “How often is this likely to happen?” It may happen once or twice in a year or twice in a month and then not again for two or three years.

It is important to note that mis-priced investments will happen more often that once or twice a year as a whole, but the only mis-priced investment that is important to you is one that falls within an area in which you are very competent. The smaller the area in which you apply your time and effort to being competent, the more likely is that you will genuinely spot the opportunities.

If you try to be competent in all areas and you will never be smart enough to find these investment opportunities. ”Focusing” your work and time within a circle of competence  matters a lot when trying to outperform the market. In other words, to generate “alpha” for you accounts specialize in an area and look for a few great opportunities.

Now we get to a critical point that requires some math to understand fully.  But the principle is simple: the more investments you own beyond a given number of investments (owning about 20 stocks means you are 80% “correlated” to the performance of the index) the more its is virtually guaranteed that you will under-perform the index or at best match its performance.  You will have done a lot of work at best to do as well as you would have buying an index fund and so this is called “closet indexing.” 

The good news is that the number of stocks that you can actually follow and be competent about is significantly less than 18.  It will take a huge amount of time and effort for you to follow even 12 stocks in a way in which you will remain competent and yet continue to engage in the essential job of scanning within your circle of competence for better stocks that improve the stocks in you account (called your “portfolio” of stocks).

You will find people who will tell you that eight to 12 stocks is not sufficiently diversified so as to reduce your “risk”. If you are have decided to be an active investor and you know you can do the work and devote the time and control your emotions, do not take this advice. Many investment firms are afraid that you will not be able to pick investments successfully and may file a lawsuit against them.  So they want you to buy a lot of stocks, be a closet indexer and still pay them a high fee. They would rather that you just under-perform the index by a few points and be merely grumpy instead of angry. They also may have attended a business school where taught goofy ideas about what “risk” is and how to reduce that risk. Explaining why these ideas are goofy involves math and is not the right discussion for this audience right now.  You can find some great thoughts  about “risk” and “diversification” in the quotations section of this site.

One can say that these “goofy” thinkers are busy now writing off billions of dollars of subprime investments that they created, sold and held.  They don’t sound like the sorts of people who should be advising you about how to invest and reduce risk now do they? They problem with investment advisers is that if they really were good, then they would not be willing to spend their time advising you now would they? It’s like the old Woody Allen joke about not wanting to be a member of any club that woudl actually accept him. So again, thinking for yourself is essential. 

Hopefully, many readers will at this point have had their overconfidence bubble pricked by a pin and have resolved to themselves to buy low fee index funds and forego active investing or at least have decide to barbell as a strategy. Again, fewer than 10% of the people who started out reading this should be active investors.  But I fear the number is larger than that.

For those people who are still determined to be active investors, the discussion must continue. The terms used will from this point forward get more complex and technical. Unless you are willing to learn what the terms mean and how to use the concepts then you should send youself “back to go” and buy the low fee index funds. I am hopiong that more and more people send them selves back to go as the discussion continues.

The next question for somene who wants to be an active investor is: what is the process by which I find an investment that has a substantially better than 50% chance to outperform an index fund? 

The first place to start is to have a knowledge of business.  A share of stock is partial ownership in a business. Full stop.  The best way to understand business is to operate a business. Having a lemonade stand as a child or even as an adult is a good start.  There is no better way to learn how to fish than to actually fish.  If you have never owned a business or been responsible for a business then the odds are stacked against your being a successful active investor. It is not impossible to understand business by reading books and talking to people, but it is very hard to do.

In contrast, the approach which does not look at a stock as partial ownership of a business instead involves thinking of a share of stock as a piece of paper and that a person’s job is to guess what great numbers of people will think about the value of that piece of paper in the future.  In other words, these people are trying to make accurate predictions based on psychology about what large masses of people may or may not do in the future.

The discussion which follows is only for those  people who are open to the idea that a share of stock is partial ownership of a business.  Advocates of the “mass psychology” school on investing should, instead of reading what follows, devote the time saved to reading Freud, Jung or perhaps Dr. Phil.

Anyone who has been in a real business quickly realizes that there is a big difference between revenue and profit. It is stunning how many people, particularly journalists, do not understand this fundamental point (in most cases because they have never operated a business). Very often a business has revenue but no profit. Lots of fancy accounting has been created by promoters to get people to focus on numbers other than profit. All revenue and no profit can fool people in the short term but not in the long term because in the short term the price of a share of stock is determined by a voting machine and in the long term by a machine that weighs profit.

The other key idea is cash flow. The only unforgivable sin in business is to run out of cash. You can have lots of profit as accountants define it, but if you do not have cash you are dead as a business. The first rule is to always watch how much cash a company has and how that is changing over time. The second rule is to not forget the first rule.

To understand why some businesses earn a profit and many do not it is useful to look to the comedy of Father Guido Sarducci:

“I got this idea for a school I would like to start, something called the Five Minute University. The idea is that in five minutes you learn what the average college graduate remembers five years after he or she is out of school… Economics? ‘Supply and Demand.’  That’s it. ”

 

The problem with selling anything at a profit in agiven business is that others will start doing the same thing and increased “supply” of what you and the others sell will take away your profit.  So you need to have something that makes it hard to supply what you do– this “something” is the basis of what is called a “competitive advantage” or a “moat”.

The complexity of the discussion is again about to be turned “up a notch” and I hope that more people will, as a result of this complexity, head toward the low-fee active indexing approach. That post will be coming soon.