“An investment in knowledge pays the best interest.” – Benjamin Franklin
The average American spends 8.8 hours a day at work for most of their life, but spends very little time in comparison taking care of their lifetime earnings. They could learn how to invest their own money in productive assets, but instead outsource the decision making process to expensive money managers. The extra expense each year adds up and can be the difference between reaching retirement goals and working a few years.
Americans invest with money managers because when mutual funds were first invented, they offered an easy way to invest money in a diversified portfolio. Information was hard to find and trading costs at brokerage firms was very expensive. Early startup mutual fund managers with skin in the game invested their portfolios the same way they would manage their own money. However, over time, things changed.
Asset managers have become giant corporate behemoths. Many managers don’t even invest in their own funds, but are happy to gather assets and collect fees. At the same time, commissions at discount brokerages have gone down and information has become readily available on the internet. It is now possible to build a diversified portfolio that is cost-effective.
Many Americans understand the importance of getting a good return on their investments so that they can reach their retirement goals. They have seen and heard the different ways to invest money pitched by their financial planners and brokers, but with so much information out there, it’s really hard to know what is right for them. The confusion only benefits the companies that manage money with all these different investment products.
So here’s an idea, let’s separate the signal from the noise and take back control of our own financial future. Let’s end this nonsense and take a look at the different ways to invest money in stocks and make our own informed choice.
The Index Fund
When it comes to avoiding fees, index funds are at the top of the list with expense ratios as low as 0.03%. The costs are low because the index funds are passively managed by tracking a list of stocks and unlike most actively managed funds, a team of stock analysts isn’t required to run the fund. The low turnover in a passively managed fund also keeps taxes to a minimum. Over a period of 30 years, the fees have a significant impact. For example, a $10,000 investment that compounds at 10% over 30 years will return $174,494. Even a small fee causes a big difference with the end result.
Although index funds weren’t available for people to invest in until the 1970’s, there is data that shows the S&P 500 index compounded at around 10% a year from the early 1900’s.
Besides low fees, there are also other advantages to index funds. Index funds are diversified across hundreds, if not thousands, of different companies and reduce the impact that a single company failure will have on the entire portfolio. By definition, index funds also prevent style drift and a change in strategy at inopportune times. For example, the S&P 500 index is made of the largest US companies and will almost always be a mix of large cap value and growth stocks. The rules for constructing the index rarely change.
The advantages of indexing have allowed index funds to beat many actively managed funds. This is also partly because many actively managed funds invest in the same type of stocks as index funds and become closet indexers. With the same investments, but higher fees, there is no way for a closet indexer to beat the market.
However, there may still be a place for active funds that use different strategies to invest money in stocks. Index funds tend to do well against actively managed funds when the markets are on the rise, but lag during a downturn. With the increasing popularity of index funds, many actively managed funds are forced to pursue alternative active strategies instead of closet indexing to stay in business. This could be a benefit to investors as competition in active investing brings fees down and make alternative strategies accessible to the average investor.
The Value Investor
Value investing is one of the oldest strategies for investing based on fundamentals. The framework was established by Benjamin Graham and David Dodd in their book, “Security Analysis”, published in 1934. The book stresses the importance of buying stocks below their intrinsic value in order to have a margin of safety. Although the book is outdated with their examples, the concepts are timeless and many professional investment managers use a value investing strategy.
Stocks in a value fund are usually mature businesses that trade at a lower multiple than their peers and tend to have a higher dividend yield. Many of the stocks are in industries that are out of favor and some of the companies are also facing company specific challenges. These are usually companies that people read about in the news and wonder why anyone would invest in them. But, the value investor buys the stock because they believe that the market was too quick to dismiss the company. When the market realizes its mistake, the share price will increase.
The value investing strategy has been used successfully by several fund managers such as Warren Buffett, who compounded his early hedge fund partnership’s money by 29.5% from 1957 to 1969. This is in comparison to a 7.4% compounded annual growth rate for the Dow Jones Index during the same time period. Warren Buffett’s results, highlighted in a speech at Columbia University, also includes other value investors and their impressive returns.
Although the results from the “Superinvestors of Graham-and-Doddsville” are astonishing compared to what any passively managed index fund can hope to achieve, more recent results from 1995 to 2015 tell a different story. The S&P 500 index compounded at 9.29% while large cap value funds compounded at 9.03%. What gives? Isn’t value supposed to outperform?
There might be several reasons for the underperformance of value investing in the recent years. No strategy consistently outperforms all the time. Value might just be out of favor right now and will come back later. The funds might have a small percentage of their portfolio in cash that is not invested and drags down results. Most fund managers aren’t a super investor like Warren Buffett. It takes a lot of hard work and discipline to develop an edge that beats the market over a long period of time and not everyone is cut out for it.
