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Blog82: When Simplicity Rewards Investors Handsomely……

6th August 2018

Paddy Delaney

In a meeting last week I was asked why my philosophy toward successful long term investing was so simplistic and boring. I was delighted! For context the people I was working with had understood me to have been in the financial planning profession for 13 years (correct) and that I was a ‘finance expert’ (marginally correct!). Based on these two bits of information they had concluded that I would have a very complex, very elaborate, and dare I say it, very confusing approach when it comes to investing. This is what most of us have been conditioned to believe. That is most likely as a result of the unnecessarily complex products and layers that are rife in the Financial Services Industry.

When I explained my (very non-complex) belief on how one can achieve long term success they essentially scoffed at it, as if disappointed that I had not unleased a bout of verbal financial terminology and nonsense on them! It really got me thinking, it challenged me, and for that I am so grateful. As a result of that interaction this week I am sharing a short (true) story about long term results when one investor took a complex approach and when another took a very very simplistic and boring approach….and let you decide which might work best!

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A Wager!

When thinking about the whole concept of simple investing versus complex investing approaches I felt that there was one really really clear recent event which may tell the story far better than I could do by writing a long piece. This event happened over 10 years ago and was a wager that was placed between 2 very individuals, both of whom are far more experienced & wealthy investors than I (and at the risk of insult, than you also!). They both had their own beliefs as to what approach delivers long term investment success, and both believed them wholeheartedly. If you don’t believe it then it’s hardly a belief is it!

Last year saw the conclusion of this 10-year wager between non other than Mr. Warren Buffett, whose is the Chairman of Berkshire Hathaway Inc. whose net worth is estimated at $84B most of which as a result of wise investing over the past 4 decades, and Mr. Ted Seides, a New York hedge fund consultant and former Hedge Fund Manager at Protege Managers in USA. The wager came about when Buffett predicted in 2007 that a low-cost and very simple basket of US Shares (S&P Index) would outperform any active managed fund or hedge-fund over the coming decade. He put down $500,000 and invited someone from the ‘other camp’ to put down the same money. Buffett was offering a provocative and public challenge to an industry which prides itself on ‘making money work harder’ etc by actively managing funds and charges investors for the privilege. Seides responded to this public challenge issued by Buffett and selected five (never to be disclosed) actively managed funds to go head-to-head with the S&P 500 Index which Buffett was backing. The bet was to run from Jan 1st 2008 to 31 Dec 2017 and the winner of the $1m nominated the charity to which their potential winnings would go to.

Apparently around the half-way point in the bet some wise soul suggested the $1m which had been sitting in Bonds as a ‘holding’ spot should be invested in Berkshire Hathaway shares, which meant to winner ended up claiming $2.2m instead of marginally over $1m (don’t invest in bonds if you want long term growth it seems!)

The Volatility:

This particular 10-year period (like all 10 year periods) included years of dramatic declines for the S&P 500 Index (minus 37.0% in 2008) as well as above-average gains (up 33% in 2013). Some suggest that this represented more than enough opportunity for smart fund managers to attempt to outperform an index which takes a ‘buy it and hold onto it’ strategy.

While we are talking about volatility of investing the S&P 500 over the course of 1926 to 2017, the annualized return was 10.2%. However the returns achieved in any single year were rarely in that region. The return of the S&P 500 fell in a range between 8% and 12% only six times in that 92 year period however experienced gains or losses greater than 20% 40 times (34 gains, six losses). 40 times in 92 years the S&P 500 fluctuated by more than 20%, that is a sharp incline or decline almost every other year!

The Results:

If your money was on the hedge-fund horse you would have been quite disappointed! For the period from January 1, 2008, through December 31, 2017, the average return of the five hedge funds achieved a total return of approx 22.0%, meaning $1m invested over those 10 years would have been worth $1.22m by the end of the term.

This compares to a return of 85.5% for the S&P 500 Index meaning $1m invested grew to $1.85m.

Apparently Seides graciously threw in the towel with 6 months to go, he was that far behind. He did make a parting shot when he suggested that in 2008 when the S&P 500 lost 40% odd that the average of his 5 Hedge Funds fell by less than half of that which may have resulted in an investor being more likely to stay invested (one of the golden rules of successful investing). He makes a very fair point however we firmly believe that when properly informed properly advised and expectations set with regards to likely volatility most investors can hold tight in times of extreme noise and scare-mongering.

The result does not at all prove that active management is an inferior approach to a simple ‘buy an index and forget about it’ approach. There are some active managers who consistently outperform high performing indices such as the S&P 500 (wait till you hear Podcast 100 next week!). It does however point to the very fact that even in a decade which began with the worst global financial crisis and a decline of 40% that an investor can still stand to do extremely well and achieve returns far and above the rate of inflation, far and above the returns that many of us actually need in order to achieve our investment objectives, but only if we can hold on when the going gets rough! And yes if you were beingreally prudent you could say that a more considered and diversified portfolio may be a more suitable remedy for most investors the results are quite telling nonetheless.

Our inability to hang on is what results in such a gaping chasm between investment Returns and Investor Returns, but that’s for another day! My approach to investing has been largely shaped by the only thing that we can base our beliefs on, the burgeoning evidence of history. It may be simple but in all reality it certainly isn’t boring!!

Thanks for reading.

Paddy Delaney

QFA | RPA | APA | Qualified Coach

 

 

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