You’d think we’d know better by now. Unlike our forefathers who traded houses for tulips and bought US railroad stock on hock, we’ve got behavioural finance to remind us our caveman brains go all Harlem Shake when trying to weigh up risk and return.

But no, even now there lurks inside each of us a Jekyll and Hyde investor, itching to run with the herd, to jump off a cliff, and to generally get emotional about what should be the rational business of investing.

And so risk in investment swings from meaning the fear of losing money to the fear of missing out – just like it did 100 years ago, and 300 years before that.

In a deep bear market, all the talk is of capital preservation. Having lost their shirts, investors fear losing their pants.

In contrast, when markets hit new highs you’ll hear far more about the risks of missed opportunities. The foolish chase hot shares and funds, and may even abandon their asset allocation altogether.

You say risky, I say risqué

The start of 2013 was a case in point. In just four years we’d gone from a stock market crash – and talk of the death of equities, of buy-and-hold investing, and of capitalism itself – to a roaring bull market.

It seemed that almost overnight many more people agreed that cash was trash, bonds were in a bubble, and equities were the only game in town. Yet precious few of these voices were heard when shares really were cheap.

Worse, such opinions seldom come with even a nod to individual circumstances.

• If you’re 25 and you will invest regularly for the next 30 years – and if you’re made of stern stuff – then a 100% equity strategy may well be the way to get started.

• If you’re 55 and you’ve done most of your saving, being 100% in equities is probably not for you, not matter how crummy the alternatives.

Your aim in investing should probably not be to try for the maximum possible return – or even the most likely maximum return.

Your aim is to meet your investment goals. The big risk is you don’t.

Beta not pay too much attention

Even those two different uses of the word “risk” – of losing it and of missing out – barely begins to cover risk’s many guises when it comes to investing.

For example, to academics the upside and downside risk of a share is treated as the same thing. When they say risk, they are talking about how far shares or other assets have previously moved up or down in price terms, compared to the market – something we might instead call volatility.

This academic idea of risk (called beta) is extremely useful when you’re neck-deep in theoretical portfolio construction.

But even if you believe market efficiency underpins all our investing choices, in my opinion their notion of risk is not of much practical use, whether you’re a passive investor working out a retirement plan or a value investor looking for bargains.

Passive investors should be more interested in asset allocation and the likely range of potential returns over the long-term – and in the prospects of falling short of their goals.

And value-minded stock pickers?

We should laugh at the proposal that Sainsbury shares at 240p in 2009 were a higher risk investment than at nearly 600p in 2007, whatever the academics say.

Time, investment, and risk

There are myriad other kinds of risk in investment – from currency risk to political risk to interest rate risk.

But the main one we’re interested in is the risk of permanently losing money.

Here academic notions of risk as volatility can make peace with a more common sense idea of risk as the chances of living off baked beans in your old age because you blew your pension spreadbetting.

The academic sort of risk – volatility – increases over time. But the deviation of your annualised returns versus those you expect based on historical precedent tends to decline over time. The UK stock market has fallen 20% or more in a year several times, for instance, but it’s never delivered a minus 20% annualised return over a decade, or anything like it.

This graph from Barclays Capital makes the point clearly:

The longer you hold a basket of shares, say, the more confident you can be of achieving the expected returns. ¹ Investing in shares is less risky over the long-term, than it is in the short-term.

This is why we’re advised to reduce (not eliminate!) the amount we have invested in the stock market – the riskiest asset over shorter periods – as we age, and to increase the proportion of less volatile assets like cash and bonds. We simply have less time ahead for the superior returns we expect to earn from shares (on average) to compound and outpace their year-to-year volatility, and so we can’t be confident of getting the return we’re banking on.

Note this doesn’t mean share prices, say, won’t keep going up after you sell a few. The stock market was doing its thing long before you arrived and it will trundle on long after you do. It’s a tool, not a competition.

It also doesn’t mean that my 70-year old mother and I can’t agree that, for example, the stock market looks good value whereas bonds seem expensive.

But it does mean the damage done if we’re both wrong is potentially far greater for her than it is for me, if she ignores the rules of thumb about asset allocation and holds the same proportion in equities as I do.

