For the person who makes a large chunk of their living gambling or for that matter any occupation where you work for yourself and the income stream is bumpy, the choices you make in building financial security are different from those of the typical person. Most people are paid a salary or an hourly rate, so they have a relatively steady cash flow picture from month to month. Issues like health care insurance are often part of a benefit package and paid for in pre-tax dollars. A sports bettor, poker player, professional horse player, or small business owner on the other hand is much closer to risk, depending on their abilities to maintain an edge over competition. The ideas of a paid vacation, holidays, or someone sharing their health insurance costs are foreign to them. Obviously the work they do takes a lot of focus, so a dilemma occurs when investing. Do you attempt to gain an edge and outperform the averages or do you look for some “beta” in your life and try to index? I guess the answer depends on how it affects your main source of income. If it forces you to lose concentration and the influence is negative, then indexing may be a way to go. Even if you look at investing as another venue to gain an edge, understanding the case for indexing may be useful information in understanding the game.
In this light, I thought it might be interesting to look at some books a person new to investing might use to learn how to diversify their overall risk profile or get a better understanding of where to apply the skills they already have.
Common Sense On Mutual Funds (Fully Updated 10th Anniversary Edition) – John Bogle (Wiley 2009)
This book is a nice first read because it immediately tackles perhaps the two most important issues for investors. These would be the costs inherent in the investment process and the subject of market efficiency. Anyone from a gambling background easily understands these issues. The take and the people you are playing against will determine your long term success in any gambling endeavor. A look at how even seemingly minor costs lead to tremendous differences in the final value of a portfolio over decades is an important issue to understand. Bogle also comprehensively outlines the effects of turnover and taxes.
It is only in recent years, when data on the gap between the returns most investors have generated and the returns on the asset classes and funds that they have invested in has become clearly evident, that the value of simplicity has come into vogue. Bogle’s chapter on simplicity points out many of the pitfalls investors face and uses aggregated results to point out the advantages low cost passive strategies have had over long periods of time. The case is particularly persuasive when comparing bond funds.
Bogle is the founder of the Vanguard Group and preaches a long term focus when it comes to investing. The 10th anniversary edition is unique in that it retains the original text and contains comments and insights from Bogle in light of the financial events of recent years. This is most interesting when one looks at the appendix which contains Mr. Bogle’s view on the coming decade written in 1999. He cautioned against the euphoria of the time which includes references to the now infamous Dow 36,000 and the “new era” mentality.
Unconventional Success – David Swensen (Free Press)
David Swensen made his name as the chief investment officer the Yale endowment, where his stellar return record has spawned a number of books and articles detailing the techniques he used. These included the wide use of hedge funds, extensive diversification, as well as the use of asset classes that had been previously shunned by most managers. Swensen’s own account of his philosophy, entitled Pioneering Portfolio Management (Free Press) first appeared in 2000 and was updated in 2009.
According to a New York Times interview dated August 13, 2005, Swensen’s original intent when beginning what became Unconventional Success was to adapt the techniques he used at Yale for the individual investor. Instead much of the book is devoted to the reasons why this is impossible. Among these is financial incentives resulting from the structure of the mutual fund industry and the resulting fees in the funds themselves; which according to Swensen work to the detriment of the investors they serve. Investors themselves often contribute to their own disadvantage, failing to understand the effects taxes, market timing, and overtrading inflict on their results. Swensen has also been critical of the mutual fund industry’s marketing efforts and the development of superstar funds that become bloated to a degree that the ability to continually outperform becomes almost impossible.
The strategy the book recommends is to index using low cost providers, employing diversification to ride out the waves and rebalancing to avoid becoming over-weighted in asset classes. He finds market timing to be an ineffective strategy and the proliferation of non-core ETF’s disconcerting.
One of the ideas Swensen has espoused for the industry itself, the use of index funds as an accompanying alternative for every mutual fund works well on an individual level (even for those who choose to actively invest). If one includes basic index funds in their portfolio there is a constant benchmark that lets you know just how much value the decisions you make are adding to your portfolio. This generates some interesting results when you take five and ten year time frames and compare specialized funds that employ strategies that are supposed to be market neutral with simple low cost balanced index funds.
The Fundamental Index- Arnott, Hsu, and West (Wiley 2008)
The nice thing about indexing strategies is not everyone has to agree about the best path to take. A majority of benefits to indexing accrue as a result of cost savings from lower turnover and reduced taxes. This opens the door to a great deal of strategies and vehicles. The traditional index strategy uses a market capitalization weighting, seeking to take advantage of market efficiency much in the way the final line of Sunday’s NFL game is extremely accurate in that it accounts for the accumulated cash backed opinions of the entire betting community. This book argues that the weakness of traditional indexing is that overvalued stocks drag down returns. In times of euphoria such as tech investing in the nineties, index funds continue to scoop up shares of the bloated companies. As an alternative, fundamental indexing weights stocks in an index based on economic footprint. Instead of capitalization, factors such as dividends, sales, cash flow, and book value are used to determine weighting. In recent years, a large amount of investment products have appeared in the market based on this and similar strategies. They include ETF families such as Wisdom Tree and products based on the RAFI (Research Affiliates Fundamental Index) indexes associated with Mr. Arnott. In the advisor world, Dimensional Fund Advisors has offered funds that seek to improve on traditional index strategies.
The book gives a detailed explanation of the theories behind the strategy, the historical record, and how it can be applied in a variety of market sectors. Asset Allocation is covered and criticisms of the approach are addressed.
This concept is controversial in the investment community, and indeed John Bogle has been one of the critics quoted on the subject. His criticisms have focused on the idea that fundamental indexes generate higher costs than a traditional index fund as they have to trade more to adjust indexes to fundamental factors.
The idea, however, that the crowd makes mistakes should not be foreign to anyone who has consistently successfully cashed bets in a gambling environment.
Conclusion
Arguments in favor of indexing often have a religious zeal to them. The world is painted in black and white with no shades of grey. It is said that the market is efficient and trying to beat it is a fool’s errand. My personal belief is that like any gambling endeavor, it is possible to have better risk adjusted returns than the indexes over time. Like sports betting, poker, and horse racing the people who succeed put in a tremendous amount of effort and are a very small percentage of the playing population. Indeed a look at Swensen’s Yale operation reveals many of these traits. He employs an enormous amount of people generating detailed research on the asset classes he chooses to invest in. He has a reputation as a shrewd negotiator, finding extremely talented hedge fund managers at pay rates he does not find onerous, and requires a degree of transparency in the investments they make. In a way, his operation reminds one of D. Wayne Lukas’ 1980’s and 1990’s horse racing training empire. Like Lukas, who counted Todd Pletcher among a group of assistants that went on to their own success, Swensen has had a number of those who worked for him successfully run endowments of their own.
Since investing has historically been a positive expectation game, low cost indexing strategies make sense for a majority of people given the difference in the work they entail. This is quite a different thing than saying it is impossible to beat the markets. If someone’s interests and focus need to be elsewhere, a dose of “beta” makes sense for long term investment.
