The first thing I strongly advise most people to consider is to Stop Investing in Equity Markets! What I mean by that slightly misleading statement is that as an individual investor you must first of all stop trying to build a portfolio of specific stocks and if you must, limit such allocation to not more than 5-10% of your total portfolio.
There are several reasons for making this claim.
1) Understand Alpha: To put it simply, for equity investments in a particular market alpha is the return that your investment will generate above what a benchmark market index would have given you (for the same market). For example if your US equity portfolio gave you a return of 15% during a period in which S&P500 index was up by 10%, then the extra 5% return is the alpha you have generated.
Note: You are unlikely to be able to generate alpha!
The biggest problem of investing in stock markets is that it is incredibly difficult to generate alpha and to do it consistently over long periods of time is damn near impossible. There are notable exceptions to this like Warren Buffet, John Templeton, Mohnish Pabrai etc. however these are outliers and for the average person who has limited time, knowledge and resources on hand, it is a futile pursuit. I won’t get into the details of why it is hard to do, as the evidence is all around you. If you have been investing in the past you may already have experienced it first hand on occasions when all your trading/investing/speculating failed to generate a return better than the index.
So why is it that most of us like to chase alpha? I think it is partly because people don’t even realize how hard it actually is to do so. But the bigger reason is the emotional aspect: the fun in trading, the gambling high of buying/selling sometimes at a profit and sometimes at a loss. The ability to brag when your random stock pick did well and the ability to come across as a star among your colleagues/friends when conversation tilts towards finance. Most of us don’t even bother calculating how our self-managed portfolios really did in the long run compared to an index.
2) Minimize the instinct to gamble/speculate: The constant barrage of news/advertising/sales pitches from the financial media which always promises you that the recommended stock is the next big thing and that anyone can generate outsized returns is a fallacy. Of course it can happen to some people but the likelihood is similar to someone winning a lottery. This is probably the one single reason why most of us like to buy stocks and then hope for the next big win. Building a portfolio of individual stocks with the hope of striking big money with some of those stocks is like buying a stack of lottery tickets as a retirement plan.
Trust me I get it! I enjoy the whole process of identifying/researching (or at least what I think is research) and trading stocks. I wouldn’t stop it completely myself and I am not suggesting that you stop either. But from a wealth management perspective, you must realize that your whole portfolio should never be based on individual stock selection.
Stop trying to get rich quick by finding the next big thing and focus on getting a decent return on your investment which would help you beat inflation. The key is to focus on absolute performance rather than a random number based on some index.
There are all sorts of risks associated with equity investing and most of us realize that you must never put all your money in one stock. But what we often don’t ask ourselves is, how many stocks are enough to have a diversified portfolio? And how many of these stocks will you be able to research thoroughly and then monitor on a regular basis to identify if the companies continue to do as expected? And after you have done all this, how much alpha can you really generate?
Well, even among the professional fund houses with analysts, economists and portfolio managers, on average only about 40% of the funds actually beat the index over a 1 year period and the percentage declines rapidly as the time frames are extended.
So if you are an individual who will potentially be investing in the market for the next 5, 10, 20+ years and if you were to pick and choose your own stocks, odds are that you would fail to beat the index consistently. In fact in all likelihood, you may end up doing even worse than the fund managers, given your lack of resources and time dedicated to thorough research. Again, I am not saying no one can do it, I am saying most people don’t have the patience or perseverance to do this over the long term. If you truly believe you can, my only suggestion is to start small and grow the self managed portfolio over time.
So why then, would you waste your time and effort in trying to design a portfolio and then manage it when you can easily invest in a managed fund or even an Index fund such as an ETF? In fact for many developed markets, Index fund ETFs are probably your best investment option as most fund managers have a hard time beating them (an even better option is equal weighted index ETFs, provided you can find one for your target sector/region). Choosing the right fund manager who can generate alpha consistently is almost as hard as building a portfolio that does so consistently as such you are probably better off mimicking the index.
This is not to say that all actively managed funds are bad because there are several advantages that you get via mutual funds. While ETFs are often a good option to consider there may be some issues you need to consider such as:
# Non-Availability of an ETF focusing on the desired region/sector/strategy.
# The ETF may not be actively traded as such liquidity will be an issue when you want to sell it also the bid ask spread may be quite high.
# ETF exists but is traded on an exchange that you do not have access to.
# ETF may not be denominated in a currency that you want your investment in.
# Some banks allow you to take a loan against your mutual fund investments but this option is usually not available for ETFs.
# For emerging markets, it has been observed that active management does add value to the process and a higher proportion of professionally managed emerging market mutual funds generate alpha than for developed markets.
Instead of doing stock specific research, it is most critical to spend your effort in identifying the right region/sector/asset allocation and use fundamental as well as technical analysis methods to identify the product as well as the time to invest in it.
Managing beta, which I define as focusing your efforts on ensuring investing into the right markets/sectors indexes (trading at low/reasonable valuations) is what I focus on.
And the most interesting thing is this: If you do are able to implement the above strategy well, i.e. make diversified investments of low valuation indices , overtime that portfolio will outperform a market cap weighted index i.e. technically you would get alpha!
This is what I meant by Smart Beta > Alpha.