Asset Class Investing
Billionaire David Booth’s Investment Tips for New Zealanders
Investment guru David Booth visited New Zealand to talk about his mission to change people’s lives through investments, reports Richard Meadows.
When a billionaire gives you investment advice, you listen.
When it’s backed by the research of several Nobel-prize winning economists, you really pay attention.
David Booth is co-founder and chairman of Dimensional Fund Advisors, which manages almost US$400 billion (NZ$600b) of assets.
Here’s his advice:
How the Best Investor in the World Beats the Market
For good reason, Warren Buffett has long been considered one of the most judicious investors of his generation. In fact, his firm Berkshire Hathaway has the highest risk-adjusted returns of any listed U.S stock or managed fund with a history of more than 30 years.
Which begs the question: What’s the source of Buffett’s above market returns?
The “conventional wisdom” has always conveniently been that his success is explained by his share-picking skills and his discipline. However, a new study1provides some very interesting and unconventional answers.
The following is a summary of the study’s findings:
- From November 1976 through December 2011 (a 35 year period), Berkshire realised an average return of 19.0% pa over and above the risk free asset (being U.S Treasury bills). In comparison, the S&P 500 (or the 500 largest listed stocks in the U.S) returned 6.1% above the risk free asset. That is an incredible result over such a long time period.
(It’s important to remember that Standard & Poor’s research comprehensively demonstrates that most investors don’t even get the market return – or in this case the S&P 500 return – over 5 years or longer. This is entirely due to ill-disciplined behaviour in volatile markets).
- As risk and return are related, you would expect Berkshire to have been exposed to more risk than the overall market to achieve this result. And indeed it was, with one measure being that Berkshire’s share price was 58% more volatile than the overall market. So only investors who remained disciplined and held onto their Berkshire stock would have enjoyed the long term performance.
- Berkshire had to endure periods of substantial losses compared to the overall market and significant drawdowns to achieve its results. For example, over the 20 month period to February 2000 (during the IT boom), Berkshire shares lost 44% of its market value, while the overall stock market gained 32%.
Not many fund managers could survive a 76% underperformance over a two year period! And no doubt there were many media commentators desperate to fill their column space each day who wrote off Berkshire shares during this time.
Buffett is clearly a proponent of our mantra “It’s not timing the market that counts, it’s time in the market that matters.”
- Buffett has boosted returns through the use of low cost debt to invest.
- Buffett has stuck with his strategy for a very long time period, surviving rough periods where others might have been forced into a fire sale or allowed emotion to interfere with the disciplined process of investing.
- Buffett’s approach is to buy large stakes in operating businesses and, in certain cases, provide strategic advice to management. He tends to nurture and support management more than other investors.
The study concluded that it is Buffett’s strategy that generated the alpha or above market returns, not his stock selection or market timing skills.
Our approach of targeting the dimensions of higher expected returns focuses on the factors that drive returns and deliver a premium:
Cash & Fixed Interest
- Credit & Term – only take credit risk and term risk where the bond portfolio is widely diversified and investors are adequately rewarded.
- Market – over time the sharemarket provides higher expected returns than cash and bonds because risk and return are related.
- Small – a well-diversified portfolio of small companies provides a higher expected return than large ‘blue chip’ shares because small companies are riskier assets to own and tend to have a higher cost of capital. A higher cost of capital over the mid to long term results in a higher expected return.
- Value – a diverse portfolio of ‘cheap’ shares as measured by book to market ratios provides higher expected returns than large, established ‘growth’ companies because these value companies are riskier assets to own.
It is the ones relating to the sharemarket – plus some additional elements like low cost borrowing – that the report concluded were the foundation of Buffett’s success.
Buffett’s genius thus appears to be in recognizing long ago that “these factors work… and sticking to his principles,” the study finds. It notes that it was Buffett himself who stated in Berkshire’s 1994 annual report: “Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.”
When the study considered all the factors that Buffett targets in his investment approach, it found that only 0.1% pa of Berkshire’s stock price outperformance compared to the market could not be explained. In other words, whilst 0.1% could be attributed to skill or luck, the remaining outperformance could be quantified by academically accepted investment strategies employed by Buffett.
So we know that Buffett has one extrodinary gift that few others share, he is disciplined. He combines that discipline to buy primarily value (out of favour) shares and using low cost debt.
Whilst the average high net worth investor cannot access the type of low cost debt available to Buffett, you can access the other factors that contributed to his market-beating results.
Bradley Nuttall’s Asset Class investment approach already captures the academically accepted factors that drive returns, plus ‘momentum’.
