The Challenge of Investing
PIA’s investment philosophy discusses the challenge of investing and its solution.
Nobel Laureate Harry Markowitz, the father of Modern Portfolio Theory, identifies the challenge faced by all investors: decisions about portfolio selections are made under uncertainty. This uncertainty becomes obvious when an investor, after surveying a long list of investments available for inclusion in the investor’s portfolio, realizes that it really has no way of knowing today which investments – going forward – will turn out to be superior performers and which ones will turn out to be inferior performers.
The root cause of the uncertainty involved in making portfolio selections is the constantly changing volatility in the prices of investments. For example, a stock worth $25.00 today was worth $22.75 yesterday (or five minutes ago) but can be worth $21.25 (or $31.25) tomorrow. The reason why the prices of investments are constantly changing, of course, is that they’re subject to the impact of unpredictable future events – otherwise known as “news.” This makes changes in the prices of investments random and therefore unpredictable.
Many investors – including stockbrokerage firms, trust companies and other investment advisors – don’t acknowledge this fundamental issue. Instead of attempting to reduce this uncertainty, they focus on increasing return. Such investors believe that the best way to maximize return is with an investment approach called “active investing” by which they attempt to “beat the market.” This approach takes a number of different forms.
One form of active investing – known as “track record investing” – focuses on the past. This involves attempts to assess which superior performing investments from the past will continue to be superior in the future in order to invest only in them. (It’s useful to remember that superior investment performance can be identified as superior only after it has occurred.)
Other forms of active investing – known as “stock picking” and “market timing” – focus on the future. The goal of “stock picking” is to identify and profit from mismatches between the current market prices of individual stocks and what are thought to be their “true” underlying values. The goal of market timing is to shift money in and out of different investments in order to profit from short-term cyclical events in financial markets. They involve attempts to predict the future price movements of stocks and bonds.
All such forms of active investing lead to the widespread idea that to be successful, an investor must be able to “see” into the future or find a “skillful” money manager who can.
Yet many “skillful” money managers are identified as skillful simply because they have superior track records. Since the Securities and Exchanges Commission (SEC) (“Past performance is no indication of future results”), academic studies and principles of modern prudent investing all show that track record investing has little (or no) value, efforts to identify money managers who are skillful on the basis of track records also have little (or no) value. Sometimes it’s possible to identify a “skillful” money manager on a statistical basis. In order to do this, though, the manager must have an investment tenure that’s relatively long. But even when a money manager is found to be skillful statistically, there’s no guarantee that it will continue to be skillful in the future.
In fact, attempts to find investment “winners” based on past performance or forecasts of the future often result in poorly diversified portfolios saddled with high costs and taxes. These portfolios, such as those heavily invested in high technology stocks (or whatever sector of the market may be currently “hot”) generally aren’t regarded as prudent portfolios. Finding investment winners by looking at the past or attempting to forecast the future, then, isn’t the key to successful investing.
The Solution to the Challenge of Investing
The real key to successful investing involves disciplined application of three major themes found in modern prudent fiduciary investing: broad diversification of risk, low costs and low taxes (for taxable investors). These factors, upon which the Employee Retirement Income Security Act, the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule) place such great emphasis, allow investors the chance to reduce portfolio risk and enhance long term wealth effectively and efficiently.
Broad Diversification to Reduce Risk and Increase Return
Risk, as noted, is the uncertainty that the future returns of any given investment are unknowable today. Many investors are therefore left wondering if their portfolio will generate enough money to fund a desired standard of living. The uncertainty they experience arises from the “volatility” in a portfolio’s market value over time. Reducing this volatility reduces total portfolio risk.
Efficient diversification, achieved by using the tools of modern portfolio theory (the preferred method of diversifying risk according to modern prudent fiduciary investing), is fundamental to reducing total portfolio volatility. The following example illustrates the importance of reducing volatility (or risk):
Assume that Investor A invests $100 and gets a 50% return. $100 turns into $150. In the next year, the investor loses 50% of the $150. $150 turns into $75. The investor therefore loses $25 of the original $100. Assume that Investor B invests $100 and gets a 10% return. $100 turns into $110. In the next year, the investor loses 10% of the $110. $110 turns into $99. The investor therefore loses $1 of the original $100. Investor A has a percentage loss that is 5 times greater than Investor B (-50% vs. -10%). Yet Investor A has an actual dollar loss that is 25 times greater than Investor B (-$25 vs. -$1). Reducing portfolio volatility (or risk) -i.e., reducing the size of fluctuations in portfolio values – is a more effective and efficient way of enhancing portfolio wealth than track record investing, stock picking or market timing.
Investor A |
|||
| Year | Beginning Value | Return | Ending Value |
|---|---|---|---|
| 1 | $100 | +50% | $150 |
| 2 | $150 | -50% | $75 |
| Average Return | 0% | Loss $25 | |
Investor B |
|||
| Year | Beginning Value | Return | Ending Value |
|---|---|---|---|
| 1 | $100 | +10% | $110 |
| 2 | $110 | -10% | $99 |
| Average Return | 0% | Loss $1 | |
Low Costs and Taxes to Increase Return
In addition to broad diversification to reduce risk and increase return, prudent investing involves minimizing costs and taxes to increase return. The Prefatory Note to the Uniform Prudent Investor Act asserts, when investing trust assets, that a trustee’s “central consideration” is to determine the tradeoff between risk and return. The “main theme of modern investment practice is therefore sensitivity to the risk/return curve.” The Uniform Prudent Investor Act suggests that the most prudent way for investors to reduce portfolio risk and enhance wealth is through “passive investing.” This involves investing in broadly diversified, low cost and low tax asset class mutual funds and index mutual fundsthat effectively and efficiently capture market level returns at market level risk.
This reasoning leads to the conclusion that actions taken to reduce risk and lower costs and taxes tend to promote prudent investing while track record investing, and attempts to pick stocks and time markets tend to encourage speculation. Apart from the fact that fiduciaries (who are responsible for managing other people’s money) should not engage in speculative investing, one of the many issues with speculative investing is that it requires fiduciaries to constantly be right.
Yet fiduciaries cannot always be right when it comes to portfolio performance. They must, however, be prudent when it comes to their fiduciary conduct. Fiduciaries as well as attorneys, accountants and other professional advisors who are concerned with issues of legal liability and fiduciary obligation should understand this crucial difference.