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Investment adages that don't make sense

John Rekenthaler  |  31 Dec 2019Text size  Decrease  Increase  |  
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Some of these sayings initially struck me as insightful, while others never did. Either way, here are four investment bromides that can safely be ignored.

1. You’re too diversified

This criticism is omnivorous, applying across the investment food chain. It is levied at mammoth pension funds that hire hundreds of subadvisers, as well individuals who have investments strewn across multiple brokers. Were there any retail mutual fund of funds still in business (they were once fashionable), the reprimand would be directed at them. I should know; I once routinely wrote such comments.

Silly me. Pruning won’t boost performance, unless the portfolios contain obvious mistakes, such as high-priced funds. The underlying logic is that when cutting funds, investors will shed their weaklings and keep the strong children. Perhaps.

Or, perhaps, they will sell their future winners and retain their losers. The expected return for such trades is zero at best, and less than zero at worst, if they result in capital gains within a taxable account.

The other argument is that by possessing so many securities, sprawling portfolios effectively become costly index funds, because they can’t help but resemble the overall market. That claim implodes upon being tested.

To give one example, Yale’s endowment portfolio is both sprawling and famously successful. To give another, Fidelity Magellan was the top-performing equity mutual fund in the 1980s, while also holding more stocks than almost any actively managed rival.

Simplicity is a virtue. There’s nothing wrong with reducing clutter by consolidating accounts. Just don’t expect that action to improve investment returns.

2. Buy bonds, not bond funds

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The premise sounds reasonable. Why pay fund expenses when purchasing conventional, high-quality bonds? Buy fixed income directly. Investment-grade bonds are priced very efficiently; they almost always pay their debts; and in the rare cases when such issuers have encountered problems, most mutual fund managers responded after the fact.

The scepticism about fund-manager abilities is warranted. I don’t expect bond-fund managers to foresee credit busts, any more than I expect stock-fund managers to dodge market crashes. Fortunately, funds are protected by diversification.

One lemon among dozens of securities is no great sorrow. However, one lemon among several positions, as would generally be the case for individual investors, spells disaster.

The argument about fund costs also weakens under examination. It was powerful back in the day, when many of the popular bond funds came equipped with front-end loads and annual expense ratios exceeding 1 per cent.

It is far less compelling today, with 221 bond mutual funds and ETFs (I counted) having expense ratios of less than 0.25 per cent. Those directly purchased bonds aren’t free, either. A 2015 study found the average retail transaction cost on corporate-bond trades to be 0.77 per cent.

One could, of course, reduce trading costs and eliminate credit risk by owning only Treasuries. That’s not a bad idea, even if it does lower yields and, under most market conditions, total returns.

But avoiding corporates does not change the biggest problem with the “buy bonds” thesis: It rests upon the misperception that individual bonds are safe because they are guaranteed to be redeemed at par, while funds are less reliable because their net asset values cannot be predicted.

That is correct but misses the point. Bonds are redeemed at fixed nominal values. The real value of those dollars, adjusted for inflation, is unknown at the time of purchase and subject to change.

Also, just because individual bond-owners tend not to check their issues’ ongoing prices, while bond funds publish daily NAVs, doesn’t mean that bonds are less volatile than bond funds. It’s a Jedi mind trick.

3. Core and explore

The Core and Explore asset-allocation scheme is popular. Most people immediately appreciate the merits of dividing one’s portfolio into 1) a majority “core” that contains mainstream securities, and 2) a minority stake that “explores” less-common investments. Sometimes, the phrase also implies indexing the first portion and investing actively with the second. The tactic seems… intuitive.

For such mindsets, adopting the Core & Explore approach reduces future regret. If one person’s core portfolio declines, then so did everybody else's. No need to fuss over that decision. Nor should one worry about losses in the explore position, because those were merely house monies. Besides, the phrase rhymes. (An apple a day keeps the doctor away. If it doesn’t fit, you must acquit. Conjunction Junction, what’s your function?) That’s worth something right there.

I am not against Core & Explore. It’s a perfectly acceptable way of thinking about a portfolio. It’s just not a superior investment approach, which was how the concept was originally pitched. Mathematically, the best portfolio is that which has the highest rate of return, while blending investments that work well together, meaning they are imperfectly (or better yet, negatively) correlated. None of that has anything to do with how assets are labelled.

Nor is there support for the scheme’s indexing/active subtext. Indexing is indexing. As long as its expenses are substantially lower than the category norm, indexed funds figure over time to outperform the average actively run competitor. Indexing the core investments while seeking active managers for the explore positions might seem logical, but it’s not.

4. A stockpicker’s market

This phrase was once as common as flies at a picnic. Each December, financial journalists would ask portfolio managers about their performances, as well as next year’s prospects.

Their response would sound something like this: “Beating the market this year was easy. All somebody had to do was own technology (or healthcare, or financials, or consumer staples, or whatever). Next year will be harder. Investors won’t win by riding trends. It will be a stockpicker’s market.”

Translation: “To understand this year’s stock market, we can look backwards. That’s an easy task. Unfortunately, we don’t yet understand next year’s market. Eventually, we will realise that it, too, had prevailing winds, but those winds are not yet apparent. Therefore, from our perspective, last year’s market rewarded themes, but next year’s will favour stockpickers.”

Twelve months later, the same questions would again be asked, and the same answers given, except that the names of the current themes would change. Meet the new boss, same as the old boss.

One would think that with active stock managers in disgrace - this week, the US's largest pension fund abruptly fired all but three active equity managers - and this cliché being so frequently uttered and so frequently wrong, that such claims would no longer be voiced. Half true. The words are no longer stated so baldly.

Indirectly, though, the argument continues to be made, or at least implied, with the oft-cited research showing that the five FAANG stocks have driven much of the market’s gains.

Well, yes, but that doesn’t mean that 2015’s investors held an advantage, because a simple trend awaited. For them, the future was a stockpicker’s market. The future always is.

This article originally appeared on the website of Morningstar Inc.

is vice president of research for Morningstar.

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