There are hundreds, if not thousands, of mistakes that investors make on a consistent basis. We don’t all make the same mistakes, but there is no question that we all – even the best of us – make mistakes. With that acknowledgment, the biggest mistake we want to be aware of, and hopefully avoid, is to not know why we are investing. Or said another way, not having clearly defined goals for our investment outcomes. This one mistake can lead to a myriad of other mistakes as we reach for yield, take on too much risk (or not enough risk), or structure an investment portfolio that will not accomplish the goals we have for that portfolio.
The purpose of this Insight is not to discuss the various mistakes that investors make, but rather to focus on the components that comprise our investment returns (or losses). The importance of understanding and avoiding the most common mistake of not having clearly defined goals pertains directly to the components of investment returns, and therefore needs to be mentioned to provide the appropriate context for the remainder of this discussion. We all need to know what we are trying to achieve with our investment decisions!!!!
In investing lingo, alpha is defined as investment returns generated above market expectations based on an equivalent amount of risk, with risk being defined as price volatility (a ridiculous – but market standard – definition of risk in my opinion). For example, the S&P 500 index is a compilation of the stocks of the 500 (+/-) largest companies in the USA. The prices of those stocks individually vary on a day-to-day basis, some vary a little, some vary more. Those price changes are compiled to determine the volatility of the entire index. A fund manager using the S&P 500 as their comparative index will then compile a group of securities that have a combined similar volatility. If the combined returns of that portfolio perform better than the S&P 500, then that manager has created, and can document, alpha.
Beta is the amount of risk, again defined by volatility, associated with any investment or portfolio. It is measured on a scale where 1 is equivalent volatility to the broader market. Higher beta investments such as Nvidia (beta = 1.75), have considerably more volatility than a lower beta investment such as British Petroleum (beta = .66). By adding beta to the calculation of alpha, return expectations can be calculated across a wide universe of traded securities. Alpha and Beta measurements are far more difficult for non-traded securities, which represent a huge universe of investments that can’t easily be defined in terms of risk. But just because risk can’t be easily measured in non-traded securities doesn’t mean it doesn’t exist… Taking on more beta (risk) should result in higher returns when taken across a broad swath of investment. Once we understand our investing goals (whether in terms of hard numbers, purchasing power, or quality of life), we then need to understand the risks of the investments we are evaluating.
Investing goals, and the returns needed to achieve these goals, aren’t solely based on the expected investment outcomes. In a perfect world, and if we were 100% non-emotional, only the outcomes would matter. But the truth is we are all influenced in varying degrees by our emotions, events outside our control, and several other external influences (spouses/partners/children fears/preferences/etc). Additionally, most of us also have investments that we prefer, or prefer to avoid for ethical reasons. I wouldn’t invest in Philip Morris or Facebook because I don’t support their products. Other people may avoid Uber because they want to support taxi drivers, or avoid Apple because it uses labor in China, or…any number of other causes we oppose. And guess what? It is our money, so that is entirely legitimate. Investing isn’t just about outcomes, but also about how it makes us feel. Or in the case of many investors, how it doesn’t make them feel. Many investors don’t want to be stressed about their investments.
That is an overly long introduction to the question: what does it take to reach our investment goals? The following are important factors:
- Time invested: This is the runaway winner, no contest. Supposedly, Albert Einstein called compound interest the 8th wonder of the world. Compounding, by mathematical definition, requires time to pass. The more time that passes, the more compounding that can occur. Warren Buffet has achieved average returns of 20% a year. That is incredibly impressive. But more impressive is he has done it for almost 60 years. In rough numbers he has been able to turn each dollar invested into $27,000. But what if he had stopped after 40 years? It still would have been a long and incredibly successful career. But each dollar invested would have been worth less than $1500, a massive 95% reduction in ending wealth for only a 33% reduction in investment time horizon. We can’t all be Warren Buffet, but we all do have the ability to buy index funds. Sixty years of S&P returns increases $1 to $340 while only growing to $50 over the shorter 40-year time horizon. Sadly, many people don’t have, nor have ever intended to have, even forty-year investment horizons (let alone 60 years). Forty years is as long as most people’s entire careers. The takeaway here is this: To reach your financial goals there is nothing as important – nothing! – as getting invested now.
- Consistency: If the amount of time invested is exhibit 1a, then consistency in investing is 1b in terms of importance. Consistency can mean a lot of different things, and all of them are important. Warren Buffett stayed consistent by staying invested. He stayed consistent by not being caught up in euphorias. He stayed consistent by not changing his spending habits in line with his growing wealth (which would have required him to dip into his wealth). There is a preponderance of evidence that we, as fallible humans, tend to buy and sell at the worst times, so I think the most important consistency that most of us can have is to simply stay invested. A second important consistency is to continue to add to our investment position each month/quarter/year/etc., at whatever predefined calculated amount we committed to invest. A third consistency, which is far more difficult, is to have a defined set of investing rules and stick to those rules – which may also include not making new investments while growing our cash bucket for investment – regardless of what is going on around us. Buffett excelled at this, which has allowed him to score huge wins when others wouldn’t, or couldn’t, make the same investments.
