On Sound Fundamental Principles of (Passive) Investment

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Whenever I write on anything remotely connected to securities, people ask me many questions. Why is M1 flat and gold rising? Should I follow M1 or M2? Why did the Fed discontinue M3? When will the housing market recover? What’s a good investment during a recession? They are more than curious. They want to know what to do with their money.

I think that most of these people are making a basic mistake. They are seeking information in an attempt to speculate. I think they’d be better off if they became passive investors and left the speculating to speculators (or traders). Most traders lose money.

How should one invest? The textbooks on investing run almost 1,000 pages. Such a mass of material overwhelms and confuses many people. For example, these texts distinguish between active and passive investing. They use the term active investing to avoid using the term speculation. But active investing, which is an attempt to beat the market, is speculation. To my way of thinking, investment is passive investment.

This article provides counsel on investing viewed solely as passive investing. In this way, I answer many of those individuals whose queries I have not answered. Naturally, no matter what I say, it will not be enough.

Investment and speculation in securities are two different things. They require very different fundamental principles. One should not confuse them.

The investment and speculation I discuss here both involve placing funds into securities or asset-related securities. That is about all they have in common.

Speculation is an attempt to profit, that is, earn an above-average rate of return, by forecasting the future price movements of specific securities. Investment aims for average returns without forecasting specific price movements. It relies on general price movements. Speculation typically involves moving in and out of securities based on the evaluation of new information that is constantly occurring. The time horizon may be anything from a few seconds to several years. Investment positions are typically not altered simply because new information has transpired, and the portfolio changes are likely to be infrequent and related to basic matters such as portfolio rebalancing, need for income, taxes, and risk preferences rather than interpretations of new information. Speculation, even without using borrowed funds which I am ignoring, involves greater risk because the speculators typically concentrate their money in a few securities. By contrast, investors diversify to reduce risk.

Speculation is a business and a very difficult business. The number of people who make a profit by starting and running businesses is relatively small, especially in lines of business that are highly competitive. Speculation is a highly competitive business. There are very few highly successful people in any field of endeavor. The average person who attempts to speculate is very likely to fail at it. Studies of brokerage and commodity trading accounts show that upwards of 80 percent of traders who speculate lose money.

The reason for this is that most amateur speculators do not follow sound fundamental principles of speculation. They don’t know what these principles are.

Engineers build bridges (or should build bridges) based upon sound fundamental principles of physics, engineering, geology, meteorology, geometry, and trigonometry, to mention a few. Violin-makers craft violins (or should craft them) based on sound fundamental principles, not all of which are in the public domain. They include knowledge of acoustics, wood, aesthetics, music theory, harmonics, and so on. What do economists do (or should do)? They explain economic activity. Their explanations should be based upon sound fundamental principles, such as the purposeful behavior of individuals, choice among ends, and the scarcity of time and means to achieve ends.

Similarly, speculation and investment each has its own sound fundamental principles. Buying a stock because it is low in price and selling a stock because it is high in price is not a sound fundamental principle of speculation. The reason is that a stock’s future price movements do not depend on whether it is low or high in price. Low-priced stocks may just as easily fall as rise in price, and the same goes for high-priced stocks. Whatever the sound fundamental principles of speculation are, they are based upon a knowledge of those factors that provide an accurate guide to future stock price movements. Knowledge always is the basis of true basic principles. You will not find revealed here the fundamental principles of speculation. If you search for them yourself, you will find many competing claims and little evidence to back up most of them.

Warren Buffett has sound principles. His wealth and success prove that. Is Warren Buffett engaging in speculation, investment, or something else? Should we look to what he does in order to find basic principles that we can apply? Buffett is in large measure a businessman. He buys whole companies after meeting the owners and managers. His holding company has a structure for managing these purchased enterprises. This part of Buffett’s procedure is not security investment. It is investing in real assets. This is not our subject, which is investing in securities.

Buffett also buys individual securities. His usual strategy is to buy first-rate companies at prices that are at a discount to the values he perceives them to have. Buffett concentrates wealth in a few of these securities that he likes a great deal. This is a variant of what is called value-investing, which I shall now argue is speculation.

