INVEST LIKE THE PROS
“It’s not whether you’re right or wrong that’s important,
how much money you make when you’re right and how much you lose when you’re wrong.”
- George Soros
Institutional investors (a.k.a. “The Pros”) - such as pension funds and endowments - generally avoid many of the psychological biases and pitfalls that are so common among individual investors. One way they avoid human biases is by creating written Investment Policy Statements (IPS) that lay out some ground rules in advance for their investment decisions. The IPS includes their portfolio’s objectives, their income distribution policy, a range of how much of the portfolio can be directed to various asset classes (asset allocation), and criteria for when (at what valuations and conditions) they will buy and sell. This written guideline is not developed during times of crisis. It is written when everyone is thinking clearly and enables institutional investors to focus on the long-term. As a result, these institutions frequently achieve higher “Risk-Adjusted” returns than individual investors.
Everyone would like higher returns. However, it may not be worth it if your attempt to earn higher returns requires you to take more risk. The goal for most investors is to get higher returns with the same (or preferably less) risk than they were taking previously. You cannot accurately compare the performance of two investments or two money managers simply by looking at past returns. You have to look at both returns and the risk taken to get those returns.
Let’s say an investor walks into our office and says he earned 10% last year on his portfolio. Do we think that is a good return? The answer is…we don’t know. It depends on how much risk he took to get that return. A 10% return is phenomenal if his portfolio had the same risk as a Treasury Bill (which is a 90-day loan to the U.S. Government). However, it’s not a very good return if he had the real possibility of losing half of his money.
So, we have established that the Pros use a written Investment Policy in order to guide their decisions and minimize behavioral biases. What else do the Pros do differently? One thing is they commit to alternative asset classes (i.e. a more diverse set of investments).
Alternative Asset Classes
Most retail investors predominantly use traditional investments, which means that they own some combination of stocks, bonds, and cash. It is very difficult to attain significantly higher risk-adjusted returns by simply using these asset classes with a buy, hold, and rebalance approach. In today’s economy, integrating alternative asset classes into your portfolio has never been more important.
What are alternative asset classes? Alternative investments include, but are not limited to: real estate, private equity, hedged equity, commodities, currencies, futures contracts, arbitrage, and absolute return. ¹
Why Are Alternative Asset Classes So Important?
The two reasons why alternative asset classes are so important are that they:
- Provide growth during long-term cyclical bear markets (when markets move sideways for many years): Many individual investors design their portfolios by looking in the rearview mirror. They feel they can count on stocks to deliver double digit returns because they are relying on statistics extrapolated from 80+ years of market data. However, what happens when you experience twelve years with zero returns in the stock market such as we have seen from 1999-2011? Even worse, what if the sideways market lasts for 16 years such as it did from 1966-1982, or 25 years from 1929-1954, or 18 years such as it did from 1906-1924. (see chart below)
1. See Appendix A for Alternative Asset Class definitions
This scenario (a long-term sideways market) is even more devastating if you need to take distributions from the portfolio like most retirees, endowments, and pension funds. More and more retirees and mid to high net worth investors want consistent returns they can count on to provide systematic income in retirement. Endowments also need systematic income to support their institutions’ operations.
- Reduce Volatility: Thirty years ago, all you needed were stocks and bonds to have a diversified portfolio. However, it is important to understand that diversification does not mean that you simply hold many different investments. The key to diversification is to have a portfolio of investments that will not all decline at the same time. Therefore, you need some investments that go up when stocks and bonds are going down. Most major asset classes have become highly correlated over the last 30 years, meaning they now tend to move in the same direction. Institutions are relying on alternative asset classes to behave differently, in order to cushion downturns by going up (or even sideways) when the stock and bond markets have significant downturns.
Why Focus on Consistent Results (Reducing Volatility)?
One reason to reduce volatility is to minimize the extreme stresses that lead to poor decision-making. It is at market highs and lows that we see fear, greed, and the psychological biases we have discussed so far, hijack our otherwise good judgment.
A second reason is that “slow and steady” produces a better end result. Even the best money managers are going to have good years and bad years; however, by minimizing the severity of bad years, investors end up with higher compounding, which means a lot more money. Consider this example of the following two investors:
|Beginning account Value $1,000,000||Investor A “Slow & Steady”||Investor B “Wild Ride”|
|Simple Avg Return||5%||5%|
|Compounded Avg Return||5%||2.36%|
They each have an average return of 5%, but Investor “A” ends up with much more money after just three years. This result happens because a portfolio with lower volatility compounds at a higher rate. The difference in the ending portfolio balance is even more pronounced if the account owners were taking distributions from the portfolio each year or if you look at a longer period of time.
For example, from 1950-2007 the S&P 500 produced a 9.19% average annual return. Over that same time period, an investment with the same simple average annual return, but half the volatility, would have produced 60% more wealth!
The institutional approach to investing is not designed to hit “home run” returns of 20-30% per year (although years like that can occur). Instead, it focuses on consistent compounding of more moderate gains to achieve greater results.
Who Has Been Achieving Consistently High Risk Adjusted Returns?
The endowment funds of top universities such as Harvard and Yale have been pioneers in using non-traditional asset classes to produce higher and more consistent returns, and to achieve them with less volatility. Take a look at their results below:
Results of the Endowment Approach to Investing ²
|1985-2008||Annual compounded Rate of Return||Volatility
(measured by Standard Deviation)
|Yale & Harvard Endowments (Combined)||15.95%||9.75 α|
|S&P 500||11.98%||15.6 α|
2. Source: Faber, Mebane T. and Eric W. Richardson. The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets. Hoboken, NJ: John Wiley & Sons, 2009.
NOTE: Standard Deviation(α) measures the variation in returns from the average. A low standard deviation shows consistency; higher standard deviation indicates wild swings.
In 1980, Harvard’s entire endowment fund was invested solely in domestic stocks and bonds. In 2010, those two asset classes (combined) only accounted for 15% of its endowment. So where had the other 85% gone? Some has gone into investments that are still considered traditional asset classes such as international and emerging market stocks and bonds. However, Harvard’s largest allocations in 2011 are Absolute Return, Commodities, and Private Equity. In 2011,
Invest Like the Pros
the average endowment fund has 57% of its portfolio allocated to alternative investments, yet the average retail investor has less than 10% in alternatives.
Harvard Endowment Results vs. Benchmarks ³
|10 year returns (through 2009)||20 year returns (through 2009)|
|Typical 60% stock / 40% bond portfolio||1.4%||7.8%|
3. Sources: Harvard Gazette, January 2010, www.hmc.harvard.edu; S&P annual return from Yahoo Finance.
A great book for investors interested in learning more about the endowment approach to investing is Pioneering Portfolio Management by David Swensen. Mr. Swensen is the Chief Investment Officer for the Yale endowment and has an extraordinary track record.