Choose a simple, diversified portfolio for long-term investment success

An edited version of this article was published in the 19 June 2017 issue of TODAY.

Below is our original article in full.

In 2007, Warren Buffett made a famous charitable wager that no investment professional would be able to choose a basket of high-fee, complex hedge funds that could outperform a simple broadly diversified equity index fund over a 10-year period. Only one person stepped up to the challenge. To cut a long story short, this person has already conceded defeat, even with around 6 more months to go till the bet ends. Warren Buffett’s chosen index fund, the Vanguard S&P 500, is up over 80% in returns compared to the basket of hedge funds – which is up around 20%.

Mr Buffett has long been an opponent of hedge funds and other high fee investment businesses, stating that they provide no value to investors other than salesmanship abilities. When asked for investment advice, he recommends that people buy and hold a low-cost diversified fund.

Let’s not forget that Mr Buffett himself is a great active manager who has beaten stock market indices for many years in a row, and has a very good eye for value when he sees it. He admits that whilst it is possible to beat the index, he knows only a handful of very good investment professionals who are able to do so, whereas the ordinary investor does not possess the guile nor behavioural capacity to do it.

But is what Warren Buffett says true? Let’s look at the evidence. For 23 years, DALBAR (an independent research firm which evaluates financial services) has published an annual report – the QAIB (Quantitative Analysis of Investor Behaviour) – which looks at how ordinary investors fare when buying funds. The report's objective is to show how investment performance can be easily enhanced by simply managing some of our common behavioural biases. In the latest 23rd edition of the report, sadly, nothing has changed. Whether you take recent 1 year data or data from the past 30 years, average investors continue to underperform broadly diversified stock and bond indices by 4 to 6%.

The conclusion is clear: investment results depend on investor behaviour, and investors who had allocated sensibly to broadly diversified instruments, and did not try to time the market, were more successful. Trying to pick a handful of stocks out of thousands, trying to guess the outperforming asset class every year and short term trading all led to poor outcomes.

What about the more complex and supposedly superior funds? Why did they not perform as expected? This was explained simply by Mr Buffett, who quoted what Nobel Laureate William Sharpe wrote in his 1991 paper, “The Arithmetic of Active Management”. He noted that there are indeed many very smart individuals in the finance industry whose main mission is to do above average in the stock market. These individuals are active investors who have a view on certain securities, forecast how markets would move and would trade according to their predictions.

These active investors would hold a portfolio very different from that of a passive investor. A passive investor is one who has no view and holds every security available in the market. As such, the passive investor would simply receive the market return, no more or less.

As investing is a zero-sum game, the active investors' aggregated returns would also be average; if some do better than the market, the rest would do worse. However, the catch is that these active investors as a whole would do worse, as they incur far higher costs from their activities than a passive investor.

So, you may say, “That’s easy, I will choose the active managers who performed above the market”. However, that is the hardest part, for how would anyone know whether that particular manager would be able to outperform going forward?

In the study “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas” conducted by Professors Barras, Scaillet and Wermers, they found that after looking through 32 years’ of fund manager performance, 99.4% displayed no evidence of any alpha generation (i.e. they were totally not able to beat a diversified index), and of the 0.6% who did, it was statistically indistinguishable from zero (i.e. they were just plain lucky!).

This inability to consistently beat a diversified index was also written about in 1973 in a bestselling book by a Princeton University professor, Burton Malkiel. He famously claimed that a “blindfolded monkey throwing darts at a newspaper’s financial pages could select a stock portfolio that would do just as well as one carefully selected by experts”. Warren Buffett also alludes to this difficulty in finding a manager who can consistently beat the market, and notes that investment professionals, just like some amateurs, may hit a lucky streak over short periods.

The important lesson to be gleaned here is that investing need not be very complicated nor convoluted.

The slogan of one well-known fund management firm is “There is opportunity in complexity”. Unfortunately, this attitude pervades the financial industry, with “experts” telling laymen that they would not be able to invest properly without their help, always feeding investors ideas to get them excited enough to buy into the latest offering. As such, many people feel that investing is complex and requires the help of experts to guide them along.

However, in the financial industry, especially where there is a wealth of talent, it is hard to stand out. As such, professionals who make correct calls are idolised and elevated to “guru” status. Again, Mr Buffett derides this culture of market prediction by the financial industry in his shareholder letters, stating; “If 1,000 managers make a market prediction at the beginning of a year, it's very likely that the calls of at least one will be correct for nine consecutive years. Of course, 1,000 monkeys would be just as likely to produce a seemingly all-wise prophet. But there would remain a difference: The lucky monkey would not find people standing in line to invest with him.” (ref Warren Buffett's Letters to Berkshire Shareholders, updated 25 Feb 2017)

The truth is that investing can actually be quite simple. By understanding a few essential points, even the novice investor can strive for a better investment outcome:

1. Believe that markets work.

There is a multitude of evidence pointing to the fact that it is very hard to consistently beat the market, whether through active trading and/or trying to forecast which stocks or economies are expected to do well. For investors to maximise their outcome, it is better for them to allocate to a broadly diversified portfolio of stocks (ideally through indexing) and just sit through it for 10 years or more.

2. Know that investing comes with the risk of losing money.

Although the long term average of a global stock index is about 7.5% per annum, this doesn’t mean that you will get 7.5% return every year. In fact, over the last 35 years, the highest return was 43% (in 1986) and the lowest was -42% (in 2008). Thus, understanding that stock markets can go down nearly 50% in bad times helps investors not to panic when it really does go down by that amount.

The reason that seasoned investors don’t panic when that happens is because they know what happens next – that in every case of a market collapse, markets recover their losses and eventually surpass previous highs. But one first has to fight the very strong natural instinct to follow the herd and ‘cut and run’ when the news says it is the end of the world and markets start plummeting.

For the investor who understands that this is just part of the market cycle, he or she can stand to gain when markets eventually rebound, which has happened in every single case!

3. Be wary of complex investment products and fancy marketing which purportedly promise stellar returns.

It is probably best to steer clear of products where you have difficulty understanding how they work without a lengthy explanation (the more technical jargon used, the more you should be wary!). Do not be naive and buy blindly. Do your research on the product and always ask about the downside – how much could you lose? Be watchful of high and hidden fees (how else would all the advertisements and free gifts be funded?). Know what your exit options are, and whether there are any penalties involved.

Although investing is simple, the difficult part lies in being aware of your natural tendencies and biases, and how they can run counter to your long term investment success. Some investors who have the ability to be disciplined and possess the know-how of constructing their own portfolio, can perhaps go it alone. Others may need the help of a fiduciary adviser to help them get started with a properly constructed diversified portfolio following an asset allocation fitting their personal risk tolerance and then holding their hands throughout the ebb and flow of investment cycles.

Happy investing!

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