The Growth Investor
Growth investing is a strategy focused on capital appreciation from fast earnings growth. Unlike value stocks, growth stocks tend to have seemingly high valuations with most of their earnings reinvested into the business for the future. Many growth stocks have a long runway ahead of them and have disruptive business models.
The strategy is popular today due to fund managers like Thomas Rowe Price, Philip Fisher, Gerald Tsai, and Peter Lynch. The latter, wrote the bestseller, “One Up on Wall Street” and compounded the Magellan Fund by 29.2% from 1977 to 1990.
What should be noted is that rapid growth does not last forever. As a business matures, growth slows, and the company may eventually become a value stock. For example, Microsoft reported earnings of $0.21 per share (adjusted with 16 for 1 stock split) in 1996. With a share price around $7.50, the P/E ratio for Microsoft was about 35 — clearly in growth stock territory. A little more than a decade later in 2010, Microsoft reported earnings of $2.10 per share. With a price around $25, Microsoft became a value stock with a P/E ratio slightly below 12.
Although some studies have shown that growth stocks underperform value stocks over long periods of time, the outperformance isn’t consistent and there are long stretches of time when growth investing outperforms value investing. Investing some money in a growth stock like Google might be a good way to get a free option on future developments in technology that can potentially disrupt other value stocks in a portfolio.
The Long / Short Investor
Many long / short investors are hedge funds that try to perform well in both bull markets and bear markets. The long side of the portfolio buys stocks that are expected to go up and can come in the form of value stocks, growth stocks, or a combination of both. The short side of the portfolio picks stocks that are expected to go down. Many of the stocks in the short side of the portfolio have high valuations, face challenging business environments, or engaged in behavior that might be fraudulent.
The ideal scenario for a long / short hedge fund is for the long positions to gain in value and for the shorts to decline, but this doesn’t happen all the time. During bull markets, most stocks go up including the ones in the short side of the portfolio. When this happens, the long positions make money and the short positions lose money. The opposite is also true for bear markets, where most stocks in the portfolio go down and the long positions lose money, but the short positions make money. Hopefully, one side makes more money than the other side loses.
The long and short exposure for hedge funds are not always equal. Many hedge funds have a bias towards the long side and are long 130% and short 30%, while a few other hedge funds focus on the short side.
Performance results of long / short hedge funds are harder to come by than mutual fund data since most of them are private partnerships. However, there is some data that show hedge funds used to perform well, but now face declining returns. Rolling 10 year returns have declined from almost 25% in 2000 to less than 3% today for long / short hedge funds.
Whether long / short hedge funds are in a temporary slump or permanent decline, hedge fund strategies might be interesting to look at for investors to reduce volatility in their portfolios. However, hedge fund strategies are not a necessity and most investors can do well without the added fees and complexity.
The Event Driven Investor
Stocks often move up or down based on new information. This can come in the form of new product launches, corporate restructurings, or legal and regulatory changes. Since there are many different types of events that can cause a change in stock price, event driven investors form a diverse group and the only similarity is that the investments have a catalyst for change. Some event driven funds focus on clearly defined opportunities such as merger arbitrage whereas others have events with outcomes that are more ambiguous.
The event driven investments are often short term in nature and evaluating an event driven investment requires expertise to assess the probabilities of certain events from playing out. This is a field where deep industry knowledge can become an edge. A lawyer or policy maker might have a better grasp at what happens to a company that relies heavily on the government for profits. Alternatively, a doctor might have a better idea if a new drug will get approved or adopted by the healthcare system. The point is, a lot of very smart people look at event driven investments and it is very difficult to find an opportunity in this market where the odds are mispriced. Investors looking to diversify and include a market-neutral event driven strategy to reduce volatility need to really dig deep and perform their due diligence.
Which of the ways to invest money in stocks should you choose?
“The stock market is filled with individuals who know the price of everything, but the value of nothing.” – Phillip Fisher
As you can see, there are many different ways to invest money in stocks and there is a fund for almost anything out there. Gold funds, art funds, stock funds, the list goes on. Investors are bombarded with so many options to invest their money for a simple reason — the companies that manage the funds make a lot of profit from gathering assets to invest. Despite the underperformance of many funds, investors continue to entrust their money to fund managers.
There is a better option. Investors can either invest in an index fund and get the market return or learn how to invest in stocks themselves. Beginner investors should stick with a tried and true strategy such as value investing or growth investing and stay away from alternative hedge fund strategies. Invest for the long run and consider building a forever portfolio. Finally, stop trying to pick a winning fund manager. An investor without the ability to pick a good stock isn’t going to have the ability to recognize a future super investor.