The academics we work with in the U.S have, after extensive research, uncovered a sixth factor that is currently being tested. This may be another evolution in our investment approach that is helping to provide our clients with the greatest probability that their lifestyle and financial goals will be achieved.
So in our own way, we are capturing the nous of Buffett through our evidence based approach to investment. However instead of our clients spending their time like Buffett studying the market for opportunities, we hope our clients are instead enjoying full and meaningful lives that don’t involve the day to day worries of investing.
Adapted from Larry Swedroe, Money Watch, 2 October 2012, and from Rick Walker at Stewart Partners, Sydney Australia
1. ‘Buffett’s Alpha’, by Andrea Frazzini and David Kabiller of AQR Capital Management, and Lasse Pedersen of New York University and the Copenhagen Business School, 29 August 2012
Harvard Study: Are Financial Advisers Giving “Good Advice”?
Harvard and MIT Professors sponsor the largest ever mystery shop on financial advisers. What did they find?
I’m sorry to say but there is a large, compelling and growing body of research that shows that most households make very poor investment decisions. The reasons why are fairly well documented: we are overconfident, follow the crowd and are ruled by emotions like fear and greed. Every single independent study that I’m aware of shows that buy and hold investors do better than the average investor fleeing in and out of markets and following hot tips. Collectively, academic researchers call the bad investing instincts we all share “biases”.
In the academic world, all that is old hat. But a recent study by the National Bureau of Economic Research (Massachusetts) conducted by professors from Harvard, MIT and the University of Hamburg (and commented on recently in the NZ Herald) added an interesting twist to the discussion.
“We ask whether or not the market for financial advice serves to de‐bias individual investors and thus correct potential mistakes they might make.”
In other words, do advisers prevent their clients from making financial mistakes based on their emotional biases? Good question!
To find their answer, researchers distinguish between “good advice” and “bad advice”.
What is good advice? From the study:
“We define ‘good advice’ as advice that moves the investor toward a low cost, diversified, index-fund approach, which many textbook analyses on mutual fund investments suggest, see for example Carhart (1997).”
Bad advice does just the opposite: it exploits investors’ built-in biases to encourage the high cost and poorly diversified investments that are in the adviser’s best interests to promote.
Armed with these definitions, the study sent out mystery shoppers to perform 284 audit visits to financial advisers.
So what were the results? Not good.
Again, we quote from the study:
“These results suggest that the market for financial advice does not serve to de‐bias clients but in fact exaggerates biases that are in the adviser’s financial interest while leaning against those that do not generate fees. In our index fund scenario, the advisers are even advocating a change in strategy (away from low fee index funds and towards high fee actively managed funds) that would make the client worse off than the allocation with which he or she started off.”
As much as this report looks bad for the financial advice industry, here at Bradley Nuttall we want to stand up and applaud. Finally, researchers understand that advisers are part of the problem. By and large, advisers do more to encourage poor investing behaviour than correct it. Why? Because most advisers (but not Bradley Nuttall) are paid, at least partially, by the “high fee actively managed” investments they recommend. It’s a flawed model.
But there are other reasons bad advice is so pervasive.
Good advice is hard to give. It often means that you tell a prospect or client what they emotionally do not want to hear. This decreases the chance they want to work with you, because your advice doesn’t “feel right”.
Combine this emotional hurdle with the fact that advisers can get paid handsomely to give bad advice – and that bad advice often has the air of exclusivity or inside knowledge that investors love – and you can see why we have a problem.
It’s good advice to suggest that investors will be compensated for the risks they take. The higher the risk, the higher the long term returns will be.
Bad (but emotionally satisfying) advice gives clients the expectation that, due to the adviser’s inside knowledge, there are high-return/low-risk investments out there just waiting to be picked off. This almost always leads to disappointment, as the figure below portrays. Good advice steers clear of get-rich-quick, can’t-lose and glamorous investments.
We strongly advocate the findings of this academic study. Bradley Nuttall has been giving good advice, defined in the study as “low-cost diversified efficient portfolios”, for over a decade now. And to ensure we are never compromised we do not take any revenue from investments we recommend, which is one reason the costs of the investments we use are about four times lower than the industry average.
However, our experience is that investors are confused. They hear so much noise; so many calls to buy or sell; so many worrying and conflicting reports, that distinguishing between good and bad advice is almost impossible.
Who do they trust?
How are they to know?
Here’s hoping that this report, and more like it, will start to have an influence on the hard working investors who simply want financial security and peace of mind.
Those investors, like all others, have biases. But we know that good advice delivered with honesty and integrity can make a big positive difference.
