I'm sure if I were to query a group of bowling proprietors about the most important business lessons they've learned over their careers, their top 10 list would look quite similar. Running our operations, day in and day out, teaches us common lessons. For example, when it comes to customer service, anything that improves the guest experience is an idea worth considering. Showing guests you care by regularly asking for feedback or through consistently delivering a clean and safe environment, will be deeply valued, and richly rewarded. On the other hand, it's true: you can't make everyone happy, and don't take it personally when you don't. Finally, what proprietor hasn't learned the value of planning, to ensure the success of one specific event, or the rollout of a new league. The point is that over time, through failures and successes, we all learn what it takes to run our business, and to affect the best possible outcomes.
Before buying my center, I spent over twenty years working on Wall Street learning many of the "best practices" of investing, also through trial and tribulation. In launching my own investment management firm, I incorporated those as core investment tenets. I share with you some of those lessons learned.
Bowling centers rely on numerous revenue streams; bowling, food, alcohol and vending, to name a few. Investors call this diversification.
Investopedia describes diversification as "a risk management technique that mixes a wide variety of investments within a portfolio." By assembling a broad group of assets, an investor will reduce the chance of portfolio losses while simultaneously achieving higher expected returns. This is what we call a "free lunch," resulting in less bad news and more good news, simply because you hold different investments. But what kinds of investments should you own?
There are four major categories of investable assets to consider: stocks, bonds, real assets (including gold, real estate, and oil), and cash equivalents (money market funds, CDs, and savings accounts). Historically, the returns of these different asset classes have not depended on the movement of the others. That's what makes diversification so special. If one asset is performing poorly, it is likely that another is doing well. Only on occasion will everything move together.
Putting the right mix of these assets together, though, is complicated. Ideally, your portfolio will reflect two important considerations; how much time you have to achieve your investment goals, and what kind of tolerance you have for taking on risk. A portfolio balances your personal financial goals with your risk comfort level. Just because you can afford to lose principal doesn't mean you can personally stomach the losses. An ideal diversified portfolio is, therefore, also a personalized one. Some financial experts even argue that how you decide to allocate your assets is more important than which individual securities you choose to own within that specific asset class.
Passive vs. Active Management
We've now established the delicacy of putting the right mix of stocks, bonds, real assets and cash equivalents together in a portfolio to achieve optimal diversification. But as an investor, how do you know what to buy specifically and how should they be managed over time?
In response to these questions, the investment management industry was invented. It is populated by some of the most-credentialed, brightest minds. Above average compensation and competitive spirit are big attractions to high achievers. These money managers are hired by their clients to sort out the best investment ideas, from which they construct portfolios. The ultra-rich may prefer hedge fund managers, while the bulk of investors turn to mutual fund managers. The problem with either arrangement is that while these very smart individuals set out to do better than average, two things get in their way- fees and forecasting.
When you pay fees to these managers, you end up paying for the chance to make money--and sometimes, these costs outweigh any incremental returns. In Warren Buffet's 2005 annual letter, he argued that even a group of professional managers who buy their best investment ideas could not beat a group of amateur investors who put their money in an unmanaged, low cost index fund. In 2008, he put (a little of) his money where his mouth was and wagered $500,000 on his argument. Now, nine years into the bet, it would appear impossible for him to lose. This "passive" investor made 7.1% a year over this period, whereas the "active" investor made only 2.2%. On a $1 million portfolio, your genius manager would have made you $216,000, while doing nothing but putting your money in an index fund would have earned you $854,000. And the bet isn't over!
The other problem with the investment management industry is forecasting. What do the experts really know?
At Starlite Lanes, I can only guess how many lines of bowling will be played, how many pizzas will be ordered, or how many coupons will be redeemed. I've done the projections, but only once all of the day's shoes have been returned can I confirm any results. Money managers are dealing with the same challenge: they can try to predict the direction of stock or bond prices, but they can't know with certainty the future of a portfolio.
John Kenneth Galbraith sums it up well:
"We have two classes of forecasters: Those who don't know – and those who don't know they don't know."
With index investing, the human is taken out of the equation. Portfolio weightings are set, and are not adjusted further based on forecasting.
The bottom line, according to Buffet, is: "When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds." I make the same recommendation to you.
Watch for more Best Practices for retirement savings in next month's column.
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