I have time on my side. She does not.

Don’t risk losing sight of your goals

I’ve had spirited discussions on Monevator with readers who were all-in cash, others all-in equities, one or two who were all-in emerging markets, and even one who was 100% in gold.

All the individuals concerned are articulate, personable-sounding folk that I enjoyed arguing the toss with. But obviously they can’t all be right, given that their positions contradict each other.

Luckily, being right or wrong is a risk you don’t have to take.

By all means favour some asset, sector, or geography if pure passive investing isn’t your game. But be very wary of betting the farm, especially if you’re closer to the end of your earning years than the beginning.

At some time or another, all asset classes and stock markets around the world have delivered unexpectedly terrible returns for years on end. You only live once, and I doubt you’re here to discover how it feels to be all-in on the next Japan.

By diversifying across assets and countries – and by not going entirely in or out of cash, bonds, equities, gold, property or anything else, even when you suspect you’re slightly reducing your returns by doing so – you can make sure that the all-in-a-sinkhole feeling is somebody else’s fate.

Howard Marks puts it very well in The Most Important Thing, his wonderful book on investing:

We may have an idea which one outcome is most likely to occur, but we also know there are many other possibilities, and those other outcomes may have a collective likelihood much higher than the one we consider most likely.

[Given this] we have to practice defensive investing, since many of the outcomes are likely to go against us.

It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favourable ones.

True, I guarantee that by diversifying you won’t win – not in the very narrowest sense of the word.

Some particular slice of some asset class or another will be the top performer over the next decade. If you’re diversified, you might well own a bit of it. But someone somewhere will own nothing else.

Putting up with the boasts of the reckless few who bet everything on black and won (or who claim they did) while remembering the silent losers who went all-in on the wrong horse is all part of the challenge.

But my idea of winning investment starts with avoiding losing, and with always remembering why I began investing in the first place.

1. You can never be entirely confident. Stock markets sometimes get nationalized. Governments default. Cash falls to hyper-inflation.[↩]

Good reads from around the Web.

Unlike most blogs, I don’t pay much attention to who linked to me in the past week when I choose what to put into Weekend Reading.

Instead the articles are mainly drawn from a stable of regulars, plus a few gems I come across on my travels.

And that’s good news for Rick Ferri, who I feature almost every week here, and who to the best of my knowledge has never linked once to Monevator.

Yes, it smarts a bit – not that he doesn’t link to my stuff, but that he hasn’t even patted the poor old Accumulator on the head.

Imagine! It’d be like David Beckham hollering “great pass” from the sidelines of your first born’s five-a-side football match!

Analysis paralysis analyzed

Mr Ferri writes such consistently excellent stuff that his position here is pretty secure. (Your need for quality reading is more important than my ego.)

Take his recent article on how some passive investors swap divining the future of individual companies for the equally elusive hunt for the perfect portfolio.

The result, he says, is “analysis paralysis”, where a would-be investor ends up sitting on his or her hands (or worse, spending their savings) when they should be getting on with investing and life.

Happily Ferri has a cure for analysis paralysis:

First, come up with a couple of portfolio choices that make sense, given your long-term goals.

Second, pick one.

It doesn’t matter which choice you pick because the probability of being right is the same for both. It’s not possible to know if a 70% U.S. stock and 30% in international stock portfolio will beat a 67% U.S. stock and 33% international stock portfolio. We do know the difference in returns will be negligible. So don’t become paralyzed over the decision.

What matters in successful portfolio management is deciding upon a sensible allocation based on your needs, filling those allocations with low-cost investments such as index funds and ETFs, and then staying the course through all market conditions.

I made a similar point the other week when I featured a post from the other titan of US passive investing, Larry Swedroe.

I wrote:

Be sceptical whenever you see anyone presenting ‘proof’ that you should put 2.33% in Spanish equities or 1.72% in the utility sector or anything like that.

This sort of fine tuning reveals that they’ve mined a database for specific and unrepeatable outcomes in the past. It tells you little about your future.

Instead, favour logic and simplicity over spurious accuracy.

