Three Simple Rules for Investors
Last night I came across what has long been one of my favorite papers: Rules of Prudence for Individual Investors by Mark Kritzman.
Mark is the founder and CEO of Boston based research firm, Windham Capital Management. He is a highly respected contributor to the field of quantitative finance and is one of those guys who is on another level of intelligence. He’s wicked smaht. Most of the time, an average investor would have no idea what he’s talking about, but in this paper, his advice is simple and timeless.
The paper is brief and any investor would benefit greatly from reading it in its entirety. Here’s a quick summary of the most important points.
Rule 1: Diversify
Most investors understand the need to be diversified but they do it inefficiently. How markets are correlated can change a lot depending on their direction. Two markets increasing in value may appear relatively uncorrelated, but when the markets begin declining, correlations tend to move towards 1.
This pattern is the opposite of what we need. The assets chosen to complement a portfolio’s main engine of growth should diversify this asset when it performs poorly and move in tandem with it when it performs well. The evidence shows that most asset pairs have significantly asymmetric downside and upside correlations.
Be more thoughtful about how you diversify. If you’re concerned with the risk in your portfolio, foreign stocks aren’t the answer to domestic equity downside.
Rule 2: Invest Passively
Not only do most actively managed funds underperform their passive benchmarks, but many of the funds that do outperform, do so as a result of luck rather than skill.
From 1989 to 2006, the fraction of skilled managers (active returns exceed costs) declined from 14.4% to 0.6%. BSW* attribute this shift to an increase in unskilled managers who nonetheless charged high fees.
* False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas (Barras, Scarlet & Wermers)
Rule 3: Avoid Taxes
The majority of studies focused on active fund returns purposely ignore the tax consequences. Taxes are tough to generalize because of the different tax burdens across states and investors. While most institutional investors can ignore their impact, for individual investors, the importance of considering taxes when making investment decisions cannot be overstated.
The best way to avoid taxes is to follow rule 2; invest passively. The main source of taxes is turnover. Passively managed funds experience very little turnover, because they rebalance only when the index is reconstituted. Actively managed funds, by contrast, generate significant turnover, because their managers continually attempt to replace overvalued securities with undervalued securities.
Here’s Mark’s knockout punch. Consider an investor who lives in Massachusetts (2009) and is in the 35% federal tax bracket.
You are presented with three investment options: an index fund with an expected return of 10%, a mutual fund with an expected return of 13.5%, and a hedge fund with an expected return of 19%.
Which fund would you choose? The right answer will surprise most people.
I’ve seen other studies with similar conclusions but this one is burned into my mind. These are the results you won’t see in backtests or marketing brochures. Think about that next time you’re judging the performance of a fund or strategy.
It is very hard, if not impossible, to justify active management if your goal is to grow wealth. If, instead, you view active management as a source of entertainment, you may wish to consider less costly ways to amuse yourself.