Tag: value investing

Recently, there has been a strong push within the investment community towards passive diversification of investments through the use of ETFs and index funds. With programs that offer incredibly low cost-basis fees, down to even 0 fees, it can seem quite enticing to own such broadly diversified securities.

The rationale behind general passive investing (through ETFs and index funds) is predicated on two factors. The first factor being that individuals will not be able to beat the stock market as a whole as it is highly efficient (aka efficient market hypothesis), where the securities themselves reflect true intrinsic value at any given moment. The second factor is that the economy as a whole will continue an upwards trend over the long-term, as innovation within a capitalist society will spark general prosperity. Given these two factors, we have emerged with a general consensus that leaving a bulk of your net worth within a broad-based investment fund such as the SP500, a target date index fund or a robo-advisor is a generally safe option. While it is true that the economy as a whole is mostly efficient with processing recent information into the price of a security, there are unspoken downsides with a traditional passive investment strategy.

Here are the downsides of traditional diversification through passive investment strategies:

1. Through the use of broad-based passive investments, your portfolio will be highly correlated with the general outlook of the stock market at all given times. While this protects you from the downside of being a poor “individual stock-picker”, your portfolio will also have a slim chance of being able to beat the market on a consistent basis. There are a number of quantitative strategies proposing to beat the market through analysis of macroeconomic factors or past data of volatility within various classes of securities. These types of predictions amount to shaky guesses at best. If someone was able to consistently “guess” the market’s direction in the short-term on a repeatable basis, they would be trillionaires. It is also equally suspicious to assume the next 10 years of a certain asset class will be similar to the last 10 years.

If we were to look at who is able to consistently beat the market over the long-term, we would find that it is not the “top-down” macro people who are consistently beating the market over the long-term. The people beating the markets consistently are often completing “bottom-up” fundamental analysis of individual securities. This makes sense because it’s much easier to figure out how an individual security will do over a long-term period than it is to figure out the entire direction of an economy over the short-term on a repeated basis. Basically, using ETFs and index funds, even if you have “specialized” strategies, makes it very difficult to beat the market, not factoring in the luck of educated macro guesses. The lesson here: broad diversification through ETFs and index funds is very likely to lead you to average results and prevent you from being able to achieve consistently better investment returns. If you’re fine with average results (and most people should be as it is difficult to beat the market), this should not be a problem. But for those with the ability to identify securities that will provide larger gains, or an ability to identify individuals who are capable of doing so, the average path would not be a reasonable option.

2. Because a traditional passive investment strategy is exclusively focused on the “long-term”, it is often rationalized that an individual could dump their entire excess cash into the stock market at any point and forget about it. However, if you were to dump your excess cash into the stock market at the peak of 2007 for example, you would find that you would have broken even by 2017/2018, after over a decade. While it is arguably true that over a long-term period of 30-50 years, this would be irrelevant but why lose out when this could have been avoided? This is the rationale that many investors ironically take when looking at these long-term investment strategies.

When resigning to a broad-based passive investing philosophy that invests in the market as a whole, the investor has a negative incentive to focus on the short-term and try market timing because their investments are recognizably subject to short-term macroeconomic factors. This incentive explains why many people are proposing in 2018 to put less money overall into investments because they are worried about a market crash. Overall, this reasoning is limiting because there could be good deals out there for individual securities that would not be as susceptible to market crashes, and would offer opportunities for stable dividends and future potential growth. Being able to identify individual securities that are already cheap would remove a need to try market timing. The other limiting factor is that the market as a whole may continue to keep increasing for a few more years despite all the predictions. Look at how many people were able to predict the Great Recession in 2008, has anything changed with our forecasting abilities since then?

While a lot of this writing was spent criticizing modern diversification strategies, it remains a good option for investors who want to automate the investing process and are truly in it for the long-term. But for those who are particularly susceptible to short-term fluctuations within the stock market or are interested in pursuing better than average market results, they would be better off with strategies such as value investing. This rationale is a large driver for the investing philosophy at Taher Financial Planning.

The famous Intelligent Investor book written by Columbia Professor Benjamin Graham was first published in 1949. Establishing the basis for what is now called value investing, this book set out a different way of thinking about stock market investing than what was prevalent in Wall Street at the time.

