I spend a good deal of time speaking to investors. And this week was no different. It was another difficult week to be an investor in a difficult year. Given this backdrop two seemingly isolated moments really struck me. Both of them got me thinking about what it takes to be ‘successful’ at investing. A natural place to start is the definition of successful. This is surprisingly simple to define. Being successful at anything is simply achieving your goal. Investing is no different. We all have different goals and there isn’t one pathway or destination for any of us. Being a successful investor is achieving your investing goal. That may mean a modest retirement and a trip to the Gold Coast every year. It may mean bathing in Champagne. You do you.   

Back to the two moments from my week. The first was an investor showcase hosted by Sharesight. Sharesight provides the portfolio manager on Morningstar Investor and also has relationships with several other companies. This partner showcase was an opportunity to talk about investing to Sharesight customers. One of the other presenters took the opportunity to talk about how critical it was to design a portfolio that was positioned along the efficient frontier. I wouldn’t lose any sleep if you don’t know about the efficient frontier. Trust me you can still be a successful investor.  

This efficient frontier nonsense got me thinking about an email I got earlier in the week from an Investing Compass listener. The listener was complimentary of the podcast but said that some of the concepts that Shani and I talk about go over his head. He asked for resources to build foundational investing knowledge and likened his current position to when he first started medical school and needed to understand the basics of medicine before progressing to more complex concepts.

And this is the gap we are facing. We have an investor event where retail investors are being told that the key to achieving their goals is to ensure their portfolio is on the efficient frontier. What we need is a population of investors with enough financial literacy to know the load of bull that is being pitched to them. What is so clear to the author of the email is not clear to many people. Knowledge is the foundation of becoming a successful investor. The problem is that as investors we are constantly bombarded with messaging about how investing is too complicated for the average person to understand. Naturally when something is complicated you should seek help. Since the average person can’t be a successful investor you should pay a lot for that help. Unsurprisingly this narrative is pushed by companies that want to sell you investment products.

Facts have become a commodity ever since we all started carrying around what historically would have been considered a supercomputer. To understand investing is to internalise the inputs needed to achieve your goal. Knowing the impact of different saving levels and the impact of time on the growth of your portfolio. Knowing what return is needed to achieve your goal. And finally understanding the drivers of share market returns. This will enable you to strip away all the commentary we hear about markets to the actual drivers of returns – changes in valuation levels, changes in earnings and dividends.

If I bought Cisco at the end of 1999 there would be a lot of people that would have said I was a genius. The prevailing wisdom in 1999 was that investing in anything connected to the internet would make you rich. Cisco was selling the plumbing of the internet – what could be better. This was an amazing narrative and it resonated to such a degree that Cisco was the third most valuable company in the world in 1999. If I took a look at the three drivers of share market returns maybe I wouldn’t be so quick to anoint myself a genius.

Cisco didn’t pay a dividend in 1999 so that source of returns wasn’t available. That leaves changes in valuation levels and earnings growth to propel the share price higher. Cisco made $2.25B USD in 1999. We aren’t talking about some crazy internet company that was losing a ton of money. Cisco had a market capitalisation of $337B USD which means it was trading for 140 times earnings. This compared to the S&P 500 that was trading at ~30 times earnings. Cisco’s valuation was 4.6 times more than the index. This extreme valuation makes it very unlikely that the share price would be driven higher from further valuation increases.

Far more likely than maintaining the elevated valuation is that it falls over time. All things being equal the share price would then also fall. If Cisco traded at 100 times the same earnings the share price in 1999 would have fallen close to 30%. This is very plausible scenario as over time sky high valuations tend to revert to the mean even if they remain higher than the overall index. As an investor in a company with an extreme valuation the hope is that earnings grow fast enough to make up for any reductions in valuation levels. Lets explore a scenario where Cisco experienced mean reversion and simply traded at double the index level of 1999 over the subsequent decade. Reverting to a valuation level of 60 times earnings would require earnings to grow 9.87% a year for 10 years just for the share price to stay the same. A tall order.

This extended example is looking at the past where everything that seemed so murky at the time has the clarity that comes from knowing the outcome. Between the last trading day of 1999 and August of 2022 Cisco’s share price was down 16%. Twenty-two and a half years later and the share price is down 16%. Earnings grew 6.7% annually over that period. That impressive run was buried by the valuation hit of having the price to earnings ratio drop from 140 to under 16.

Warren Buffett once said that investing is “simple but not easy.” The hard part is not learning about the efficient frontier. It is resisting the urge to go with the crowd. Understand how to achieve your goals. Explore the drivers of returns and what is priced into any investment you make. That is how you become a successful investor.   

What is happening at Morningstar

We are counting down the days to a new experience for www.morningstar.com.au. I’m really excited to share the new home of investing insights that only Morningstar can provide. The new site will be rolled out on October 1st.

My colleague Justin Walsh who works for our manager research team shared his thoughts on Gemma Dale’s podcast Your Wealth. Give it a listen.

Speaking of Gemma Dale, she will be part of the line-up of great speakers at our conference on October 13th. Join us in Sydney at the ICC or watch from the comfort of your own home. Included in your ticket is a comprehensive guide that walks through building a portfolio to achieve your goals. Email me at mark.lamonica1@morningstar.com for a discounted ticket.

In case you were wondering, it takes around 180 bottles of Champagne to fill up a bathtub. Nobody wants to float around in crappy Champagne so I would imagine you would want to be a bit discerning. If you picked Moet & Chandon White Star it would cost around $14,400 to fill up your tub. Something to think about in case that is your goal.

Still thinking about the efficient frontier? It is supposed to represent a series of optimal portfolios that have the highest level of return given the amount of risk that is being taken. That sounds good in theory but there are a couple key issues with it. Risk is measured in volatility or how much a portfolio bounces around in value. I would argue that for most investors that is not the risk they need to worry about. If I’m 40 years old and trying to save for retirement at 65 I shouldn’t care about how much my portfolio bounces around in any one year during the next decade. I care about making sure I’m invested in a way that will have a change of getting me the return needed to meet my retirement goal. The efficient frontier and the Modern Portfolio Theory tries to make investing into a science. It takes vast amounts of historic data on returns, correlations between asset classes and risk measures such as standard deviation to simulate a future based on the past. I think there are better things to worry about as you try and achieve your goals.