Warren Buffett and Charlie Munger’s Best Advice

November 26, 2013

…talk about the best advice they have even gotten in a short piece from Fortune.  I think it clarifies the difference between a blind value investor and an investor who is looking for good companies (not coincidentally, many of those good companies have good relative strength).  Warren Buffett and Charlie Munger have made a fortune implementing this advice.

Buffett: I had been oriented toward cheap securities. Charlie said that was the wrong way to look at it. I had learned it from Ben Graham, a hero of mine. [Charlie] said that the way to make really big money over time is to invest in a good business and stick to it and then maybe add more good businesses to it. That was a big, big, big change for me. I didn’t make it immediately and would lapse back. But it had a huge effect on my results. He was dead right.

Munger: I have a habit in life. I observe what works and what doesn’t and why.

I highlighted the fun parts.  Buffett started out as a Ben Graham value investor.  Then Charlie wised him up.

Valuation has its place, obviously.  All things being equal, it’s better to buy cheaply than to pay up.  But Charlie Munger had observed that good businesses tended to keep on going.  The same thing is typically true of strong stocks—and most often those are the stocks of strong businesses.

Buy strong businesses and stick with them as long as they remain strong.

Source: CNN/Money (click on image to enlarge)

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Option Income Isn’t Really Income

November 22, 2013

Fans of the free lunch will disappointed to find out that option income isn’t really income—it’s just part of the total return stream of an option income strategy.  There’s nothing wrong with option income, but a buy-write strategy is just a way to slightly reduce the volatility of an equity portfolio by trading away some of the potential upside.  I get concerned when I see articles promoting it as a way to generate extra income, especially when the trade-off is not fully explained.

According to a recent story in the Wall Street Journal, investors are increasingly turning to option income.

So far this year more than $3.4 billion in options contracts have changed hands on U.S. exchanges, according to the Options Industry Council in Chicago. That’s almost as much as 2008’s full-year volume and is on pace to be the second-best year in options trading history. The all-time record came in 2011 with $4.6 billion in contracts changing hands.

A buy-write strategy to generate option income might make sense if it is part of a total-return strategy.  All too often, investors have the wrong idea.

How big of a dent can it make on a portfolio’s long-term prospects? A lot, says Philip Guziec, a Morningstar analyst who studies various options strategies. He recently looked at six years worth of performance data through April 2010 using the CBOE S&P 500 BuyWrite Index, which follows a strategy of selling call options on the S&P 500 Index every month and reinvesting premiums.

During that period, a covered-call strategy where premiums were reinvested would have increased the portfolio’s return by around 19%. By contrast, spending each month’s options payments resulted in reducing the options portfolio’s value by more than 50%, according to Mr. Guziec.

“Too many people sell covered calls to generate extra income to live on, not realizing how severely that type of a strategy can eat into a portfolio’s upside over time,” he says.

Many investors would be shocked to learn that their portfolio could take a 50% haircut in only six years if they spent the option income!  As always, the bottom line is total return.

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Relative Strength and Philosophy

August 28, 2013

At first, you might not think that relative strength and philosophy are related in any way.  But they are, because every strategy is based on some philosophy of the market.  Different philosophies lead to different strategies.  We like relative strength because it is simple, straightforward, and performs well over time.  Of course, there are other strategies that work also, including some that are quite complementary to relative strength.  A nice encapsulation of philosophy leading to strategy appeared on The Bloodhound System blog.  A couple of excerpts from the article are instructive.  The first is a quote from Rick Ferri in a Morningstar interview:

“Strategy comes from philosophy. If you don’t have a philosophy, you can develop a strategy, but it’s only going to blow apart the next time it doesn’t work for a month or two. And you are going to go onto another strategy, and that’s the worst thing you can do.”

This is very true.  Over my career, I’ve seen many investors careen from strategy to strategy, never sticking long enough with any of them to enjoy success.  The author of the blog piece, Bill Moore, I think really cuts to the core of why  a deeply held philosophy is so important to success.  Having some kind of belief system is necessary to have conviction.  With conviction comes discipline—and discipline is the key to everything.  I put the good part in bold.

…what’s really important is that you have a philosophy that makes sense to you and that you believe in–and that you then create a strategy which you would execute with discipline.   As much as pundits might dogmatically espouse one investing philosophy or another–making it seem like it’s their way or the highway–there are thousands of investment philosophies–and in turn strategies.  The reason multiple philosophies can work out well is that inherent in having a philosophy, or belief system, is that you have conviction in it. That kind of discipline, not so much the philosophy itself, is the key to an investment plan.

