How to invest

It must be incredibly disorienting looking at the world of investments for the first time (and beyond). Huge moves in asset prices often seem unrelated to the news of that day. Specialist TV channels offer parades of strategists, economists and other market magi offering authoritative but often conflicting analysis on what is wrong or right with the world. Meanwhile all of those offering to manage your money seem to tout their superior processes, recent/long term performance or ability to not lose you too much money. The performance of their offering is generally shown against the performance of something else you may not really understand – an appropriately mixed cocktail of capital markets assets, or perhaps a peer group of competitors, adjusted on some measure of risk that may mean little to you.

Here we try and provide a framework for thinking about some of these things.

The market return

We should start with a few core assumptions. First, we know for a fact that the future is unknowable from our current vantage point. This starting assumption can be useful in trying to weed out some of those institutional investors you don’t want to give your hard earned funds to – overconfident predictions are generally a sign of ignorance rather than the reverse. The only long term prediction that we would hold to would be that humankind will more likely than not continue to unevenly improve its lot over the medium to long term. This is not knowable of course, but it is based on a careful assessment of the trends of the past. The collective value of the world’s financial markets, particularly stocks, tends to reflect this longer term trajectory in well-being for a number of reasons (Figure 1). The most important of these is innovation - the steady stream of productivity improving ideas and inventions helps to grow corporate sales and profits over time. These profits belong to the people who own these companies - us as soon as we decide to take the plunge and invest. 

So the first and most important question for investors to answer is how am I going to harvest this return. There are many answers to this question, but if we assume that we can’t know the future, then it makes sense to cast this initial net as widely as possible. This means you may not want to just give money to those countries and companies that are the superstars of today. Changes in how the world economy is organised, regulated and viewed by investors are simply too hard to predict with much confidence. 

In terms of what I can expect from this market return, a starting point is the trend in growth in global output. Again, we can’t know what this is in the future, but a reasonable assumption for the long term is between 1-4% after inflation. The growth of the world economy essentially describes the rough opportunity set for the world’s companies. Those that concentrate all their investments in a smaller subset of the world economy can generate much larger returns for short periods of time, but there is likely to be some payback for that concentration over time too. Our strategic asset allocation is very much a reflection of these principles. Our team here mathematically imagine hundreds of thousands of different viable futures and strive to locate the most all weather mix of assets to deploy for our clients over the long term.

Is that it?

There are other ‘excess’ returns to potentially harvest on top of that market return. However, this is where it starts getting complex as one’s view on how to exploit these opportunities hinges on things such as your view on something called market efficiency. This is essentially the debate surrounding how efficiently the prices of the stocks, bonds and other capital markets assets publicly quoted around the world reflect all available relevant information. Academia is not of one mind here. Nonetheless, our starting assumption is that markets are efficient, but not perfect. In that context, there is some merit in very selectively deviating from that core mix of diversified assets described above in order to add to that market return. There are three areas where we do this at the moment.

1. Tactical Asset Allocation (TAA)

We have a team that scours the world looking at the various incentives on offer at the asset class and country level. This is not an exercise in soothsaying. This is more about persistently evaluating the incentives on offer in various corners of the world relative to a range of plausible outcomes. This range is often guided by the experiences of the past, both near and far. For example, in March amidst plunging equity and credit markets, the team took the view that the range of probabilities reflected in these two areas of the market leant too heavily on what could go wrong rather than a more balanced assessment of the full spectrum of possibility. As a result, we added significant exposure to stock and credit markets at that point. The result has been significantly positively boosted portfolio returns. Not every call will work so well. However, the aim here cannot be to get everything right. It is simply about getting more right than wrong over as many years as possible (Figure 2). 

