How should you invest?

“Investing is simple, but not easy”- Warren Buffett

A lot of ink has been spilled in discussing the best strategy for investing.  The debate includes fees, the types of investments and of course the returns generated.  At the end of the day, it’s pretty easy.  There are good points to some strategies and also good points to others.  What I’ve pressed towards is designed to be (a) low fee, (b) not high risk and (c) provide good returns.

Some old ideas revisited

In a 1973 paper, Jack Treynor and Fischer Black came up with a way to build portfolios.  In essence the theory is very simple.  The portfolio here is made up of two parts.  One part is a passive index and the other is an active portfolio that consists of stocks that are expected to generate alpha.  The idea is that while most stocks are efficiently priced, there are some that are not and once these are identified we can increase our returns.

The other idea is far more widely known, and has been popularized by Warren Buffett and Berkshire Hathaway.  This is the concept of value investing pioneered by Benjamin Graham.  There is no doubt that the track record of these individuals tells you everything that you need to know about the effectiveness of the method of investment selection.

So how have I combined these two systems?  I use the Treynor-Black model as the underlying idea to build portfolios, but the stocks I use to generate alpha are selected using theories of Benjamin Graham, Warren Buffett and Charlie Munger as opposed to a mathematical model.  It’s effective, measureable and sensible.

Why can’t you just buy the index?

Buying the index is effective for some reasons, and not for others. Pretend it’s January 1998 and the price of oil is $14.56 a barrel.  We know with the benefit of hindsight that this was a good price compared to the prices of today, and of course as compared to the highs in 2008.  The composition of the index changes through time, depending on the value of its constituents.  So in 1998 you had far less exposure to oil (in this example) than you did when we saw all-time highs in 2008.  When the prices hit those record highs in 2008, you held more than you did at that point. Because we have the full benefit of hindsight here, we know that these holdings were the exact opposite of what you would’ve wanted! So while there are some definite advantages to buying the index, it doesn’t solve all of the issues.

Why not just hold the alpha generating securities?

Clearly there are benefits to the passive index as well. Countless studies have shown that they are cheaper and provide more diversity than some other potential investments. I also find that a lot of clients simply aren’t comfortable in holding a few stocks entirely, and prefer to have much more diversity and the protection it adds for them.

So that’s it?

That’s it.  Just select your indexes from the thousands of Exchange Traded Funds and investment funds, and then add the securities from the thousands of potential investments and you’re good to go.  Make sure that this all falls within your risk tolerance and monitor it for the years to come.  Make changes as necessary and look out for those global risks.  Easy as pie.