One of our senior portfolio managers, Harold Parker, likes to say “to the disciplined go the spoils.”  He’s right.  Even a good strategy that is poorly executed will lead to bad results.  Every strategy might be driven by some philosophy, but none of them are worth a darn without conviction and the resultant discipline to execute well.

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3 Keys to a Simple Investment Strategy

August 8, 2013

Simplicity is the ultimate sophistication.—-Leonardo di Vinci

This quotation doubles as the title of a Vanguard piece discussing the merits of a simple fund portfolio.  However, it occurred to me that their guidelines that make the simple fund portfolio work are the same for making any investment strategy work.  They are:

  • adopt the investment strategy
  • embrace it with confidence, and
  • endure the inevitable ups and downs in the markets

Perhaps this seems obvious, but we see many investors acting differently, more like this:

  • adopt the investment strategy that has been working lately
  • embrace it tentatively, as long as it has good returns
  • bail out during the inevitable ups and downs in the markets
  • adopt another investment strategy that has been working lately…

You can see the problem with this course of action.  The investment strategy is only embraced at the peak of popularity—usually when it’s primed for a pullback.  Even that would be a minor problem if the commitment to the investment strategy were strong.  But often, investors bail out somewhere near a low.  This is the primary cause of poor investor returns according to DALBAR.

Investing well need not be terribly complicated.  Vanguard’s three guidelines are good ones, whether you adopt relative strength as we have or some different investment strategy.  If the strategy is reasonable, commitment and patience are the big drivers of return over time.  As Vanguard points out:

Complexity is not necessarily sophisticated, it’s just complex.

Words to live by.


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Investment Manager Selection

April 12, 2013

Investment manager selection is one of several challenges that an investor faces.  However, if manager selection is done well, an investor has only to sit patiently and let the manager’s process work—not that sitting patiently is necessarily easy!  If manager selection is done poorly, performance is likely to be disappointing.

For some guidance on investment manager selection, let’s turn to a recent article in Advisor Perspectives by C. Thomas Howard of AthenaInvest.  AthenaInvest has developed a statistically validated method to forecast fund performance.  You can (and should) read the whole article for details, but good investment manager selection boils down to:

  • investment strategy
  • strategy consistency
  • strategy conviction

This particular article doesn’t dwell on investment strategy, but obviously the investment strategy has to be sound.  Relative strength would certainly qualify based on historical research, as would a variety of other return factors.  (We particularly like low-volatility and deep value, as they combine well with relative strength in a portfolio context.)

Strategy consistency is just what it says—the manager pursues their chosen strategy without deviation.  You don’t want your value manager piling into growth stocks because they are in a performance trough for value stocks (see Exhibit 1999-2000).  Whatever their chosen strategy or return factor is, you want the manager to devote all their resources and expertise to it.  As an example, every one of our portfolio strategies is based on relative strength.  At a different shop, they might be focused on low-volatility or small-cap growth or value, but the lesson is the same—managers that pursue their strategy with single-minded consistency do better.

Strategy conviction is somewhat related to active share.  In general, investment managers that are willing to run relatively concentrated portfolios do better.  If there are 250 names in your portfolio, you might be running a closet index fund.  (Our separate accounts, for example, typically have 20-25 positions.)  A widely dispersed portfolio doesn’t show a lot of conviction in your chosen strategy.  Of course, the more concentrated your portfolio, the more it will deviate from the market.  For managers, career risk is one of the costs of strategy conviction.  For investors, concentrated portfolios require patience and conviction too.  There will be a lot of deviation from the market, and it won’t always be positive.  Investors should take care to select an investment manager that uses a strategy the investor really believes in.

AthenaInvest actually rates mutual funds based on their strategy consistency and conviction, and the statistical results are striking:

The  higher the DR [Diamond Rating], the more likely it will outperform in the future. The superior  performance of higher rated funds is evident in Table 1. DR5 funds outperform DR1 funds by more than  5% annually, based on one-year subsequent returns, and they continue to deliver  outperformance up to five years after the initial rating was assigned. In this  fashion, DR1 and DR2 funds underperform the market, DR3 funds perform at the  market, and DR4 and DR5 funds outperform. The average fund matches market  performance over the entire time period, consistent with results reported by  Bollen and Busse (2004), Brown and Goetzmann (1995) and Fama and French  (2010), among others.