That’s the difference we try to make every day.
Investing When Others are Fearful
Warren Buffett, legendary US investor, has made billions of dollars investing based on a fundamental behavioural premise (coupled with ingenious business acumen): be “greedy when others are fearful”.
It sounds good. It seems pretty clear, when share prices look like the chart below, that the logical time to invest is at the bottom of the curve.
With the situation in the world so uncertain these days, many investors are reluctant to invest. We understand that reaction, in the current global environment. Many conclude that, since the world has slow economic growth (measured by GDP), it must mean the outlook for shares is also poor.
After all, it is widely believed share market returns are based on economic growth. If growth looks to be sluggish, doesn’t that mean that the share markets will also be sluggish?
How sound is that conclusion?
Fortunately we are here to shed some light and optimism. There is simple and compelling academic evidence that the intuitive link between economic growth and share market returns is probably flawed, or at least over-stated.
Research conducted by an American professor, Jay Ritter of the University of Floridaii, on the relationship between economic growth and real share market returns from 1900 to 2002 (that’s 102 years) showed that economic growth did not at allexplain share market return over the 102 year period. Look at the chart below. You’ll see that the height of the blue bar (economic growth) and the height of the green bar (share market performance) are unrelated across several different countries.
For example, Australia averaged 1.6% per annum real per capita economic growth. That’s the second worst of the six countries listed above, yet it had the best share market performance. Japan had the best per capita growth at 2.90% per annum, but only the fourth best share market performance. UK has the worst growth but the third best share market performance, better than the Japanese. How can this be?
The point is simple – economic growth does not tell us much about how share markets will perform.
It’s important that this result was found for a 102 year period. That period includes a global financial crisis (the Great Depression) and a series of World Wars, oil shocks, currency crises, a tech bubble and a terrorist attack, so it’s very robust data.
So the question remains: why? Why doesn’t economic growth link directly with share market performance? It seems like it should.
The paper offers multiple suggestions:
- When the economy grows often it’s the workers who receive the benefit, not just the owners of shares
- New businesses owned by private investors, not owned in public share markets, are better at catching the wave of growth
- Economies with poor growth have low share prices because market participants are a bit scared, so new investors can get better deals leading to higher potential returns
Buffett captures the last point best in his Berkshire Hathaway 2004 Chairman’s letter:
‘Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful’.
Fear is a natural human reaction to the current catalogue of negative stories from the media, but fearful investors make the mistake of imagining they can sell their shares before these bad news stories affect prices. This information is alreadyembedded in the price, so the only thing a fearful investor consistently achieves is to sell at the bottom of the curve. Warren Buffet responds differently – he acts like it’s Boxing Day and everything is on sale. The trouble for the rest of us is that living true to Buffett’s wisdom is very hard.
Bradley Nuttall’s approach is first to diversify so that we’re not over-exposed to any one set of market expectations for either country or company. We invest in over 40 countries and about 8,000 underlying securities. We resist the urges of fear and use discipline to hold on to our portfolios, knowing (as in 2009 and 2003) that patience will be rewarded. Down-markets are an unfortunate and inevitable reality of global business. But markets have always come back and, with discipline, or even with a bit of greed, smart investors will reap the benefit.
i From Carl Richards of Behaviour Gap
ii The paper can be found at http://bear.warrington.ufl.edu/Ritter/PBFJ2005.pdf
What Does the Bank Do With Your Money? Alternatives Beyond Term Deposits
When debating whether to invest in a diversified New Zealand fixed interest portfolio or put your money in the bank, one question worth asking is, “What does the bank do with your term deposits?”
The bank can’t simply hold on to the term deposit and continue to pay interest.
What do they do with the money?
Simple, the bank invests in a diversified portfolio of fixed interest. They issue loans backed by property to mortgagees. They lend to large corporations and small businesses and receive interest in return. To control their risk the bank pays close attention to the credit worthiness of the borrowers and the length of the loans. Importantly, the bank issues many loans and is careful not to put all its money in one basket.
Alternatively, investors could consider investing in a diversified portfolio of fixed interest similar to the bank’s own portfolio. To provide a diversified portfolio of fixed interest there will be an advice fee plus a management fee, say 1.20% combined. However, I’d contend that fee is much smaller than the bank’s implied fee of what they earn on investors deposits versus what they give depositors in terms of guaranteed returns.
I acknowledge that the diversified portfolio of fixed interest bears more risk than the banks guaranteed deposit. However, if such a portfolio fails over the long term to provide positive returns, you can be sure the bank is also going to be in trouble. Why? Because the bank and the diversified fixed interest portfolio are investing in the same thing.