Here’s another thing to consider. Besides the futility of seeking a ‘perfect’ asset allocation, you’re also wasting a lot of time and energy.

[continue reading…]

I don’t think the market is always efficient and – unlike my virtuous co-blogger here on Monevator – I invest some of my money accordingly.

Please note: I’m not suggesting you should try to beat the market at home. I don’t even think I should!

For most, the best results will come through passive index investing. The chances that you or I will follow in Warren Buffett’s footsteps are tiny, whether his returns are down to luck, skill, or cheap money from his insurance operations.

Some people are drawn to active investing for reasons other than greed and delusion, however. There’s intellectual stimulation, an interest in business, the sheer challenge, and an aversion to having fun in the evening.

So if you’re an incurable moth and the market looks like one giant candle, what’s the best way to get burned?

Why I like value investing

When it comes to the quixotic – and for the last time optional and ill-advised – goal of trying beat the market, I think value investing has the edge.

Most of my favourite investors were value investors, from Benjamin Graham and Warren Buffett to Sir John Templeton, Walter Schloss, and even The Motley Fool writer Stephen Bland.

They all backed their judgment that the market isn’t always efficient, and found that a value-based investing method was the best way to root out the truffles from beneath the wood and the trees.

I like value investing because it makes logical sense. Buy the unloved stuff that stinks, and sell it when it doesn’t. If you’re looking for profits in real-life that’s not a bad formula, so it seems a good place to start hunting for profits in the stock market, too.

I also like value investing because I’ve noticed most people can’t do it. Oh they talk about contrarianism and buying cheap, but most of their investments are in companies that have been doing well, and that look fully valued to me. Often in life you can get paid for doing something that others can’t or won’t do.

A final reason I like value investing is because even the high priests of the efficient market have anointed it as a market-beating strategy.

After all, they can hardly refute the data ¹, which consistently shows that over the long-term, stocks with value-based metrics (such as a low price-to-book value) have outperformed the wider market:

Source: Credit Suisse/London Business School

Of course, efficient market supporters don’t see value as a violation of the efficient market.

They typically either think that value investors are taking on more risk to get higher their rewards, or else they think that there was a genuine anomaly in the market due to ignorance, but now it is being whittled away by everybody knowing about it.

I’m not so sure. I’m more in the emerging camp of behavioural finance, which takes the notion of human beings as rational creatures, and puts them in a silly hat then plonks them on a photocopier to make duplicate asses of themselves at the Christmas party.

Metaphorically speaking, you understand.

People will always be foolish, greedy, scared, and more interested in jam today than Victoria sponge tomorrow. I therefore suspect that value anomalies will persist, too, although whether you or I will profit from them is another matter.

Small companies deliver bigger returns

It’s not only value that beats the wider market, as it happens.

A few famous growth investors have been successful. In the UK, Jim Slater found fame as a stock picker of small, fast-growing companies. Slater did have a value tilt though, in that his metrics centered on the PEG ratio he made famous, which aims to prevent an investor overpaying for growth. Some other growth investors all but dismiss valuation altogether.

Growth has a poor record when statisticians crunch the numbers, tending to underperform value shares over multi-year periods.

In focusing on smaller companies, though, Slater was on the side of another proven market-beating strategy:

Source: Credit Suisse/London Business School

Unlike with value, I can easily believe higher risk is the reason for the higher returns from smaller companies.

Very small companies – which are the ones that have delivered the highest returns – are illiquid and often difficult to trade, which adds to risk in the academic sense, and so to higher returns.

Higher yield, higher returns

In the UK Neil Woodford has soundly beaten the market by investing in dividend-paying stocks, as we never seem to keep hearing these days.

Few other income investors have Woodford’s record. But the performance of equity income investment trusts as a class has been very good compared to the market for as long I’ve been watching, suggesting to me there may be more at play than just a clutch of lucky managers and a fair investing climate for dividends.

Sure enough, professors at the London Business School report that high yielding shares have also beaten low yielding shares over long periods of time:

Source: Credit Suisse/London Business School

The success of high over low yield is to my mind value investing in another guise.