Thus,  strategy consistency and conviction are predictive of future fund performance  for up to five years after the rating is assigned.

The bold is mine, as I find this remarkable!

I’ve reproduced a table from the article below.  You can see that the magnitude of the outperformance is nothing to sniff at—400 to 500 basis points annually over a multi-year period.

Source: Advisor Perspectives/AthenaInvest   (click on image to enlarge)

The indexing crowd is always indignant at this point, often shouting their mantra that “active managers don’t outperform!”  I regret to inform them that their mantra is false, because it is incomplete.  What they mean to say, if they are interested in accuracy, is that “in aggregate, active managers don’t outperform.”  That much is true.  But that doesn’t mean you can’t locate active managers with a high likelihood of outperformance, because, in fact, Tom Howard just demonstrated one way to do it.  The “active managers don’t outperform” meme is based on a flawed experimental design.  I tried to make this clear in another blog post with an analogy:

Although I am still 6’5″, I can no longer dunk a basketball like I could in college.  I imagine that if I ran a sample of 10,000 random Americans and measured how close they could get to the rim, very few of them could dunk a basketball either.  If I created a distribution of jumping ability, would I conclude that, because I had a large sample size, the 300 people would could dunk were just lucky?  Since I know that dunking a basketball consistently is possible–just as Fama and French know that consistent outperformance is possible–does that really make any sense?  If I want to increase my odds of finding a portfolio of people who could dunk, wouldn’t it make more sense to expose my portfolio to dunking-related factors–like, say, only recruiting people who were 18 to 25 years old and 6’8″ or taller?

In other words, if you look for the right characteristics, you have a shot at finding winning investment managers too.  This is valuable information.  Think of how investment manager selection is typically done:  “What was your return last year, last three years, last five years, etc.?”  (I know some readers are already squawking, but the research literature shows clearly that flows follow returns pretty closely.  Most “rigorous due diligence” processes are a sham—and, unfortunately, research shows that trailing returns alone are not predictive.)  Instead of focusing on trailing returns, investors would do better to locate robust strategies and then evaluate managers on their level of consistency and conviction.

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Keeping It Simple in the New Year

January 3, 2013

Barry Ritholtz at The Big Picture has some musings about portfolios for the New Year.  I think he’s right about keeping it simple—but I also think his thought is incomplete.  He writes:

May I suggest taking control of your portfolio as a worthwhile goal this year?

I have been thinking about this for awhile now. Last year (heh), I read a quote I really liked from Tadas Viskanta of Abnormal Returns. He was discussing the disadvantages of complexity when creating an investment plan:

“A simple, albeit less than optimal, investment strategy that is easily followed trumps one that will abandoned at the first sign of under-performance.”

I am always mindful that brilliant, complex strategies more often than not fail. Why? A simple inability of the Humans running them to stay with them whenever there are rising fear levels (typically manifested as higher volatility and occasional drawdowns).

Let me state this more simply: Any strategy that fails to recognize the psychological foibles and quirks of its users has a much higher probability of failure than one that anticipates and adjusts for that psychology.

Let me just say that there is a lot of merit to keeping things simple.  It’s absolutely true that complex things break more easily than simple things, whether you’re talking about kid’s Christmas toys or investor portfolios.  I believe in simplicity over complexity.

However, complexity is only the tip of the iceberg that is human nature.  Mr. Ritholtz hints at it when he mentions human inability to stay with a strategy when fear comes into the picture.  That is really the core issue, not complexity.  Adjust for foibles all you want; many investors will still find a way to express their quirks.  You can have an obscenely simple strategy, but most investors will still be unable to stay with it when they are fearful.

Trust me, human nature can foil any strategy.

Perhaps a simple strategy will be more resilient than a complex one, but I think it’s most important to work on our resilience as investors.

Tuning out news and pundits is a good start.  Delving deeply into the philosophy and inner workings of your chosen strategy is critical too.  Understand when it will do well and when it will do poorly.  The better you understand your return factor, whether it is relative strength, value, or something else, the less likely you are to abandon it at the wrong time.  Consider tying yourself to the mast like Ulysses—make it difficult or inconvenient to make portfolio strategy changes.  Maybe use an outside manager in Borneo that you can only contact once per year by mail.  I tell clients just to read the sports pages and skip the financial section.  (What could be more compelling soap opera than the Jet’s season?)  Whether you choose distraction, inconvenience, or steely resolve as your method, the  goal is to prevent volatility and the attendant fear it causes from getting you to change course.