There is disagreement on sound fundamental principles of investment just as there is disagreement on how to build violins. Many so-called investment strategies are actually speculation. Consider value-investing. The investor seeks securities whose prices appear to be relatively low compared to some measure of value, such as book value or cash flow. The investor must monitor many securities to determine the value measure for each of them. As individual securities change in price, so do the value measures. The investor then changes the portfolio over time to maintain its value orientation. All of this requires monitoring, assessing new information, a steady stream of buying and selling, ongoing transaction costs, and taxes. These are the same kinds of things one encounters when one speculates. Of course, there are variants of value-investing in which the holding period is lengthy; but that doesn’t matter much because the basic idea of value-investing is speculative. One is forecasting that the value securities will outperform other securities if and when the market recognizes their value quickly and bids the prices back up so that the buyers get an above-average return. But seeking profit is what speculation is about. Speculators are not content with average returns. Another speculative aspect of value-investing is that, in order to gain the benefit, the buyers unbalance or concentrate their portfolios in favor of the value securities. This adds risk to the procedure. Value-investing is actually not investment. It is active investment, which is speculation.

I am definitely in a class of one to call value-investing speculation. One need not be too concerned over this. Properly executed, value-investing is a good way to speculate. My only reason for explaining it and calling it speculation is to steer the average investors toward passive investment and not let them detour to any of these alluring side streets. If you insist on detours, then what you should do is divide your money into two piles. One pile will be for passive investment, the other for speculation. One will be for money you do not want to lose, the other for money you can afford to lose. Keep them absolutely separate and you will have fewer regrets. Mix up the two and you will find yourself getting nowhere as the years pass.

What then is involved in investment? Various states-of-the-world can happen in the future, in fact, an infinite number of possibilities. The investor makes no effort to discern what these will be and which ones are more likely to occur. He makes no attempt to speculate on the future. The first sound fundamental principle of investment is not to speculate in any way, shape, manner, or form. The investor swears off trying to forecast the future. This means he pays no attention to the investment markets, to changing prices, to the news, to economic data, to political events, etc. He does not let any of those things influence his investment policies. He will not be wasting his time trying to decipher M1, M2, and MZM. He will not be Fed-watching. He will not be constantly on edge about the markets. He will not constantly be in a state of confusion wondering why stocks fell when he thinks they should have risen.

The second sound fundamental principle of investment is to buy and hold a value-weighted, highly diversified or market portfolio. One may rebalance that portfolio on occasion as new securities become available, but low turnover will be a hallmark of a portfolio that is following sound fundamental principles. Investing will be a boring sideline, requiring very little of one’s time and effort. One will not be doing much buying and selling, and this will keep both transactions costs and taxes low. The effort will go into finding out what one’s asset allocation should be, that is, finding appropriate value-weights and diversifying properly. Diversifying properly means really diversifying. This goes well beyond merely buying the major stock index of one’s country.

Those two principles are the main ones that you need to get you into the investment ball game in good shape. A third sound fundamental principle is to start investing as early in life as possible. This means saving and not consuming. It means not going into debt.

If there is one thing that the finance literature shows definitively, it is that diversification pays. The gains of a portfolio rise relative to the losses as one diversifies into more and more different kinds of securities. This means that the average return rises compared to the possible loss or risk, or the ratio of return to risk rises. There is absolutely no question that diversification pays. To diversify as broadly as possible, the idea is to hold the world market portfolio of all securities. This is an unattainable ideal, but today’s mutual and exchange-traded funds allow one to get close to this very quickly and at very low cost. Today’s investment products are a tremendous improvement over what was available 50 years ago.

You may disregard those who laugh at diversification because it is merely average investing. These giants of active investing all claim that by focusing on a few well-chosen securities, they can do far better than average. They are speculating, however. That is for your other pile of money, the money that most people lose. The speculators who do not boast do not let you inspect their sorry brokerage trading records.

How shall you diversify? Very, very, very broadly; the more broadly the better. There are many asset classes. The ones that provide most of the market value are domestic securities, foreign securities, stocks, bonds, real estate, and real assets. These are the mainstream investments. Stay with them. There are some potentially attractive classes that the average investor will find it difficult to get into, such as venture capital. There are some securities that one should simply avoid, like hedge funds. One may avoid abstruse derivative-based securities.