High yield occurs when a company’s price is depressed, perhaps because of uncertainty about its future or the unpopularity of the sector. Sometimes companies are punished just for paying dividends – it’s hard to believe now, but in the 1990s income was barely discussed by most investors and journalists, if not actively looked down upon.

Yet the cash flow suggested by a strong dividend usually indicates there’s at least some money-making going on at the company.

If things don’t turn out as bad as feared – so the dividend is not cut or worse – then high yield shares can keep on paying a high income, and you might see their share price rise in time. Both factors will boost returns.

The trend really is your friend

Hedge funds and others have been able to profit from all sorts of anomalies over the years.

The book More Money Than God offers an excellent history of a succession of hedge fund pioneers spotting inefficiencies and then exploiting them until others join the feast and the easy profits are gone. (The market might not be 100% efficient, but it’s definitely no mug!)

A common thread to many hedge funds’ success is momentum, in which they find and back trends they see in the market.

To over-simplify, momentum means that if prices are rising then they will tend to keep rising, and vice versa. Such trends should not exist according to efficient market theory. Prices should follow an unpredictable random walk.

One of the biggest investing upsets in the past couple of decades though was the discovery that momentum – long derided by both academics and value investors – does in fact exist.

I still feel queasy when someone shows me a rising price chart as the rationale for a share price going up some more. Yet at the market-wide level, the proof is in the data:

Source: Credit Suisse/London Business School

Of all these market-beating metrics, momentum is the biggest challenge to the efficient market hypothesis, in my humble opinion as a blogger as opposed to a Nobel prize-winning economist. It shouldn’t exist.

That said, I should stress for novice investors that there is an immense difference between the amateur stargazing that passes for momentum investing on bulletin boards, and the Phd-heavy supercomputing-powered high frequency stuff done by hedge funds.

Even hedge funds have been failing to match the simplest combination of equity and bond ETFs lately, so perhaps academics will have the last laugh (although hedge fund returns are also crippled by their enormous fees).

Can we exploit these market-beating strategies?

Let’s end by asking the obvious question: Could we use these stock picking methods to beat the market ourselves?

I can’t give you a definitive answer. What has worked in the past might not work in the future. I’m on-board with the idea that at least some anomalies will vanish, if they’ve not already, as the mostly-efficient market ferrets out the inconsistencies.

However I do think it’s not an entirely discreditable aim to try use these proven market beating methods to boost your returns.

One sensible approach might be to tilt your passive portfolio to try to capture some of the potential outperformance, rather going whole hog into one market-humiliating venture or another.

Even some of the passive investing gurus recommend as much, suggesting minor additional allocations towards specialist ETFs or tracker funds tilted towards small companies or those with higher yields.

But here’s a few things to consider before you get carried away.

Firstly, the academic research showing the outperformance I’ve cited looks at market wide data, and typically ignores costs.

We can’t forget about costs as private investors, and in the UK it’s hard to invest across the market based on these themes too, although some outfits such as The Munro Fund have tried to change that.

US investors enjoy access to a wider range of passive vehicles, including ETFs that seek to capture these extra gains. You might consider buying into one of these US-listed ETFs if you’re keen, but remember that introduces currency risk, withholding tax, and other complications.

Secondly – and in semi-contradiction to my earlier paean to value investors – just because some metric has previously worked across tranches of hundreds of shares, that doesn’t mean it’s a sure way to pick a handful of stocks.

• Buying a basket of 250 low price-to-book small cap shares and mechanically shuffling them year-on-year for an academic study is one thing.

• Buying four or five penny shares you fancy because they seem cheap is quite another thing, and likely an explosive and painful one in most hands.

Finally, academics typically crunch their data over very long timescales. You may well find that a measure such as low price-to-book value outs itself through extra returns over shorter periods – or that it does not – but in any event that’s not what I’m claiming here.

I’m just pointing out what academics have found has worked over periods of 60-100 years or so. But that’s beyond even my investing time horizon, however much I skip the booze and hit the gym!

1. This graph and those that follow comes from the London Business School researchers behind the Credit Suisse Global Returns Yearbook 2013, which is a treasure trove of interesting data.[↩]