There are two ways to make money: create value or get a good deal. Getting a good deal normally means not a lot of people know about it. You go off the beaten track. Perhaps you find an undiscovered artist. Maybe you know a Farmer who lives a subsistence lifestyle but has a little extra. You happen to hear of someone in a rush to sell their home, and they don't want to put it on the market. At the heart of this is a lack of information.
Eugene Fama, from the University of Chicago, developed a theory called the 'Efficient Market Hypothesis'. The idea is that once information is freely distributed it is very difficult to outperform on a 'risk-adjusted' basis. It was on the back of this that John Bogle took a common sense investing approach for the average investor to develop low cost index-tracking funds. If it is very difficult to outperform, and you just accept the average returns and focus on reducing costs - you end up performing above average. There are a lot of strong arguments in the case for passive investment. So much so that Warren Buffett has said that on his death he wants to put 10% of his wife's cash inheritance in short-term government bonds and 90% in a low-cost S&P index fund. Buffett is one of the most famous active investors. He has long argued for buying businesses rather than stocks, and trying to buy them at a good price. He has a phenomenal track record and is one of the world's wealthiest men, so is this him admitting defeat and saying that he was just lucky?
I don't think so. Many of the core reasons 'passive investing' are attractive are not unavailable to active investors. Active investing doesn't mean the same thing as trading. If you are buying and selling based on the price and trying to get a good deal regularly that is one thing. I agree that it is very hard to outperform. Buffett never did that. He bought businesses with the intention to hold them for ever. He made his money not primarily out of getting a good deal but out of the businesses he invested in creating value, and him not destroying a lot of it through the costs of trading.
My concern with passive investing is if it is seen as just that. It is passive. The problem with the Efficient Market Hypothesis lies in the 'risk-adjusted' basis. Risk can't be put into a number. It tries and uses volatility which is a measure of noise, i.e. how much the price changes. The great thing about the theory is it is one of those wonderful 'theories' that can't be disproved. Every time it makes a prediction that doesn't work, you can just say that there is a missing part of the theory but the theory still works. I have seen no evidence that more noisy stocks outperform and compensate for risk. It doesn't make sense that you should get paid for taking risk that doesn't add value.
Passive investing absolves responsibility about trying to understand the risks you are taking. This is my real bugbear. Most risk doesn't hide in the open like volatility. In the game of hide-and-go-seek, risk is more like the Invisible Man than a toddler who wants to be found. Why the S&P 500 is an investment Buffett is comfortable with is because he has spent his entire career studying the risks involved in the US economy. There is nothing passive about his bet. It is a bet that Capitalism in a Liberal Democracy with Rule of Law, plenty of multinational companies that believe in looking around the globe for opportunities and an incredibly transparent and well regulated market can survive. It is a bet on America.
Source: Artist Liu Hides in Plain Sight
I think it would be great if the conversations around investing shifted from finding the best deal to understanding the risks. I agree that that is very hard in markets where information is available. I still think you can get good deals but they are rare and irregular. I don't think the price includes all the information though. It is a good average, and a reasonable approximation of what the business is worth now. Averages are dangerous. They don't talk about the range of possible outcomes or what can go wrong.
'Never forget the six-foot-man who drowned crossing the stream that was five feet deep on average' Howard Marks
It is worth reading Bogle's book. It is worth staying humble about what you can achieve in investing by aiming to search for a good deal. I also think it is worth reading books like Michael Porter's 'Competitive Advantage'. In this investing is not about some clever trick of understanding where everyone is getting things wrong, it is about the first way of making money. It is about how to create and sustain the ability to add value. It is why companies like Google, Nestle etc. are able to consistently outperform.
So maybe there is only one way. You make money by adding value. If you get a good deal you just change who is holding it.
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