How I invest my own money.
In this post I argue that you should pay attention to someone only if he personally gains or loses, depending on whether what he says proves true, and in this post I opine that there is a serious economic train wreck in our future. If I am not acting according to my own words, you should ignore me.
First, a warning label. I am NOT offering investment advice. My judgment may prove wrong; for example, I have missed the “Drumpf rally”. Also, what may be right for me may not be right for you. I, for example, will soon hit the three quarter century mark so I can’t afford to lose money. I don’t have enough time to make it back before I need it. I feel, however, that you deserve to see the fit between my words and my actions.
It would be hard to find a more conservative portfolio. About 15% is in physical gold. 70% is in high quality laddered CDs with a maximum maturity of one year. The remainder consists of a legacy private equity investment and a couple of equities.
The assumption implicit in my asset allocation is that the risk of permanent capital loss is high. Markets disagree. Ten-year US treasury rates, the benchmark for the pricing of fixed income securities (bonds) have risen but are still near their historic lows, and equities are near their all-time highs. Neither I nor anyone else knows whether the stock and bond markets will rise or fall over the next few days or months. Most stock trading is done for reasons having nothing to do with the fundamentals of a particular company or industry. The combination of artificial suppression of interest rates by central banks around the world, and a historically unprecedented proportion of stock trading based solely on internal market momentum has created a disconnect between markets and fundamental economic conditions on a scale that no one has seen before. Unheard-of debt, before consideration of unfunded pension liabilities, plus anesthetized markets spells trouble to me on a biblical scale. I want to keep out of the way.
What can a non-professional investor do to grow his savings, but with minimal risk of permanent capital loss? Here are some basic lessons from the vantage point of nearly forty years’ experience investing other people’s money as well as my own:
1. Unless you are highly confident you understand a company or security better than the markets — an unlikely circumstance — don’t try to invest in individual securities on your own. The institutional investors against whom you are competing are extremely smart and well-trained, have better information than you do, and work very hard. Stick with diversified index funds.
2. Price always counts. Try to follow the advice of Nathan Rothschild who in 1810 said, “Buy on the cannons, sell on the trumpets.” When everyone, including yourself is scared, buy; when bubbly optimism prevails, sell. How can you tell? There are no hard and fast rules, but if you yourself feel you are missing out on a strong market, restrain yourself. If you hear people saying they will “never be in the market again”, you should consider investing. A couple of rough valuation guidelines are the Shiller CAPE ratio [see the link to “highs” above] and the Tobin Q ratio, which is the ratio of the market value of securities to their net worth, adjusted for replacement value [see Figure 4 of the link].
3. Do nothing almost all the time. Activity degrades your returns because of turnover costs. If you have a high threshold before you are moved to act, you will avoid lots of mistakes. Not losing money is an essential ingredient to building wealth.
4. Ignore forecasts. They are not just useless, they are downright misleading. The stock market is a complex, non-linear system whose probability distribution of future performance has the characteristic of a fat tail, where the true average (mean) performance is dominated by a tiny percent of total outcomes. Because the timing, magnitude, and duration of these rare events cannot be foreseen, no one can forecast the path of a complex system like the stock market. Most of the time, if you invest (trade) based on forecasts, you won’t hurt yourself much, but do it long enough and you will go broke. You just can’t tell when “the big one”, which drives your return, is going to hit.
But, you reply, the media are always featuring someone who has made a correct forecast. This is true, but remember, there are literally hundreds, maybe thousands of people forecasting at any given time; somebody is always going to be correct. The problem it almost never is the same person who makes a correct call from one period to another. It bears repeating that no one can forecast the path of markets or any complex system whose evolution is dominated by rare events. Paying attention to forecasts is for suckers.
5. You can’t rely on forecasts, but you can design your investment portfolio so that it can both withstand severe shocks, e.g., high downside volatility, and generate a competitive return. Here’s how: Invest most of your money very conservatively so you are robust against down markets, but invest money you can afford to lose in a diversified set of investments where you might lose all you have invested in any one of them, but if one succeeds, the payoff is huge. You have to be willing to accept that most “bets” with a very high payoff potential fail. An example of this kind of investment is something called a long-dated, out-of-the-money put. A put is an option to sell a security at a contractually agreed-on price, called an exercise price. The term “out-of-the-money” means that your option will expire worthless unless the security underlying the put falls well below the exercise price. If you don’t have the temperament for making a series of small losing bets in hopes of a possible big payoff at some unknown time, I suggest you focus on capital preservation, including protecting yourself against a decline in the purchasing power of the dollar. I, for example, would switch out of my laddered portfolio of short duration, high quality Treasury bills or CDs into equities only if I saw extreme forced selling because equity funds needed liquidity.
6. Remember that the greatest advantage you have over professionals is that they have to invest, but you don’t. If institutional investors lag the benchmark indices against which their performance is measured for an extended period of time, they are likely to lose their jobs. Therefore, no matter what they would do with their own money, most of them choose to be “closet indexers”, i.e., they tend to make sure their portfolios are not wildly different from what is included in their benchmark. If you have the stomach and patience to lighten up your holdings when markets are booming and invest when there is fear and panic, you will do well. The problem, however, is that over-reactions one way or another can last for years and the overshoot can go much further than makes sense by any rational standard.
7. Dare to look stupid for a long time. Keeping your investments conservative and being willing to wait a long time before increasing your exposure to loss in return for growing your wealth is uncomfortable for all of us because there will be times when other people are “getting rich” while you are not.
I am confident that these guidelines are sound, but acknowledge how difficult they are to live by. Good luck.