Simple or Complex Investments?

“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” – Paul Samuelson

Wall Street has made plenty of money over the years pushing complex investment strategies with high fees on their unsuspecting clients. Most of these investments fail to beat simple index funds but that doesn’t stop them from selling them or investors from buying them with hopes of market-beating performance that they can brag to their friends about.

A Yahoo! Finance article a few weeks ago caught my attention when they interviewed an author on his new book about alternative investments. Alternative investments include real estate, private equity, hedge funds, commodities and basically investments other than simple stock and bonds portfolios.

The author made some pretty interesting claims in the article. He discusses the Yale University Endowment Fund and states that even in the difficult investment environment we have seen recently Yale still managed to gain 100% over the past decade.

Yale is famous for investing a large portion of their portfolio in alternative investments and keeping small amounts in traditional asset classes such as stocks and bonds. They have been very successful over time with this investment process.

He also says that the reason alternative strategies work for the likes of Harvard and Yale is because they help them avoid losses while also making money (what he fails to mention is that these institutions have specialists on staff that are experts in these types of investments and they are not suitable or available to the majority of investors).

He then recommends that investors should diversify through complex investments like business development companies (BDCs) and royalty trusts (mineral and mining properties) which can be complex to understand. BDCs are publicly traded funds that invest like private equity and royalty trusts pay out dividends from commodities and land that they own.

The author goes on to tell us that individual investors are at a disadvantage to large institutions with our portfolios. He goes on to show that a basic 60/40 portfolio of stocks and bonds is a bad investment approach because of the risk of a big blow-up.

SIMPLE OR COMPLEX?
Since I preach a common sense form of investing I thought I would look into his claims and see what the numbers really tell us.

Yale’s 100% 10 year performance would result in an annual return of 7.18%. And the author is right about the fact that this was a pretty decent return considering the turmoil we have seen in the financial markets over the last decade.

But his assertion that a 60/40 portfolio of stocks and bonds doesn’t work for investors doesn’t seem to hold up. In fact, a simple 60/40 portfolio of stocks and bonds would have done much better than the 100% return that Yale delivered over the past decade.

Here are the returns for different sized stock markets and the diversified bond market index through the end of March:

As you can see, a simple 60/40 portfolio made up of stocks and bonds (with an equal weight between the large, mid and small-cap stocks) would have been up 141.08% in total for the last decade.  That’s 9.20% per year, actually about 2% higher than the returns he lists for Yale.

APPLES TO ORANGES
Now I am not trying to suggest that a 60/40 portfolio will always beat the returns of large institutional investors. That has not always been the case, especially with the large historical returns that Yale has produced over the years.  It’s just not an accurate comparison.

Institutional investor have more resources, experience and time to devote to the financial markets than individual investors do.  Also, Yale and similar investment funds have much different goals than you or I do.  Therefore it makes no sense to try to invest like them because they have a completely different risk profile than individual investors.

What I am trying to show you is that you shouldn’t always take every piece of investment advice you read at face value. Do your homework before making investment decisions and make sure you look for opposing viewpoints from your own so you don’t suffer from confirmation bias.

Complex investments can work. But the majority of the time they are not a good option for individual investors, especially when there are easy to understand, low-cost options available.

The great thing about simple investment solutions is that you know what you are getting yourself into before you invest. That takes away the risk of being completely blindsided by the risk of unknown features of an investment (a trademark of complex investments).

These unknowns usually include hidden fees or illiquidity when you actually need the money the most. It’s also possible that they just don’t perform how they were presented to you in the sales pitch.

Mark Dow recently summed this up nicely on Twitter:

“Simplicity manages money. Complexity is used for raising it.”

With the amount of unknowns in financial markets, future returns and economic performance it makes sense to stick with simplicity to keep you sane.

That way you won’t abandon your investment plan at the first sign of trouble in the markets.

Interestingly enough, David Swensen, the chief investment officer at Yale, agrees with me on this topic.  He also thinks that individual investors should stick to simple investment strategies rather than try to invest on his level:

“What should be done? First, individual investors should take control of their financial destinies, educate themselves, avoid sales pitches and invest in a well-diversified portfolio of low-cost index funds, like those offered by Vanguard, which operates on a not-for-profit basis. (Even Morningstar concludes, in a remarkably frank study, that low costs do a better job of predicting superior performance than do the firm’s own five-star ratings.) Such a strategy reduces the fees paid to the parasitic mutual fund industry, leaving more money in the hands of the investing public.”

It’s hard to argue with that.

Sources:
Yahoo! Finance
The Mutual Fund Merry-Go-Round

Here’s the good stuff I’ve been reading this week:

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