- Increased beta: As referenced above, increasing beta is effectively increasing the risk in our investments. The same can be true for an entire investment portfolio. If risk equals higher expected reward (definitely not always the case, but in broad strokes), then being willing to take on higher risk positions should over time increase total investment returns…but obtained in and around some losses and volatility. For most people this means extra stress. Are we willing to take on the extra stress?
- Finding Alpha. There are multiple different factors in finding alpha, which include:
- Luck: We can’t be intellectually honest without acknowledging luck in some of our investment outcomes. If nothing else we (or at least most of us) have been lucky enough to live in western economies, which have relatively structured investment markets with relatively dependable regulation, all of which makes investing much easier. Every investment carries some sort of luck – good or bad. We (Altus) try to review and learn from each investment position when it is closed out. We have made good investments that have had below par outcomes because of things completely out of our control (bad luck). We have made investments that weren’t great initially, but ended up having amazing returns because of something we didn’t anticipate. And of course, there were good investments with strong returns and not as great as investments that didn’t have great returns. However, unless one is uber lucky, luck will revert and normalize. Over time, good decisions will normalize to good returns and bad decisions will normalize to bad returns. Luck may create alpha, but it is certainly not dependable. Luck is not a strategy!
- Entrepreneurial Profit is defined as compensation for work done and value created. There is effort that goes into investing. Great investors often put in a lot more effort. When it comes to creating alpha, there is likely nothing more dependable than capturing entrepreneurial profit. How it is captured comes in many different forms:
- Expertise: Nothing reduces risk like expertise. This is especially true in niche opportunities that many will discount because they don’t understand them. Even things like low leverage private debt, that we view as simple and on the far low end of the risk spectrum, is viewed by many as super high risk because they don’t understand it. That is great news for those of us that do. Reduced competition means increased compensation (risk adjusted returns). A great example of expertise is airplane financing. I understand how to value the collateral and how to handle the transaction, but I don’t really understand how to perfect the collateral in the case of a default. There are those that are experts in that field that do know how to collect on the collateral; and they are compensated generously for their expertise. In comparison, our private real estate debt returns don’t hold a candle to airplane financing returns. To me, airplane financing is riskier. For those that know that business, and maybe don’t understand real estate debt as well, it is less risky, and with far higher returns. They are getting paid for their niche expertise.
- Effort: It is a lot of work to be an activist investor. It is a lot of work to figure out complicated real estate opportunities. It is a lot of work to be a Hindenburg Researcher that goes through hundreds of companies to find the one or two each year that are mispresenting their financials. Hard work applied appropriately can pay off in the form of alpha. More intense, and far more difficult than the hard work of pounding the streets are the steps we take around self-improvement and self-awareness. . What don’t we see? What inherent biases are creating blind spots? What emotional triggers cause us to make bad/rash/etc. decisions? Blisters on my hands from working hard with a shovel all day might be a little painful, but my pride being damaged through honest self-assessment can be much more so. The great thing about hard work and its ability to create alpha, is that so few people are willing to do it. Those that are willing, especially for the truly hard work, will nearly always win over time.
- Wisdom: Knowledge (i.e. expertise) is hugely valuable. Wisdom is more so. Wisdom takes knowledge, steps back a couple steps to look at the broader picture, and then applies knowledge for the greatest benefit. Unfortunately, most wisdom comes from mistakes, and lots of wisdom often means lots of mistakes. Lots of mistakes means staying in the game, a combination of the consistency and time bullet points mentioned above.
- Horse and Jockey: There is a sweet spot in the overlap of expertise, effort, and wisdom where more passive investors can create their own entrepreneurial profit by taking advantage of the entrepreneurial profit of others. Passive investors that excel at picking winners – the cross section between opportunity and those that can execute – can consistently outperform those that don’t. There are passive investors I know that don’t have confidence in their ability to pick winners consistently, so instead they spread around lots and lots of smaller bets. This is a great self-awareness and leads them to be able to take advantage of niche opportunities without acquiring the expertise themselves, thereby outperforming the broader market. But those that pick the winners vastly outperform the shotgun approach as they avoid much of the underperformance that comes with the losers inherent with the shotgun approach. It takes an investment of time and effort to learn how to pick winners. It takes more time to put that knowledge into action. This is not a strength of mine yet, and at this point I don’t need it to be because of Altus’s active involvement in the investment arenas where I want my investment focused. But someday, however far in the future, I won’t be as active at the ground level, and building a strength around choosing the right horse and jockey is what will determine the rate at which my investment portfolio continues to grow.
If you don’t have clearly defined life goals, please get them in place. As in yesterday. Don’t let a lack of certainty around what you want in the future keep you from defining something. There is nothing that says you can’t change it later. Once those goals are in place, quantify them into dollars of income that will be required to live those life goals, and then into a total investment base. Don’t forget about inflation. Sure, it is an option to spend the investment principal, and that is what wealth advisors normally include in their calculation, but do you really want to be staring at your balance sheet and seeing a diminishing net equity number each month? Plus, if you spend everything you have invested and grown, there is nothing left to leave for your family or your favorite cause.
Once you have a quantifiable goal, the next step is figuring out how you will get there. For some, Time is on your side. For others, not so much. Regardless, please don’t depend on Luck.
About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at firstname.lastname@example.org.