2. Manager selection 

This is an entirely different discipline that focuses mostly on the opportunities in individual stocks, bonds and more select investment exposures. This is not a package of measures that sits on top of that market exposure as with TAA, it is about getting that market exposure in a slightly more selective way. Rather than owning every single stock in the emerging market index for example, I decide to outsource some of that exposure to a professional 3rd party manager who invests in a small subset of that part of the world. This manager will charge more than those offering just to get you diversified exposure. However, in exchange that manager will seek out only the companies where the price looks wrong relative to their assessment to the fundamental prospects. Be warned though, this is not something that is easily replicated outside of such institutions. If markets are as efficient as we think they are, and there is plenty of evidence to think that they are(1), then the work of finding these market mistakes cannot be done part time. 

We feel similarly and mostly prefer to outsource this work to managers who specialise in particular parts of the market. Our job then is to use our scale and market clout to sift through the dizzying array of managers offering their services to find the ones that are best placed to deliver on their promise. We have written plenty on this subject alone(2), but suffice it to say it is not just about backing the manager whose latest performance statistics look the rosiest. It involves a painstaking assessment of the team, the business structure that surrounds it, how the team are compensated and myriad other factors. Performance is just one small part of this investigation. 

3. Styles...

Most teams of stock pickers focus on a particular style of investment. Style here refers to something that supersedes the basic industry a company operates in, from technology to banks. Styles can categorise an investment in such companies in terms of their size or the nature of their cash flows or even the degree of exposure they have to the ebbs and flows of the business cycle. The popularity of these styles can wax and wane profoundly and unpredictably. There is some evidence that valuation can contain some long term predictive power (low valuation of a style has resulted in higher 5-10 year returns), however humility is the appropriate setting in the short term. 

Importantly many of these styles can be accessed via cheap passive funds, which can helpfully provide an inexpensive alternative (and benchmark) for those ‘active’ managers who operate within the same style. Some concentrated exposure to these styles and factors has provided investors with ‘excess’ returns in the past. There are many potential explanations for this, some more convincing than others. Our hunch is that the extra returns from investing in these factors is a function of a web of complex market incentives, that provide investors with a sliding scale of return depending on the amount of risk they are capable of absorbing. There are many un-observables in this, so again humility is appropriate. However, if you take the existence of the ‘value’ premium (a tendency for cheap companies to outperform), you can readily argue that the extra returns that have been gleaned over time from investing in cheap, unloved firms (Figure 3) is related to the extra bankruptcy risk associated with them. Remember the starting point here is the idea that high quality firms are no better investments than low quality firms because the market prices already reflect that quality (or the lack of it). 

The conundrum for those looking to the long term is how to position in amongst all of these styles. However, focusing exclusively on one particular style at the expense of others can relatively unpredictably, either make or break a decade of portfolio returns. For example the performance of the value style described above has been poor over the last decade to say the least. So much so, that many are now suggesting that the style no longer works(3). Conversely, other styles such as growth and quality (there is significant overlap between the two) have soared, burnishing the reputation of those who operate within those style confines (Figure 4). 

We continue to believe that the most sensible approach here is a diversified one. We feel uncomfortable putting all of our eggs in such an unpredictable basket. However, the relative valuations of growth versus value now sits at the kind of extremes that argue for a slight tilt in the direction of value. 

Performance measurement

Here the most important context point is time. Short term performance is always going to be cluttered with luck and other noise. Very little useful information is contained in the performance of a strategy over 1 or even 2 years. The more data you have, the more signal you are likely to find. Sometimes, we unfortunately have to accept that the data years we may need to provide a rigorous assessment are longer than our intended investment period. 

For many of us, the most important benchmark for a diversified mix of capital markets assets is simply the returns that we think we could get from leaving that cash on deposit over the next 5-10 years. 

The final point to make is that this is an industry that cannot and should not promise performance. We can promise all sorts of other things – professionalism, hard work, intellectual honesty and rigorous process. If past is prologue, superior long term performance will come as a result of these often underrated attributes. 

(1) The Stock Price Reaction to the Challenger Crash: Information Disclosure in an Efficient Market – Maloney, Mulherin (Dec 1998)

(2) The Science and Art of Manager Selection – Barclays Wealth (2019)

(3) Coronavirus crisis: does value investing still make sense? – Financial Times (May 2020)

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*This article is for information purposes only. It is not intended as a product offer or investment advice.