Should you invest like Warren Buffet? How your temperament, experiences, interests and skills influence how you invest. Plus why most passive index investors unknowingly make active investment decisions.
In this episode you’ll learn:
- How investing is like being on a hero’s journey.
- How to invest like Warren Buffet and Phil Town
- Why most active managers don’t beat the market.
- What is the efficient market hypothesis.
- What assets and weights comprise the global market portfolio.
- What are active decisions made by passive investors.
Do You Believe Investment Markets Are Efficient?
One of the cornerstones of modern finance I was taught in graduate school is investment markets are efficient.
This efficient market hypothesis suggests it is nearly impossible for investors to outperform the market because securities that comprise asset classes reflect all relevant information.
In other words, the price of a security is always correct. It does not deviate from its fair value. Its price always equals fair value.
This means it is impossible to get some type of informational edge regarding a security or asset class in order to construct a portfolio that outperforms the market.
The efficient market hypothesis suggests the few managers who outperform the market do so by luck not skill.
The Global Market Portfolio
But what exactly is the market?
Efficient market proponents classify the market as the capitalization weighted sum of every investable financial asset.
This global market portfolio is comprised of every financial security, such as stocks, bonds, real estate investment trusts, etc., each of which reflects its correct price based on all available information.
And if every security is correctly priced then every asset class is correctly priced, and this market portfolio would be the best, most efficient portfolio for the average investor to own.
It would be the portfolio with the greatest diversification, offering the highest expected return for a given level of risk or volatility.
This global market portfolio is what the world’s investors own in aggregate and reflects the risk preference of the average investor.
If an investor is more risk averse than average then he or she would allocate a portion of his or her savings to the global market portfolio and a portion to cash.
If an investor prefers more risk than average then he or she would invest all of his or her assets in the market portfolio and take out a margin loan and invest even more in that same market portfolio.
The Composition of the Global Market Portfolio
What are the asset classes and weights that comprise this super efficient market portfolio?
In an academic paper titled The Global Multi-Asset Market Portfolio 1959-2012 by Ronald Doeswijk, Trevin Lam, and Lauren Swinkles, the authors estimate the global market portfolio is comprised of:
29.5% government bonds,
18.5% investment grade bonds,
5.1% real estate,
3.6% private equity,
3.0% emerging market debt,
2.3% inflation-indexed bonds
1.7% non-investment grade bonds.
Furthermore, the equity allocation for this market portfolio is 52% U.S. stocks and 48% non-U.S. stocks.
If an investor’s allocation to risky assets (i.e. non-cash assets) doesn’t approximate this global market portfolio it could mean several things.
Perhaps they don’t believe markets are efficient in that securities and asset classes always reflect the correct value. Consequently, those investors are purposely making strategic bets that differ from the market portfolio in order to outperform it.
Or the investors believe markets are efficient but still hold portfolios that differ from the global market portfolio because they don’t realize a true market efficient portfolio is comprised of more than a random selection passive index funds and ETFs. The proportional weights matter.
A third option is investors have never even considered these things and just take a haphazard approach.
Active Decisions By Passive Investors
Ironically, most investors who believe in efficient markets don’t realize the extent to which they are making active bets.
For example, many investors have a target asset allocation divided among different asset classes and implemented through passive index funds or ETFs.
If that target portfolio differs from the global market portfolio then the investors are making active allocation decisions.
Suppose, though, those investors or their financial advisor use some type of asset allocation modeling software to derive the target asset allocation weights for what they believe to be an optimally efficient portfolio.
They then implement that portfolio with ETFs or passive index funds.
One year later, due to market movements the portfolio differs from the target allocation. Perhaps there is more allocated to stocks relative to the target.
Most investors would then rebalance back to the target weights.
Rebalancing Versus Buy-and-Hold
Why do they that?
They shouldn’t if they believe their portfolio is truly efficient and optimized at the start.
If they believe the original portfolio was optimally efficient then the current portfolio would still be efficient and optimized even if the weights have changed since asset classes always reflect the correct prices.
If they sell stocks and buy bonds to rebalance their portfolio they must believe stocks are overvalued and bonds undervalued. That would suggest markets are inefficient and don’t always reflect the correct prices.
The alternative is they believe the stock market will not go up over long periods of time but will essentially stay the same even as stock fluctuates during the interim.
Why is that?
Because a strategy that buys stocks as they fall and sells them as they rise as part of a rebalancing strategy will underperform a buy-and-hold strategy during periods when the market ends up far from its starting point.
In other words, rebalancing strategies are inferior to buy-and-hold strategies during upward trending or downward trending markets with minimal reversals.
That’s because in those types of markets, the rebalancer will always be selling stocks that continue to climb in an upward trending market while buying stocks that continue to decline in a downward trending market.
I personally don’t believe markets are efficient. Yet, I also believe most investors, even professional investors, are ill equipped to take advantage of those inefficiencies by purchasing individual securities.
That means my portfolio is primarily comprised of low cost ETFs that replicate portions of the market, but I hold a portfolio that differs from the global market portfolio.
I actively allocate to those asset classes that appear undervalued and sell those that appear overvalued. I am an active passive investor.