Join Senior Financial Advisors Rob McClelland and Mike Connon as they discuss 5 concepts for successful investing as developed by Professor Ken French from the Tuck School of Business, Head of Investment Policy and board member of Dimensional Fund Advisors working in collaboration with Eugene Fama, Nobel Prize Laureate in Economics.
Transcript
Rob:
This is Think Smart with TMFG, your weekly podcast of what’s newsworthy and relevant to everyday Canadians with your hosts, senior financial advisors, Rob McClelland and Mike Connon of The McClelland Financial Group of Assante Capital Management.
Today on Think Smart with TMFG, Mike and I are going to be discussing the lessons we learned from Ken French. Ken is a finance professor at Dartmouth College, the Tuck School of Business. He was heavily involved in working with Eugene Fama, Nobel Prize winner, when they developed what is now known as the French-Fama three-factor model, which has since progressed over the last number of years to the five-factor model. Ken is a board member of Dimensional Fund Advisors. He’s also a consultant and head of investment policy. And Mike and I had the opportunity a week ago in Santa Monica to listen to Ken, and Ken did a presentation talking about the five concepts that he has learned about successful investing and we thought it might be an idea to share those with you.
Mike:
I think he called it the Five Things I Know About Investments. And they asked him with uncertainty if they were theories or if they were actually … he says they’re close in that format as he could say as being facts, so not full facts, but he said as close as you can be to being factual.
Rob:
So Mike, I’ll start off with the first one and it was rather unique and I’m still digesting it. He defined risk as the uncertainty about lifetime consumption. And so you think about it, if someone’s retiring and they’re switching from earning income to live their lives and be able to afford the goods and services that they use to using the assets they’ve accumulated or the pension income they’ve accumulated to pay for those expenses, those cost of goods that they’re going to be experiencing in their retirement and in some cases that retirement may be 30 plus years. So he basically said that risk is the uncertainty that surrounds all of that. What are your thoughts on that?
Mike:
Well, he gave a great example. He talked about home insurance and we all have home insurance, right? You have a home, is a big asset, a big part of your net worth. Is there a likelihood your home is going to burn down in your life?
Rob:
Probably not.
Mike:
Probably not. But you want to pay a significant amount every year, a thousand or $2,000 a year to protect yourself against that unlikely risk of your home burning down. And the problem if your home does burn down, it would have a catastrophic effect on your financial future and the ability to live the rest of your life. So you’re willing to pay money to go and take care of that risk. And that’s one idea on how risk works. So it’s a matter of protecting that asset for your life. And again, you have to protect your ability to have income throughout your entire life. So most people think of, we always talk about risk as your portfolio going up or down by 20% next year. We’ll call it standard deviation risk that most people discuss risk as. And that’s only a small percentage of the risk of you not having enough money to spend through your entire lifespan. And it’s a much more difficult calculation too.
We have 8% interest rate, 8% inflation rate right now. If that was to continue for the next 30 years, I think we’d all have a big problem, wouldn’t we?
Rob:
Absolutely.
Mike:
So you have to build all those into the plan when you consider risk, but it’s really a mind opening way to look at risk.
Rob:
He also discussed that there’s two types of investments that impact that risk and there are investments that you can put into your portfolio that reduce that risk. And there’s also investments that you can put into your portfolio that increase that risk. And so think of an investment that increases that risk is it may be more speculative in nature, it has no proven long term results, but you put it into your portfolio not realizing you’re increasing your risk of not having enough for lifetime consumption. Other investments like real estate or the stock market that have a long term track record, there’s a much better chance that you’re decreasing your risk of impacting that lifetime consumption by putting those investments in. Now he also pointed out though, and we’ll come to this, number five, you have to be careful. Tell the story about Enron and their executives.
Mike:
Well, Enron, as we know was a company in the States that was involved in, I believe it was more the power field in the States. And it went beyond just being involved in energy supply. It got involved in a lot of different financial instruments and things along that line. And all the executives had all their pay coming from Enron. And as there’re again the stock options, when they were being paid, they were putting that into Enron stocks. So you had a bunch of executives at Enron, which basically their entire net worth was invested in Enron. When everything came through and they found it was almost like a Ponzi scheme inside the company. All those employees lost, number one, their job, their high salaries, and they lost all their retirement assets at the same time.
Rob:
Including their pensions.
Mike:
Including their pensions. So incredible amount of lifetime risk that they didn’t realize they were taking. Because when you see someone that’s making that amount of money, you think they’re in a great position, what could possibly go wrong? So you need to have diversification in there to get rid of that risk.
Rob:
So let’s go to Ken’s second idea. And that was that the average dollar invested holds the market. What does he mean by that?
Mike:
Basically saying for every winner there’s a loser. So for every person who does better than the marketplace, there’s a person with an equal amount of money invested that has to do worse than the marketplace minus the fees and expenses associated with it. So the average person should get the market returns. But if you know someone who is above average, chances are you may be below average. So everyone wants to be above average. Everyone thinks they’re on the upside of that curve. But the reality, there’s only 50% that can be on the upside proposed to 50% of the downside minus fees and expenses.
Rob:
We’ve talked about home country bias numerous times and that means that an investor who lives in Australia is more likely to have a higher proportion of Australian companies in their portfolio. Ken also said it even extends beyond that. An investor in Australia is more likely to not only have more Australian companies, but they’re also likely to have more New Zealand companies and southeast Asian companies in their portfolio because that’s their home bias. Canadians are more likely to have American companies in their portfolio and even Mexican companies in their portfolio.
Mike:
And it probably makes sense too. In reality when you think about it, your economy is going to be more related to the companies around you. And we’re seeing that right now. We watch all the pain that Europe’s going through. Again, there’s a war going on in Europe, it’s going to have more of a financial effect on the European countries than it is over here. So there is a bit of home bias that’s required in a portfolio. We wouldn’t have wanted to have our money over in Europe right now because our inflation rate’s going through the roof and the European stocks are taking more of a dive than we have. So that would be unaffordable to deal with.