Now a diversified portfolio of fixed interest is liquid. The client can convert it to cash money in one week. But how safe is it?
Looking at New Zealand Fixed Interest over the past 21 years, the worst:
- 1 year return was 2.35% per annum (best was 16.34%)
- 3 year return was 4.89% per annum (best was 9.37%)
- 5 year return was 4.94% per annum (best was 8.11%
- 10 year return was 5.71% per annum (best was 7.51%)
In other words it’s very unlikely to lose money over periods more than a year.
In some ways a diversified fixed interest portfolio is more secure than the bank. How so? Well, for one, many of the securities in the diversified fixed interest portfolio are bonds issued by banks. If the bank is borrowing from investors it must be lending to less credit-worthy borrowers at a premium. Note that most often a bank will borrow from investors at premium compared to what they pay depositors. Beyond banks, the diversified fixed interest portfolio consists of large corporates like Fonterra and Auckland International Airport as well as the New Zealand Government.
What about the bank’s portfolio? Well in order to make larger returns the bank will often invest in small businesses. Almost every small business has a banking relationship. Small businesses pay big premiums to borrow money. The bank loves it. Remember they are still paying depositors 5% while they can charge small businesses, say, 15%. However, these businesses are much more likely to default than Fonterra or the NZ Government.
Now it doesn’t matter to a depositor if a single small business fails to return the money they borrow from the bank because the bank guarantees the deposit. And the bank protects itself by being widely diversified. But I’d argue that the bank’s fixed interest portfolio is riskier than the one we have on offer.
In other words, the diversified fixed interest portfolio has outperformed short term bank deposits. This is exactly what we expect to occur (especially over 3 or 5 year periods) into the future. Month by month, or even year by year, who knows, but over the long-term this advantage is almost required to occur. If it doesn’t, how can a bank offer those fat deposit rates? If the bank can’t get a high return on its fixed interest portfolio, how are they going to pay big deposit rates to investors? Thus the diversified fixed interest portfolio over the long term is almost destined to outperform deposits. Over the long-term it’s just about inevitable.
By the way, it’s the same principle for foreign diversified fixed interest, but the story is even better because you get much better diversification overseas than you get in New Zealand.
The End of Wall Street as We Know It – and We Feel Fine
When I (Ben) had the privileged of working for Index Funds Advisers (IFA.com) in California, one individual I worked most closely with was Jay Franklin, a very bright and passionate advocate of investors.
As IFA and BNL are now associated (BNL is a Network Member of IFA) we are able to publish some of Jay’s articles on our website. Although this one seems a bit focused on the USA I think it’s message is clear and fully endorse it. Link
by Jay D. Franklin Tuesday, February 14, 2012
Lately there has been a great deal of news coverage of the ever-shrinking pool of bonuses awarded to the traders and investment bankers of the too-big-to-fail Wall Street firms. At UBS, for example, certain highly compensated employees will have to face the indignity of having part of their previous bonuses clawed back in the wake of a $2.3 billion loss resulting from the actions of a rogue trader. New York magazine recently ran a detailed piece on this subject appropriately captioned, “The Emasculation of Wall Street.” One of the article’s most poignant statements was voiced by an unnamed hedge fund manager.
“If you’re a smart Ph.D. from MIT, you’d never go to Wall Street now–you’d go to Silicon Valley. There’s at least a prospect for a huge gain. You’d have the potential to be the next Mark Zuckerberg.”
To this, we at Index Funds Advisors, Inc. say “Bravo!” and we wish it would have happened many years sooner. Society derives far greater benefit from the application of brainpower to real world innovations as opposed to financial innovations. The simple fact of the matter is that the primary financial instruments that are used to connect providers of capital with users of capital have existed since the nineteenth century. Much of the innovation that has come from the geniuses of Wall Street has been useless at best and incredibly destructive at worst. Nevertheless, we have seen a few advances that have truly helped investors such as index funds, but none of these required the talents of PhD. Physicists from MIT.
As noted by Matt Taibbi of Rolling Stone in his blog post of 2/8/2012, “The financial services industry went from having a 19% share of America’s corporate profits decades ago to having a 41% share in recent years. That doesn’t mean bankers ever represented anywhere near 41% of America’s labor value. It just means they’ve managed to make themselves horrifically overpaid relative to their counterparts in the rest of the economy.” All we really need from Wall Street are prudent people who will be reliable stewards of their client’s money for which they can expect to be well compensated as opposed to outrageously overpaid. What we don’t need are Fabulous Fabs aided by rocket scientists who help them conjure up new ways to “blow up the client” or “rip the client’s face off.” The world is a better place when the rocket scientists are actually designing rockets (i.e., actual products or potentially beneficial scientific research) and Wall Street bankers are playing their proper role as handmaidens to capitalism.
