There is a tendency to assume that complex problems like navigating the global financial markets require complex solutions. But simple investing strategies almost always yield superior results.
VICTOR HAGHANI is best known as one of the partners of Long Term Capital Management which failed spectacularly in 1998. His trading strategies at LTCM and before that in the bond arbitrage group at Salomon Brothers were extremely complex. But after LTCM’s collapse, he went back to basics to what he learnt about academic finance as a student in London.
In the latest episode of The Investing Show, Victor explains what a simple investing strategy might look like, and why it’s appropriate for the vast majority of investors.
Robin Powell: Hi, Abraham. So last time we interviewed Victor Haghani, one of the founders of LTCM, the high profile hedge fund that collapsed 25 years ago; and you’ll recall his investment philosophy underwent a complete transformation.
Abraham Okusanya: Yes, it is an extraordinary turnaround. He used to make high-risk active bets on the market, and now he is an advocate for low-cost index funds.
Robin Powell: That’s right. To be clear: in his current business, Elm Partners, Victor still dabbles a little in active management, and we’ll hear more about that later. But yes, he exclusively invests using low-cost ETFs, and he strongly believes that most investors should simply buy and hold broadly diversified passive portfolios.
Abraham Okusanya: So, what is Victor going to be talking about this time?
Robin Powell: In short: keeping it simple. His trading strategies at LTCM and before that were extremely complex. But after LTCM’s collapse, he went back to basics to what he learnt about academic finance as a student in London. Every portfolio, he says, should consist of just two distinct parts.
Victor Haghani: Most of modern finance is kind of built around sort of a two asset portfolio. One asset could be thought of as an efficient portfolio of risky assets, and the other one is your safe asset. We need to sort of solve a two-part problem. The first part is: what is this efficient portfolio of risky investments? And then the second one is: how much should we invest in the risky investments, and how much should we keep in the safe asset? That was called Tobin’s Separation Theorem, that we could approach investing by separating the problem into these two parts.
Robin Powell: James Tobin, the man who proposed Separation Theorem, later won a Nobel Prize for it. But it was other academics who built on Tobin’s work by suggesting how to construct those two different parts of a portfolio. The risky part, and the safe part.
Victor Haghani: What is the risky portfolio? This portfolio that’s going to give me – hopefully – an excess return over the safe asset. What’s the best risky portfolio? And, you know, Markowitz and Sharpe and a litany of other great academics proved to us – both mathematically and with common sense – that that should be the market portfolio of risky assets.
So, for shorthand, we’ll just think of that as the market portfolio of equities. Private and public, but most of the world’s risky equities are public. And in terms of accessibility, the public ones are the ones that are accessible and are a good proxy for the whole market portfolio. So that’s the part of owning a market cap-weighted portfolio of all the world’s equities. That is your risky portfolio. Now, you could potentially add things around the side to that to make it more representative. You could put some real estate in there. You might put some commodities in there, perhaps. You might put in some high yield bonds, whatever. But basically we’ve got this market portfolio of risky assets and that you should go for the most diversification and you should realise that, if you don’t go for the market cap-weighted risky portfolio, you by definition are making a bet against somebody else. So if you decide that you just want to own value stocks, you’re making a bet against somebody else who’s saying, “Oh, I think that growth stocks are better.” Or, if you just want to own tech, you’re making a bet against other people who have to be underweighting tech.
So I think that’s really intuitive. The math behind it is really powerful, too. But it’s also intuitive why that market portfolio, that’s the only thing that all of us can own at the same time without making bets against each other. I believe that for me – and for people that I advise – the risky portfolio that they own should be composed of low cost ETFs, giving them broad exposure to the world’s global equity market.
Robin Powell: So, the risky part of the portfolio, academic finance tells us, should essentially comprise the total market. But a more difficult question is: how much should you put in the risky part of the portfolio, and how much in the safe part?
Victor Haghani: How much should I invest in that versus in the safe asset? Well, that is a question of your own personal risk preferences; and it’s also a question of how much expected return is in that market portfolio of risky assets relative to the safe asset and how risky it is.
Well, do we think that that expected return doesn’t change over time? Everybody thinks it changes over time. So if it changes over time, it’s sort of like if you decide what’s the right amount of your wealth to bet on a coin that has a 60% chance of landing on heads; and now somebody gives you a coin that has a 65% chance of landing on heads. You should want to invest or to gamble a little bit more of your money on the coin with the more favorable bias. And the same is true with regard to investing in this risky portfolio. When the expected return of it, relative to the safe asset, is higher; we should want to put more of our money into the risky portfolio and less in the safe portfolio and vice versa. And that’s what we do. That’s how I invest for myself. That’s how I have been investing for myself. That’s what finance theory tells us to do. And that’s how we try to invest on behalf of our clients as well. And some people say that, “well, when you’re changing your asset allocation, that’s market timing.”
