I read Howard Marks’ recent memo [CLICK HERE] with great interest. It discusses the similarities and links between investing and gambling.
“How Is Investing Like Gambling?” (pages 7 & 8) particularly resonated. It strikes at the heart of a fundamental investment decision: Should we invest “actively” or “passively”?
We are resolutely in the “passive” or “index tracking” camp. We go further by ignoring geographies, sectors, currencies, etc. Taking a view on, for example, US vs Japan, commodities vs financials, hedged vs unhedged is active investing by the back door.
I expect our stance will persist; changing it would require the odds of success being outrageously stacked in your favour – a sure bet or a dead cert, so to speak. It’s difficult to imagine circumstances where that’s even a remote possibility – I’d have to be deluded to think that I could spot such an opportunity before anyone else.
The rest of this note explains why our position is perfectly sensible and very much to your benefit. At least I hope that’s what it explains, let me know if you think otherwise! Maybe I’m deluded already?
As Howard Marks makes clear, active investing means accepting (and dealing with) the following:
- Not knowing all the relevant facts as some information is hidden;
- Luck in the form of unpredictable events which affects investments;
- The skill needed to assess revenue and profit potential, where we are in the cycle, fairness of price, safety margin etc.
On the other hand, passive investing means:
- The hidden information doesn’t affect us as we’re not taking a view of Company A over Company B. We buy both, so it doesn’t matter what we don’t know about either of them;
- You own a bit of everything and so benefit from the average of all the good and bad luck;
- No skill is required – a computer simply keeps the investment in line with the index.
The point isn’t that active investing can’t and doesn’t produce better returns than passive investing – it can and it does.
Usually outlandish (index-beating) returns exist mostly in niche areas where markets aren’t efficient and angles that persist can be found and exploited. We wouldn’t touch those niches with a bargepole. That’s because we don’t and can’t understand them or their implied hidden risks.
That leaves us with the mainstream public equity markets. Here we are comfortable being a part-owner in the biggest, most successful companies around the world. Those companies make sense to us because, as a group, they are rational. Employed by them are millions of employees making billions of decisions with the single, selfish desire to remain employed and be able to house, feed, clothe and educate their families. Those decisions mean profits for their companies which are then shared with you as a part-owner of the business.
There are truly great mainstream investors, but only a handful consistently outperform the index. Each year many do better than the index but, for most, their success is fleeting – they were lucky, not skilful. Often that luck can persist for several years and that makes the truly great managers even harder to spot. We arrive at the logical conclusion: Our chances of finding a truly great manager that does consistently better than the very cheap index we could otherwise buy is very, very slim.
But, just for a moment, imagine we could identify a true great. How do we convince you to let them invest all your money? That’s the only rational thing to do, to invest it all, isn’t it? Why water down certain superior returns with a second, likely mediocre, manager? You either believe or you don’t.
It’s then easy to agree that we stick with this true great. We know they won’t get every decision right but on average they will get more right than wrong. And then you’ll do way better than the super cheap index fund you could otherwise have bought. But how much underperformance is acceptable? 6 months? 12? 24? 36?
You’ll be slipping further and further behind the returns the super cheap index fund would have produced for you. If it persists long enough, you’ll have to question your judgement and ours. At what point do you cut your losses and look for the next true great (whilst tacitly recognising you didn’t spot one this time)? Or is this the point you go passive?
We know for sure that most active managers don’t consistently outperform the market, yet they charge large fees for trying. As Howard Marks asks: “Why pay someone to play for you in a game where there’s no such thing as skill?”
Tricky, isn’t it? And a very large gamble indeed. That’s how investing can be like gambling.
The alternative is simply to be honest with ourselves, accept our limitations, buy the index trackers and put hidden information, luck or skill to one side. And avoid the angst that comes with it.
In so doing, we make investing not at all like gambling. But only if we stick to our guns.
Here are our further thoughts on investing:
https://www.townclosefp.co.uk/wp-content/uploads/2019/11/Investment-Strategy-230319.pdf
https://www.townclosefp.co.uk/wp-content/uploads/2019/11/Investment-Expectations-230319.pdf
https://www.townclosefp.co.uk/wp-content/uploads/2019/11/Investment-Risk-230319.pdf
https://www.townclosefp.co.uk/wp-content/uploads/2019/11/Investment-Diversification-230319.pdf
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