How Do YOU Make Investment Decisions?
And still live with yourself…
People do this every day all over the world. There is an unimaginable amount of content out there. Some of it is excellent; some of it terrible. If it is serious, it will probably come with a health warning to the effect that it does not purport to be investment advice; it is for information or entertainment purposes only and please consult an investment advisor before putting a cent of your money into these crazy markets.
I listened to one of those advisors today on a podcast with a couple of other guys. The key message was to focus on the why and the how, rather than the what. Or, figure out why you are putting your money at risk, how you are going to do that and then focus on the what. The ‘what’s in this case is the specific investment.
Why are you investing? Are you a trader or an investor? If you are a trader, your focus is intra-day and highly short-term data-driven. An investor has a longer time frame. Within each category are many sub-categories. Because trading is very, very data intensive, the focus will likely be very narrow: 3-month T-Bills, as opposed to, say, corporate debt. You have to focus narrowly because otherwise it becomes impossible to deal with the incoming. That may fit who you are; it may be terrifying.
As an investor, the focus can be broader, longer term, but there are still some decisions to make. Am I investing in businesses or sectors? Am I interested in financials, pharma, healthcare, industrials, commodities, precious metals? Do I want to invest in companies or in managers that pick companies. If the latter, will I use mutual funds, exchange traded funds (ETFs), hedge funds, private equity funds (PE).
The amount of money you have makes some decisions for you because some investment managers require a minimum amount. Some commodities require a minimum amount. If you want to buy physical gold with specific gold bars allocated to you, JP Morgan requires you to buy a minimum of a 400 oz bar, which will cost you around $920k at today’s gold price of ~$2,300. Some hedge funds and PE require minimums of $500k or $1MM.
If you are using funds of any kind, you are going to be paying someone to do the work of selecting underlying companies or commodities or real assets for you. There is going to be a tracking error (difference) between the performance of the underlying investments and the performance of the fund that invests in those investments. The main reason for the difference is the fees and expenses of the fund management business that is doing the selection for you (or it should be) I found out recently that a fund I invested in, located in the UK (I live in the US) because that is where a portion of my investments are ‘stuck’ (more on that later), has a significant tracking error to the underlying asset. The fund is supposed to track gold and gold miners. Overall, it should be up for the last 12-months. It’s down and I can’t figure out why. I asked the fund manager to talk to the fund manager. This is going to be a lesson on what not to do, so I am eager to learn it and seriously annoyed, mostly with myself.
When I say ‘stuck’, what I mean is that this pool of investments is the UK equivalent of a 401K or an IRA. The way these work is that, while you are working for an employer or yourself, you can deduct a portion of your income from your taxable income and stash it in a pension plan. Some employers will even contribute some alongside it - a match - as extra compensation. The money grows tax-deferred, which is great. Then, at a certain age, you have to withdraw it and pay tax. The problem is that, even though you will have held the investments for a long time - beyond the 12-month timeframe that earns you capital gains tax at a lower rate - because you deferred tax on your income by reducing it by the amount you contributed to your pension plan, you have to pay taxes on any gains at ordinary income - the highest - rates. This is the way it works in the US. The UK has something similar. I would love to bring the assets back to the US, but that is not so easy. (Please, if you are an independent financial advisor in the UK spinning schemes to do just that, please don’t contact me: I have heard it all and these schemes are dangerous to your financial health.)
One of the main reasons to select someone to look after your investments for you is that you don’t have the time to do so. You have a job that demands most of your time. You think your time is better spent earning the money than trying to invest the surplus. You think it is smart to hire someone whose job it is to look after your money. Finding someone who will do a good job is really hard and people change advisors often. Your inbox is full of offers from people who are pitching to manage your money. Their first job is to persuade you to pay them to manage your money.
There are different models for money management. Traditionally, brokers would charge a commission on buying or selling your investments: they would pocket the difference between the bid and offer price. That created some weird incentives because their incentive was for you to make a lot of trades. The more you bought and sold, the more they made. Then came the so-called wrap fee, where you pay a percentage of the assets being managed. That way, your interests are aligned with those of your money manager: if the assets grow and you pay 1% to the manager, then the manager benefits because the denominator grows, but you get 99% of the benefit. Maybe there are some other things going on, such as the manager putting you into investments that they are incentivized to sell. So, the money manager puts you into an investment product constructed by the investment bank on whose platform their money management business is housed. They get paid by the investment bank to some degree by the number of investors they bring into that product. And so on.
Over the years, you hire and fire a few money managers. Your assets don’t seem to be growing as fast as your friends’ assets and you get angry, reproaching yourself for not choosing wisely - perhaps secretly wishing you had spent the time to understand and do it yourself...but you still have a job and you don’t have the time, so you hire someone new. Often, the folks who pitch you on using their firm are not the ones running your money: they are the sales person pulling you in. You have to wonder about those firms because you are being sold or ‘closed’ by someone skilled in that rather than in asset management. They pitch the track record with the caveat that past results are no guarantee of future performance. Of course.
This is not all bad. I work with someone at the moment who I like. What does that mean? It means we tend to agree on the macro aspects shaping investments. She is interested and curious - last week, she was late calling me because she was stuck in what she calls her research hole, reading, thinking. Fine by me. She and I discuss things and she makes suggestions; I make suggestions. When we agree, she buys and sells accordingly. Sometimes she stops me doing things or forces me to make those decisions in an account where I get charged a commission rather than an asset management fee. Those are “my” assets in a different way.
What do you want from this? Do you just want the price of everything you own to go up? If I’m honest, yes. The question is over what time period? Would you be happy if something went down for a year but steadily up over 5, 10? What do you need the assets to do? Do you need current income? Do you need a certain result by a target date? There are products to serve these needs - target date funds, for example; or you can construct your portfolio to meet these needs with what you put in it. The hardest parts are the why and the how. They demand the most thought. When you answer these questions, the what becomes clearer. When you answer these questions, the productive hard work of selection can begin.
Often, this question is framed as “are you a beta investor, or are you seeking alpha?” Beta investing means that you aim to do as well or as badly as the overall market. If you want to track the broad market, say the S&P 500, then you invest in an ETF that holds all 500 S&P stocks. If the market goes up 10%, your investment is supposed to go up 10%. Alpha investing is where you aim to outperform the market. If your basket of individually picked stocks goes up 12% when the broad market goes up 10%, you could say you added value from your investment selection. That is alpha. Asset managers love to advertise their skills in portfolio selection, agree on a benchmark against which the measure their performance and then outperform it. They will charge you a portion of that alpha. This is the classic 2 and 20 hedge fund or private equity model. A manager will charge you 2% for managing your money - selecting investments, watching them, paying their salary, overhead etc - and 20% of any increase in those investments.
This is a huge business. Hedge funds total ~$5T; PE funds ~$13T. Overall, regulated funds worldwide total over ~$60T. The title of this piece is How do YOU make investment decisions? That may be the wrong question because, in a market this big, the most important question may be how others are making those decisions. You are a tiny part of this.