Regarding the big-time traders, as more and more individual investors as well as trustees of foundations, endowments, and pension plans become wiser and go passive, the traders will have only each other to play against in their zero sum game. We wish them the best.
Finally, the increasing adoption of passive over active will automatically reduce the bloated 41% share to a more reasonable level. This is far preferable to wielding the heavy hand of government regulations which all too often have unintended consequences.
What a Day at the Races Taught Me About Investing
Betting is a mug’s game for most punters.
At the races you see betters carefully reading their race books, looking up their research notes, following the advice of experts, betting on the favourites. Yet despite all this hard work they so often go home with less than they started with (especially when you include the price of drinks and food). Some days “their horse comes in” and they score big with a trifecta. Suddenly they are the envy of everyone as they proudly discuss their winning ways.
My view is simpler. I know nothing about horses but I do go to the races once a year – cup week – but more to enjoy the atmosphere and excitement.
My betting strategy is simple: easy bet trifectas, low cost, no skill, the computer makes the bet, no predictive powers and fun – you don’t expect to win but can be pleasantly surprised. Well this past year at the Riccarton Cup I won $1,148 on a $6 computer generated bet.
I was lucky right? This couldn’t happen again could it? Those around me were interested in my success but mostly stuck to their own methods.
Then I won again using the exact same random computer generated bet.
I was amazed by what happened. Firstly I had to do my best to resist the urge to believe that I had “discovered” a winning system. Whereas before the wins, I made bets just to enjoy the buzz, now I began to think in my head that I was actually good at this.
But what was even more interesting was that others were now very interested in my next pick. They actually believed I had some expertise worth listening to. Although my two wins were based completely and totally on dumb luck, there were people around me that were ready to try any suggestion I offered. In fact, some of my own friends started buying computer generated easy bets.
So it is with investing:
Investors like to follow managers and brokers with a good “track record” or winning streak and money flows in when a manager or an investing style has a couple great years in a row.
Our minds can spot a trend or a streak very easily. Fill in the blank 2…4…6…?
Intuitively and without thinking our minds go “8”. And when we see a manager or an investment style work very successfully for a few years in a row we unconsciously and automatically fill in tomorrow’s number. And armed with a belief that we know tomorrow’s results today we place our bets… who wouldn’t?
And so my betting companions wanted to know my “system”. Heck I was enthralled with my system too. But it wasn’t a system at all. It was random.
You know, one of my favourite charts is shown below. It catalogues the top 100 managers according to Morningstar, an investing research firm. To be a top 100 manager is quite an accomplishment. There are thousands of managers vying for that top spot. Here’s the question though? How many repeat their great performance the next year.
The answer is 13.2%. Those aren’t good odds!
And really if you look at those that do repeat it tends to be because the sector they invest in had two good years in a row. If you’re a manager that just happens to specialize in a style in favour it’s possible to have two straight great years.
So what am I getting at? Simply this, following winning streaks and investing with the herd is a horrible way to invest. Following my advice about how to bet at racetracks is probably equally as poor. A two year, three year or four year winning streak tells you almost nothing about whether an investment manager or broker is skilled or lucky.
But why let a little thing like statistical proof get in the way? Most investment managers know that investors do make decisions based on small streaks of outperformance. So they push and promote those funds that do have good records, getting rid of or absorbing the funds with poor records. Investors are left years later wondering why that “sure bet” pulled up lame.
What does matter then? Really it comes down to this. Invest at low costs with close attention to execution, stay consistent to your strategic asset allocation avoiding any temptation to drift with the crowds, and perhaps most importantly, don’t believe the media or media advertising.
In other words, don’t bet on the horse; invest in the track.
- The track diversifies with many betters and many races;
- The track pays close attention to costs;
- The track stays consistent even when a few long shots beat the field;
- The track never panics or follows the crowd;
- The track doesn’t gamble; the track invests.
Then again you could always make $6 bets on a computer generated trifecta. And if you win you’ll certainly beat the pants off the track’s profit margin that day. And if you need advice on how to master this, contact Jacob who for a small fee will provide you the tools to generate your success. But don’t make my mistake and tell your friends it was just luck. Just tell them you’ve got a system. Trust me; you’ll be everyone’s best mate.