The best gift an investor has is self-discipline.  As one of our senior portfolio managers likes to point out, “To the disciplined go the spoils.”

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Quote of the Week

October 22, 2012

No strategy can make up for inadequate savings or premature retirement.—-Rob Arnott, Research Affiliates

I like this quote a lot.  It gets at some of the factors that allow clients to achieve wealth, along with intelligent investment management.

  1. Savings, and
  2. Time.

Savings is usually more important than investment strategy, especially when a client is just beginning to accumulate capital.  Without some savings to begin with, there’s no capital to manage.

Time is important to allow compounding to occur.  This is often lost on young investors, who sometimes do not realize what a jump they will get by starting a portfolio early.  How many of us in the industry have met with the 55-year-old client who has just finished putting the kids through college and is now ready to start saving for retirement—only to realize they will need to save 115% of their current income to reach the retirement goal they have in mind?  Oops.

Save early and often, and give your capital lots of time to grow.

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More on the Value of a Financial Advisor

September 5, 2012

I noticed an article the other day in Financial Advisor magazine that discussed a study that was completed by Schwab Retirement Plan Services.  The main thrust of the study was how more employers were encouraging 401k plan participation.  More employers are providing matching funds, for example, and many employers have instituted automatic enrollment and automatic savings increases.  These are all important, as we’ve discussed chronic under-saving here for a long time.  All of these things together can go a long way toward a client’s successful retirement.

What really jumped out at me, though, was the following nugget buried in the text:

Schwab data also indicates that employees who use independent professional advice services inside their 401(k) plan have tended to save twice as much, were better diversified and stuck to their long-term plan, even in the most volatile market environments.

Wow!  That really speaks to the value of a good professional advisor!  It hits all of the bases for retirement success.

  • boost your savings rate,
  • construct a portfolio that is appropriately diversified by asset class and strategy, and
  • stay the course.

If investors were easily able to do this on their own, there wouldn’t be any difference between self-directed accounts and accounts associated with a professional advisor.  But there is a big difference—and it points out what a positive impact a good advisor can have on clients’ financial outcomes.

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Relative Strength–A Critical Portfolio Management Tool

February 13, 2012

Mike Moody’s Relative Strength–A Critical Portfolio Management Tool now appears in the current issue of IMCA’s Journal of Investment Consulting.  Whether you are managing relative strength portfolios yourself or you are employing relative strength strategies, this article answers the essential questions:

  • What is relative strength?
  • Why does it work?
  • Where does it work?
  • What have been the results?
  • What are its drawbacks?
  • How does it fit in an asset allocation?

Click here to read the article.


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Dare to be Different

July 28, 2011

Advisor Perspectives ran a recent article by Sitka Pacific’s J.J. Abodeely.  There was a fantastic quotation he pulled out from Ben Inker at GMO:

“The good news is that in the investment business there are very few people who do real asset allocation and actually move money around in an aggressive way,” Inker said. “It’s a tough thing to do and survive. The nice thing about it, and the reason why we do it, is because this means it’s an inefficiency that is not going to get arbitraged away anytime soon.”

We’ve written in the past about this exact feature of many winning investment strategies: the arbitrage involved is behavioral, not financial.  Good returns derived from uncomfortable strategies do not get arbitraged away, because very few people will actually do it.  In other words, if you look at your portfolio and get a warm, fuzzy feeling, you’re probably doing it wrong.

Simple examples of this phenomenon abound.  Here’s one: to lose weight 1) eat less and 2) exercise more.  Have I now arbitraged away the entire diet book industry because I just gave you the basic advice for free?  Of course not!  When I searched Amazon for “The * Diet,” I got 65,338 results (!!), ranging from The Warrior Diet to Crazy Sexy Diet to The Juice Lady’s Turbo Diet.  Although I am in awe of publishers’ ingenuity in coming up with great book titles, none of these diets will necessarily work any better than my basic advice.  The reason people struggle to lose weight is not because reasonable advice is not readily available; it’s because the advice is hard to implement.  Eating less and exercising more is simply less comfortable than our default position of eating more and exercising less!

Relative strength is often an uncomfortable strategy whether it is implemented in equities or global asset classes simply because the portfolios can deviate significantly from the market or from traditional notions of asset allocation.  On the plus side, it may give you some comfort to realize that relative strength methods have shown excellent returns for many decades—returns that are not likely to be arbitraged away unless human nature undergoes a substantial change.

Dare to be different

Source: www.samdiener.com

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