Do As I Say, Not As I Do

Books discussed in this review:

• Unconventional Success: A Fundamental Approach to Personal Investment– David F. Swensen
• The Investment Answer– Daniel C. Goldie and Gordon S. Murray
• The Ivy Portfolio: How to Invest like the Top Endowments and Avoid Bear Markets– Mebane T. Faber and Eric W. Richardson
• How Doctors Think– Jerome Groopman, M.D.
• Better: A Surgeon's Notes on Performanceand Complications: A Surgeon's Notes on an Imperfect Science–Atul Gawande

I.

All analogies are imperfect, but to compare investment professionals to doctors is apt. In both cases, customers should consult a professional—self medication is perilous. Except there’s no Hippocratic Oath for investing pros, which means there’s a lot of voodoo advice out there.

If you have a minor ache, you pop an Advil, ask the pharmacist, or just consult WebMD. But if you need major surgery, you need a doctor—and you want the best. And not just the best, you need the best specialist. If you’ve got a brain tumor, you don’t want a cardiologist.

Also, doctors are wrong quite a lot! Even in medicine, situations are contextual and the body sometimes does things against expectations, and there are fewer ironclad rules than we’d like to believe. So the quality of the doctor matters—the best ones are sometimes wrong, but are generally less wrong than the bad ones. You listen to your doctor—even if you think he might be wrong or what he prescribes is counterintuitive. Why? Because you know your doctor has a better chance of being right than you do. Atul Gawande has recently become something of a guru in popular medicine writing. And I’m always delighted to read his books and compare what he does with what professional investors do. (It’s not always the same, of course, but a wonderful analogy nevertheless.)

It’s all the same thing with investments and planning your financial life. It’s absurd for the vast majority of folks to believe they can handle their investments on their own. You need to find a good professional to help you—someone who knows what they’re doing and isn’t just a salesman. If you need stocks, you need to find a stock specialist, and so on. And, yes, just like a great doctor, the reality is the more complex your circumstance and needs, the more that service will cost you. (This won’t be a review about how to pick the best adviser, but I can direct you on how to avoid the legit crooks: Read Ken Fisher’s How to Smell a Rat: The Five Signs of Financial Fraud.)

The landscape is littered with investment advice books of the self-medicating variety, particularly, those ultra mass-market guru tomes admonishing you to “revolutionize” or “make over” your money. This is sort of an over-the-counter style of investing—fine enough for some basic tips. But let’s face it, to plan your financial life you need more than an ultra-commercialized set of tautological (and often fairly condescending) tips, like being told to “save more.” Well, duh.

II.

But Dave Swensen’s Unconventional Success is no half-wit’s prescription. This is a fantastic book for intermediate investors (it’ll be a tad too jargony for total neophytes). There are things to quibble with (mostly tied to how he views asset allocation, more on that in a moment), but for the most part, I can scarcely point to a better book explaining the investment landscape; from pithy and elucidating descriptions of boring product types (deadening boring TIPS), to (mostly) practical views on market timing and rebalancing, to the ills of mutual funds and other misaligned incentives in the industry. Swensen calls his book “unconventional,” and it is, but most of his dictums are intuitive concepts to be found daily on MarketMinder’s editorial page.

And this is a guy you want to listen to. If you haven’t heard of Swensen, you’re probably not alone. He’s not one of the aforementioned gaga gurus. Though he’s got a few books to his name, he generally stays out of the spotlight. He’s run Yale’s Endowment (one of the largest in the world) for some years now and produced very good returns for them.

Unconventional Success is geared toward the average investor. But one of the things that becomes immediately clear is it takes a tremendous amount of time and intelligence to navigate the investing territory adequately. Swensen moves with acrobatic clarity and lucidity from topic to topic, but goodness gracious, there’s no chance a non-professional could do the same. So the lesson of this book, ironically, is to seek out a good investment doctor.

If you’re a true-to-goodness newbie to investments, read Goldie and Murray’s Investment Answer instead, which is effectively a distilled and often didactic version of Swensen’s views. Like Swensen, they stress a high degree of discipline and admonish readers to seek help of a fee-based adviser. Good advice, indeed.

It’s tough though to recommend Faber and Richardson’s Ivy Portfolio. It’s not a bad book per se, but you’re better served going straight to Swensen instead of experiencing a lesser version of him. The book’s virtue is it describes the endowment investing world, which is an interesting subject, but only for a narrow audience.

The supreme irony about all three books is they tell you (mostly) the right things to do...and then proceed to say you can’t do them. It’s “do as I say, not as I do,” because you, as an average retail investor, can’t reasonably do the things Swensen does. This isn’t just a matter of skill—endowments are just different than you. They have no end date, which means they can lock their capital up in stuff like buyout and private equity funds and real estate for decades without worrying much about liquidity.

Regular folks can’t do that. Liquidity is the unsung hero of equity capital markets—we should marvel at the high expected return they provide in addition to lightning-fast liquidation. Most folks need to be able to sell their assets, or at least parts of them, on a fairly regular basis—and it’s still better if you more or less get the actual price that’s quoted to you and quickly. For that, you need stocks, bonds, or cash.

III.

But regarding these books, there’s another rub that if not treated preventatively can turn into a rash: Asset allocation.

Swensen’s Yale and other endowments (for the reasons listed above) can invest in non-liquid assets with a higher expected return than stocks because, again, they run no-time-horizon endowments. So for them, diversification into those things can actually smooth their returns over time—and potentially even raise their expected return. Gonzo!

But for regular folks, again, this can’t work. Forget the fact most folks already have most of their net worth in residential real estate (and we’re seeing just how illiquid that can be right now!). If liquidity is a virtue, then you can’t buy tons of those non-liquid things. And of the available highly liquid categories (stocks/bonds/cash), stocks are by far and away superior—they have a higher expected return (and thus are also more volatile).

This is all to say that Modern Portfolio Theory, genius as it is, has been contorted and perverted by the industry in many ways over the years. Among the liquid asset classes, anything other than stocks by definition lowers expected return because bonds and cash won’t return as much over time with the exception of very rare periods. You might be smoothing out returns by diversifying, but you’re also lowering what you can potentially get in return. Period.

Diversification was originally intended to be a way to maximize expected return within an asset class—not the mixing of them; different rules apply when you do that. One of the many conceits sold to most investors is that because of behavioral errors humans are prone to, you should diversify away from, say, stocks, because you’re still a chimp at heart, and you’ll panic and sell at the lows and buy at the highs. So you need something to smooth it out—you’ve got a low pain threshold for all the ups and downs of stocks.

I don’t believe this is good medicine. It’s a case of the tail wagging the dog. A good doctor (portfolio manager) understands these lessons—these basic disciplines of investing—and earns his pay by not making those classic behavioral mistakes. In fact, the express purpose in my view of a great money manager is to make fewer mistakes over the long run than you would. Investing’s ultimately a discipline. That concept alone can create more wealth for folks than any genius stock pick.

It’s unconventional to say as much, but you do NOT have to allow your human-error prone nature to dictate a lower expected return for yourself. Instead, what you need to do is find the right manager. Granted, this is also tough to do, but they exist. Swensen, et. al., admit as much: Active, effective portfolio strategy can be done by excellent professionals, but most professionals and non-professionals will fail.

Don’t try the surgery yourself; find the right doctor.