I will explain next the basic idea. It will seem foreign to some and complicated to others. But, in the end, it is rather simple to accomplish a highly diversified passive portfolio. With a few of the Vanguard portfolios, for example, one can in a few minutes time own a portfolio that has thousands of domestic stocks, thousands of foreign stocks, thousands of bonds, gold and precious metals stocks, and participation in hundreds of real estate investment trusts. One can then fine-tune the process if one wants to hold gold as bullion or break down the asset classes into finer sub-divisions.

The basic idea is to buy a value-weighted market portfolio of these assets. The reason for the value-weighting is as follows. There are many thousands of securities that investors and speculators are valuing. Their valuations are better than yours. They have more information and more money that they are hazarding. You cannot possibly keep up with all the new information and how it affects security values. The market will sometimes be valuing various securities too richly and others too poorly, but you don’t know which is which and neither does the market. But it is doing the best that it can, and its valuations are reflecting huge amounts of information that you have no access to or knowledge of. The market’s valuations across all these securities are more likely to be accurate than for any one security. If you buy the entire market in value-weighted proportions, you will be mimicking the actions of all investors collectively in all their assessments, using all the available information. You cannot do better than that if you tried. If you try, do so with your speculative pile.

The reason for the market portfolio is that it, by definition, includes every existing security in the world. This gives the maximum diversification and the maximum gain/loss ratio.

Suppose that there are only three asset classes: bonds, stocks, and real estate. If the market values all the bonds in the world at $50 trillion and all the stocks in the world at $75 trillion and all the real estate in the world at $125 trillion, those relative valuations are likely to be as good as any can be, given the information packed into them. In this case, the total value is $250 trillion. Then one should place 50/250 = 20 percent of one’s funds in the bonds, 75/250 = 30 percent in the stocks, and 125/250 = 50 percent in the real estate. Once that is accomplished, you will hardly ever have to change the portfolio. No matter how the relative values change, you will always be holding something close to the market portfolio. When new assets come along or new ways to participate in the existing assets, some re-allocations may be in order.

The problem of passive investing comes down to determining appropriate market-value weights and then determining appropriate securities that match the asset classes. Obviously one cannot buy every single security everywhere, so one must find index funds that mimic these assets. The passive investor of today is extremely fortunate! There is an ample number of exchange-traded and mutual funds that provide very low-cost access to a portfolio that approximates the world value-weighted market portfolio.

Harry Browne in his little book Fail-Safe Investing explains and justifies a similar passive investment approach. If it will make you feel more comfortable, read his book. It will supplement what I am saying even though it is saying different things. Browne ends up recommending a four portfolio worry-less investment policy. He has equal proportions in long-term bonds, short-term bonds, gold, and stocks.

No one knows, including me, what the world market portfolio’s asset proportions are. You can search the internet as well as I can. I believe that the proportions are roughly 40 percent real estate, 25 percent bonds, and 25 percent stocks. Gold and other real assets such as timber may account for 5—10 percent of total assets at most. Hence, one might think about a portfolio like 25 percent bonds, 25 percent stocks, 40 percent real estate, and 10 percent gold. If one alters these proportions, it will not make much difference.

The main idea is to apply sound fundamental investment principles. They are: do not speculate, and buy and hold a highly diversified value-weighted portfolio. If one has 20 percent bonds, 30 percent stocks, 40 percent real estate, and 10 percent gold, you will not fail the course.

Within the relevant categories, one should diversify further. Suppose one has 30 percent stocks. Find out how much market value that American stocks have compared to foreign stocks. Then adjust the portfolio to those proportions. One might split the portfolio as 20 percent American stocks and 10 percent foreign stocks. Similarly, one can diversify the bond and real estate portions over domestic and international securities.

This kind of portfolio will be as worry-free as one can make it. It will have the lowest risk for the highest return. In absolute terms, its return will probably be something like 6—8 percent a year. The bond and real estate portions will cause its return to be lower than if you held an all-stock portfolio, but the risk will be a lot less. You will not endure the sharp fluctuations that stocks quite often deliver.

The risk of investing is not always easily observed until it is too late and the investor discovers to his dismay, after his stocks or bonds have fallen drastically, that his investment portfolio was risky. I cannot too strongly stress that a highly diversified portfolio of this kind has far lower risk than investing in any single asset class and far, far lower risk than investing in a handful of securities as speculators do. The goal of such a portfolio is to preserve and grow capital, earning an average return, with a minimum of risk.

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.

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