Even today, when most people think about stock market investing, their initial thoughts are line graphs about stock prices, daily percentage changes and people needlessly yelling on CNBC. This type of investing is technical analysis. Technical analysis on shares of AAPL (the ticker for the Apple company) means analyzing the trends of how the stock price has moved up within the last week, month, year, etc. But technical analysis says little about the quality of the actual company. Graham reminds us that when we are buying shares of a company, we are not merely buying a piece of paper that randomly goes up or down but we are buying actual ownership pieces of a live and functioning business. Buying a share of GOOGL means that over the long-term if Google does well, so will the stock.

While there are many lessons to potentially learn from reading this book, I present my 7 big takeaways from the book.

1. Differentiate present vs reality.

When a value investor buys a stock, they are not as interested in what the future of the company COULD be. They are more interested in knowing how the company is doing NOW and with slightly less importance, how it’s done in the past. An ‘intelligent investor’ would rather buy a company with a track record and currently favorable balance sheet than a company that has yet to prove itself and can bring you major losses. Graham emphasizes that there’s a very clear line between future speculation and present reality, and that we should keep a close eye on the current reality of any company.

2. Don’t believe that price has anything to do with quality.

If the price of a company is rising, it does not necessarily mean that the quality of the company is actually rising. Inversely, if the company’s stock price falls 20% within a day, it does not necessarily mean that the actual company has lost 20% of its total value within a day. Closely following the trends of the stock price movements to ascertain whether it’s a good company can be an easy way to misread the actual quality of the company. The market is irrational in the short-term and should not be seen as a guide for long-term investing. It is better to understand the meaning behind the company’s qualitative and quantitative position rather than its price position.

3. We really have no idea what is going to happen in the future.

To claim with certainty that a company will rise astronomically in the future or crash can be riddled with error. In truth, anything can happen. Graham, having grown up through multiple financial hardships and depressions was a firsthand witness to the realities of economic change. Because anything can happen, the best we can do is understand the position of the companies we have ownership of and spread our risk among multiple companies (otherwise known as diversification). Market timing can be dangerous.

4.”Getting good returns is easier than it looks but getting great returns is harder than it looks.”

This idea was shared in the context of ‘active’ vs ‘passive’ investing. As a passive investor, you buy a broad range of companies under the assumption that over the long-term the total economy as a whole will improve, meaning so will your financial position. But Graham states that if you try to beat the market, known as being an ‘active investor’, it’s going to take a lot of work. Graham also has a very interesting difference on how he sees risk. In finance academia, it is normally taught that to get more investment return, more risk needs to be taken on. Graham saw risk as a measure of how much work you did on researching your investments. From a value-investors perspective, it is possible to achieve higher investment return with lower risk.

5. Look beyond surface appearances and delve further.

Large public companies are fully aware and capable of manipulating how numbers will appear on earnings reports. Graham strongly urges reading company reports backwards, as management will hide everything they don’t want you to read near the end. Graham also recommends that investors conduct in-depth analysis by developing their own valuation of the company’s assets and stability of earnings rather than taking numbers at face value. By building your own independent thesis, you can catch issues or even opportunities that other investors might miss from just taking the numbers as is.

6. Always invest with a “margin of safety”.

‘Margin of safety’ is buying with a small to moderate ‘safety net’ on your investment. Even if negative results occur with your stock, you will ideally be protected by a strong book value or a strong business model or conservative assumptions on the company’s growth rates. Because stocks are being bought in such conservative ways, in the event of a market downfall, value investors would fare the best as they buy in such a price-conscious way.

7. Believe in yourself and your judgement, even if others hesitate or differ in tough market conditions.

Graham ends the book with an uplifting message reminding you to believe in yourself. Provided that you have your reasoning, data and experience to support your investing decisions, you should stick with your decision, even if the market is doing poorly in the short-term. The emotional fortitude to have differing opinions from others in times of stress, is incredibly important to succeed at investing in the long-term.

Overall, Graham presented a very lucid and rational perspective on investing, illustrating principles that still remains relevant many decades later. I utilize value investing principles like these for my own client’s portfolios.