Rob:
Ken’s number three was chance dominates realized returns. And so he talked a bit about realized versus expected returns. What does he mean by that?
Mike:
Well, if you expect a return, let’s say on your portfolio of 6% going forward, just take that as a random number. So if you expect 6%, the chance of you actually achieving exactly 6% is very rare. You’ll have some years where you’ll be up 10%, there’ll be other years where you’re down 2%. So there is much more chance of having an unexpected rate of return than an expected rate of return. And when people hear what you say their expected long term rate of return is, they begin to try to transition that to what they expect every year. And it really has nothing to do with each other.
Rob:
So it’s a bit like saying I think the Leafs are going to win last night’s hockey game by five to three. In fact, the actual score was no, they lost four to three in overtime. So rarely are the predictions what you would expect. And you see it in football with the betting all the time; this team is expected to win by seven points over that team. Rarely does it hit seven points. It’s either above it or below it. And the same applies to investing. Value companies are expected to outperform growth companies by say three to 4% a year because they have historically. But that doesn’t mean over the next year that value companies are going to outperform growth companies.
Mike:
It’s funny. After doing this for so many years, whenever I visualize anything in my mind, I always visualize a normal curve around it. So whenever anyone gives me a number, automatically that graph comes, that bell graph comes to my mind to think of what the actual expected results are going to be and what it’s going to look like. And you really have to start to think like that because everything we know respond … I was even talking to one guy who runs marathons and I say, “What’s your expected time?” It was three hours and whatever, said, “Well, what are the chances of you actually coming in that time?” Said, “No, there’s not a chance of coming that time. I might have a good day, I might be feeling really good that morning, run a little bit below that, or I might not be feeling that well that day and run a little bit slower than that.” But he has basically a bell curve around a expected result for that marathon is, but it doesn’t mean that exactly he was going to run it in that time.
Rob:
If investing could only be like a Waze app where Waze does a pretty good job, if you’ve got an hour trip, it tells you what time you’re going to arrive and at times you’re a couple of minutes ahead. At times, you’re a couple minutes behind. More often than not, you’re within a minute or two of arriving when they said you would. Unfortunately, investing’s not like that at all. Let’s go to number four. Active investing is a zero sum game. Now, Mike, you sort of touched on this briefly, but let’s expand upon it. What does that mean?
Mike:
Well, again, it goes into, for every winner there is a loser. And when you start to go into the research of how many people actually outperform the marketplace of professional managers, the numbers are stunning. What does it drop? It’s like 15% when you go at five years of active managers can outperform the index. So with that type of chance, why are you going to bother with the active side of things? We talked about this many podcasts, but that gives you 85% chance of underperforming the index.
Rob:
I think what’s interesting to me is that everyone has to hold the stocks. There’s no depository for stocks. So if you’re thinking of selling your, let’s use your Facebook because you don’t like the direction the company’s headed in. There’s someone on the opposite side of the trade who actually thinks it’s a great time to be buying Facebook and they’re going to buy your shares. And it’s a zero-sum game. There’s always as many buyers as there are sellers. And you’ll hear that the buyers were active today or the sellers were active today, but there had to be an equal number of them based on all the trades that happened that day.
Mike:
So as it’s described, the market’s going to give a specific rate of return. So if you’re going to assume that you’re going to outperform that, essentially you’ve made a side bet, right? You’ve made a bet on the side that says, well, I know the market’s going to go up over the term, but I think this stock, ABC stock, is undervalued to this time that’s going to give me better return. So you’ve made additional side bet on top of the market going up.
Rob:
So Ken was asked one question that I thought was interesting. Based on all this evidence that shows that active investing doesn’t have a great long term track record, why are there so many active investors still in the marketplace today? And his response was overconfidence. And that makes complete sense. Everyone thinks that they can do a better job at picking the winners. Let’s go to number five. Understand he threw this one in because he felt he needed to come up with five.
Mike:
Yeah, four doesn’t make for a good article. So you need the fifth.
Rob:
So what was number five, Mike?
Mike:
Most investors should diversify their portfolio. And we’ve seen this over the years there. There’s really no such thing as too much diversification. People tend to put this idea out there. You own 10,000 stocks in your portfolio, how can you get any superior returns in the marketplace? But when we look at the evidence, when we have these people with 20 stocks in their portfolio, they don’t have superior returns in the marketplace. For everyone who tries, there’s more people that underperform the marketplace than get above the marketplace. So diversification, we always were told is the only free lunch out there. It’s the only time where you can actually reduce the risk and not substantially affect your return.
Rob:
I like to think about it, with diversification you’ve eliminated one of the possible outcomes and that’s that you dramatically underperform. You’ve diversified, you own the market, less fees, and if you control the fees, you’ve eliminated that really high risk of underperforming. And we’ve seen it time and time again where people take that extra risk and underperform, and can never recover from it.
That brings us to the end of another week. Thank you for joining us. If you’re looking for a financial advisor, visit our website at tmfg.ca or call us at (905) 771-5200. This episode has been brought to you by the McClelland Financial Group of Assante Capital Management, reminding you to live the life that makes you happy.
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You’ve been listening to The McClelland Financial Group of Assante Capital Management Limited. Assante Capital Management Limited is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. Insurance products and services are provided through Assante Estate and Insurance Services Incorporated. This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources. However, no warranty can be made as to its accuracy or completeness. Before acting on any of the previous information, please make sure to see a professional advisor for individual financial advice based on your personal circumstances. The opinions expressed are those of the authors and not necessarily those of Assante Capital Management Limited.
