Why is it so? What I believe about investing.

In my posting last week I made this statement: “I have a predetermined set of simple actions that I will execute without any reservation, hesitation, fear, uncertainty, or doubt. These simple actions are documented in the Trading Plan that guides my investing actions, habits, processes, routines, attitude and culture.”

How does one reach the point of having such an uncomplicated, stress-free, and easy-to-use process in such an uncertain, noisy, volatile, and complex environment as the financial markets?

Where do the simple actions come from? Why do I follow them as I do? Why do I know that the simple actions that comprise my process will work?

There are principles at work in the processes that I use and these principles are aligned and consistent with my beliefs. A principle is an unchangeable and timeless truth that serves as a foundation for a chain of reasoning. Once these principles are grasped and trusted, the execution of the process becomes simple.

The question begs then, what do I believe in? Why do I do what I do and why do I trade in the way that I do? I gave you an insight into my trading story just over a year ago but this didn’t get into the essence of what I believe with respect to investing. I have been asked this numerous times.

My beliefs about investing get to the core of why Share Wealth Systems exists and why we passionately continue to do what we do.

• At the highest level, I believe that the main investing avenues, that of managed funds and products offered by the ‘big end of town’, need to be challenged and exposed. This is done in the first instance by handsomely outperforming them.

• I believe in the “little guy” having to do it himself through knowledge, personal growth and learning to be able to outperform the ‘big boys’ by following the mantra of “give a man a fish and you feed him for a day, teach him how to fish and you feed him for life.” He needs to do this to achieve his lifetime dreams, goals, and objectives. I see myself as one of the “little guys”.

These two core beliefs are founded in the following supporting beliefs which have been cemented and energised in my psyche through personal research and experience, studying others’ research and experiences, and mentors:

• Managed funds (also called mutual funds), including pension and superannuation funds, the world over struggle to match let alone outperform their respective benchmark indices for periods longer than three years, but typically less.

• The top 10 managed funds by performance over any single 12-month period are seldom in the top 10 for the following 12-month period.

• Top-performing managed funds are typically smaller boutique funds that oftentimes are closed to the majority of private investors.

• As smaller boutique-managed funds grow into large funds by attracting more and more investors’ funds, their performance wanes rapidly as their potential market universe shrinks to just the large liquidity stocks that more closely mimic index returns.

• Over any rolling 5-year period, managed funds, on average, perform slightly worse than their applicable stock exchange index, such as the All Ordinaries/ASX200 in Australia or S&P500 in the United States.
  • Over the long-term, the applicable stock exchange index, i.e. All Ordinaries or S&P500, underperforms its total return index (All Ordinaries Accumulation index in Australia and the S&P500 Total Return index in the United States) by approximately 4% CAGR in Australia and by approximately 2% CAGR in the United States.
    • This is due to two main reasons:
      • The fees that managed funds charge their investors for the fund to market (back to their investors) and manage their fund and to pay their distribution network of financial planners.
      • Mistakes that active fund managers make.
      • (CAGR = Compounded Annual Growth Return.)
  • Over the long-term, managed fund investors, on average, achieve returns that are less than the managed funds themselves, by approximately 2.5% CAGR less than the index, or approximately 4.5% CAGR less than the Total Return index.
    • Managed fund investors perform so much worse than the average managed fund, which slightly underperforms the market anyway, because the managed fund investor chases performance by continuously switching between funds and therefore, on average, enters funds that are growing rapidly in size of FUM (funds under management) but declining rapidly in performance, mainly due to liquidity constraints, fees and mistakes.
  • The beliefs in this bullet point are backed by The Little Book of Common Sense Investing by John Bogle which demonstrated these facts over a 25-year period from 1980 to 2005.
• The managed fund industry is fed via a distribution network of financial planners (and some accountants) who are paid on the basis of an annual percentage fee for FUM which continues to scale up in absolute terms without commensurate effort and return or reduction in risk as the size of FUM increases.

• Financial planners (historically nearly 100%, now a little less since an attempt to change the laws in Australia) distribute investors into managed funds that pay the financial planner fees for advising investors into these funds thereby creating the potential for conflict of interest on fund selection.

• To get sufficient protection and growth for their investments and overcome the issues above, private investors need to find a way to outperform the Accumulation / Total Return Index by at least 4% CAGR over any rolling 5-year period, but preferably closer to 8% or 10% CAGR outperformance. I believe that the ONLY way to do this on a consistent basis is to do it themselves using an active strategy.

• If a private investor is comfortable with returns slightly worse than the All Ordinaries Accumulation Index or S&P500 Total Return index, but far better than the average managed fund or stock market index (All Ords or S&P500), then the best way to achieve this is via a Vanguard (or other) Index Fund. Over the long term, market index funds will consistently outperform active managed funds. Why? Far less fees and far less mistakes. Provided that the investor is prepared to remain invested through large market corrections.

• The biggest threat to any investor’s nest egg is the big bear, such as occurred in 2008, 2002, 1987, 1973 or 1938 which all suffered near or greater than 50% falls in equities indices. The problem is that it is unknown when the next big bear will appear and if it occurs at the wrong time in an investor’s lifetime their nest-egg can get decimated and not recover in time to meet their retirement requirements.
  • There were five > 45% falls between 1901 and 1921 with no advancement in the DJI over this time.
  • The DJI made no gain for nearly 17 years between January 1966 and October 1982.
  • The S&P500 made no gains for nearly 13 years between March 2000 and February 2013.
• No large managed fund can remove ALL their capital from the market, meaning that a buy and hold investment mindset in a managed fund will wear the losses induced by a big bear or a secular bear market.

• The only way to avoid the big bear is to use an active strategy that will put your investment nest egg into cash and/or bonds before a baby bear turns into a big bear.

• Systematic risk has the biggest potential negative effect on long-term capital protection and growth. Therefore, market timing is mandatory in a timeframe that is consistent with the investor’s lifestyle.

• Leaving investment capital in cash for long periods of time will remove the risk of loss but will also remove the potential for growth while ensuring that an investor’s nest egg is slowly eroded by inflation.

• Price trends occur in financial instruments due to human beings inefficient decision-making capabilities caused by the emotional limbic brain overriding the analytical neo cortex brain thereby causing inefficiencies in the movements of prices.
  • These price trends offer fantastic opportunities from which to profit.
• Leverage will do more harm than good to more investors than not due to small mistakes that are magnified through the leverage.

• Every investor should have a “level of excess” which, when reached, they no longer need to continue investing only for themselves but also for others who are needy.

Motivated and inspired by these investing beliefs I have been on an ongoing journey for over 20 years discovering market principles that are consistent with these beliefs. I will share these principles with you next week.