Market timing has a whole pejorative thing around it. You know, it’s really more about people that are coming and taking all their money, and putting it into cash, and then going back in the market, going short, going long, going leverage. I don’t know what we want to define as market timing, but changing your asset allocation as the expected excess return of your risky portfolio and as the riskiness of it is changing over time is just conventional, straight down the middle finance theory. It makes theoretical sense. It makes practical sense. And that’s what we do.
Now you have to be able to estimate the expected return – not the return – but you need to be able to estimate the expected return. If we don’t know what the expected return of equities is, relative to the safe asset, we have no business investing in them at all anyway. Like, how could you invest in equities if you don’t have an estimate of the expected return? If your estimate of the expected return is just the historical return, that’s a pretty weird thing to do. It’s like saying, “I’m going to buy a bond. You know, here’s this bond and it’s giving me a 3% yield today if I buy it. But, you know, the return on these kinds of bonds over the last 100 years was 6%. So I think it’s somehow going to have a return of 6%.” No. I know if I buy it and I hold it, I’m going to get a 3% return. I need to be forward-looking with my estimates based on all the information – including historical information – but all the information, and think about it forward-looking. And that’s going to change over time.
Robin Powell: Victor Haghani doesn’t like phrases like “market timing” or “buying the dips”. But, generally speaking, he says it’s better to invest slightly more in equities when markets have fallen and slightly less when they’ve gone up.
Victor Haghani: In general, when the markets go down, all else equal… I mean, you also have to see what’s happening with interest rates. But when the markets go down, It’s often the case that the long term expected return of holding equities has gone up and you should own more equities. It’s not a dramatic difference. It’s not like you should go from owning 50% to owning 100% equities, because the expected return wouldn’t probably have changed that much from the market going down. And also, as the market goes up, all else equal, you should want to own less equities as part of your overall portfolio than otherwise. But you really need to be looking at the return of the safe asset as well, relative to this risky portfolio. But, in general, that’s one thing that it’s going to look like – but in a very tempered and disciplined manner.
Now, I want to say that the second best thing to do is to sort of ignore what I’ve said. Come up with some allocation and just stick with that over your life or for a long period of time and don’t change things too much. If you can do that, I think that’s a good second best thing to do. It’s a lot easier, it just might not be worth it depending on how big your savings are, where you are in life, et cetera. You know, it might not make sense to go through this extra effort of changing your asset allocation. And again, the changes in asset allocation aren’t that dramatic necessarily over time as the expected return is changing. But I think that there are times when it really does make sense to pay attention to that. But if you want to just ignore that and just keep 75% in equities, 25% in safe assets; that’s so much better than the third best alternative, which is like reading the newspaper and trying to figure out what to do. Should you buy Apple or should you buy NVIDIA or not or whatever? I think that we like what we’re doing. That’s what I like to do for myself. But, you know, if you said to me, “Vic, you can’t do that. You just have to choose an allocation to equities for the rest of your life and live with that,” you know, that would be a good second best alternative. And that third best alternative would be terrible.
Robin Powell: So Abraham, portfolio construction and asset allocation are very important subjects, but Victor Haghani’s right, isn’t he, when he says there’s a tendency to overcomplicate them?
Abraham Okusanya: There is indeed. But, in the end, all of this academic research – including by Nobel Prize winners – says that most people need two major asset classes in their portfolios. If you just start with: we have great companies of the world who are creating and selling goods and services that we, you, and I use in our everyday lives. You can either own part of these companies – we call that those shares; or you can lend to these companies – and we call that bonds. In the end, it comes down to those two asset classes and how you mix them in your portfolios.
Robin Powell: Now, I’m guessing, Abraham, that you – like me – would generally favour a static asset allocation, with periodic rebalancing to restore that allocation. It does seem logical though to buy more equities when people are selling them and perhaps reduce your exposure when everyone’s piling in.
Abraham Okusanya: Well, rebalancing does that for you anyway, Robin. So, the idea of rebalancing is that you set your portfolio back to the original allocation. So, if we start with this hypothetical 50/50 portfolio – 50 percent in equities and 50 percent in bonds – generally, what happens is: when equity zigs, bonds tend to zag. And so what you’ve just described: buying when people are selling… buying more equities when people are selling and maybe selling equities when people are piling in – rebalancing does that for you. So, for most people, I wouldn’t worry about buying and selling depending on whether equities are in demand or not.
Robin Powell: As we were saying earlier, the change in Victor Haghani’s investment philosophy is extraordinary. I recently read an article by the MD of J. P. Morgan, believe it or not, who was advocating the same things as Victor. Keep it simple, ideally passive, and stay disciplined. It’s fascinating, isn’t it, to see how attitudes are changing.
Abraham Okusanya: Long may it continue, Robin. Long may it continue.
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