

Picking Investments: Only Two Things Matter - jonxu
http://blog.futureadvisor.com/picking-investments-only-two-things-matter

======
patio11
2b) Tax consequences matter. Take advantage of options to reduce them, for
example by fully funding your IRA. Particularly for the young kids here, you
should be maxing your IRA every year if you're debt free. (And you should not,
not, not tap it when you change jobs, want to fund a startup or wedding, etc.)

~~~
ct
Respectfully disagree about not dipping into your IRA to fund a startup if
you're driven to succeed and raising capital otherwise falls through. Just
make sure it's for the right idea and it'll pay multiples over the crappy
returns the S&P has over the past 10 years (which is almost nothing).

~~~
ahi
Everyone thinks they have "the right idea and it'll pay multiples over the
crappy returns the S&P has over the past 10 years."

~~~
m4wk3r
on the other hand, most people are idiots.

~~~
aerique
Which is why they should listen to patio11 (and won't).

~~~
m4wk3r
sure, that's valid. it's also valid to acknowledge that their exists within
that group a sub-group of people (albeit small) who DO actually have "the
right idea" that WILL actually "pay multiples over the crappy returns the S&P
has over the past 10 years", but DOES require going "all in" to achieve.

------
yannickt
Asset allocation matters. Investors who took the time to develop a plan,
figure out an asset allocation that matches their risk tolerance, and actually
rebalanced periodically to adjust their portfolio back to their allocation
target, probably did just fine during the so-called lost decade.

Tax efficiency matters. A badly designed portfolio may lose 1% a year to
taxes. Tax-inefficient investments should be held in tax-advantaged accounts
(e.g. tax-free or tax-deferred accounts).

And it matters that you have the discipline to stick to your plan through all
market conditions.

~~~
fexl
Harry Browne demonstrates the effectiveness of asset allocation and periodic
balancing in his book "Why the Best-Laid Investment Plans Usually Go Wrong".
It's an old book from 1987, but the principle is timeless.

For example, I'm looking at a chart of his "Permanent Portfolio" from 1970
through 1987, which weights four asset classes equally at 25% each: gold,
stocks, bonds, and cash. The portfolio has far lower volatility and far lower
draw-downs than gold, stocks, or bonds alone. The portfolio also outperforms
stocks or bonds alone. It does not outperform gold over this 17 year period,
but by 1987 it comes close. It probably overtakes gold alone in subsequent
years, since gold vastly underperformed the stock market from 1987 to 2001.

One good aspect of asset allocation is that it keeps on the opposite side of
manic up or down trends. This strategy would have you selling gold at $800 in
1980, and buying gold at $250 in 2001. Gold has vastly outperformed the stock
market since then.

Similarly, this strategy would have you buying stocks in 1974, when many
people thought equities were "dead" and only fools were in the stock market.

You might think these references are a little dated, but again the principle
is timeless. Anyone who says "it's different this time" is probably wrong.

~~~
hugh3
One obvious asset class that's missing from that allocation is real estate,
which (if you bought in a sensible area) has probably easily outperformed all
of those since 1974 with the possible exception of gold.

~~~
fexl
He discusses real estate in a separate chapter, but what he says is
interesting:

"Real estate isn't an essential investment for a Permanent Portfolio. Real
estate offers no profit or protection to a portfolio that can't be achieved
more easily with stocks and gold."

He then accepts the reality that many readers have invested or wish to invest
in real estate, and goes on to talk about it at length.

Clearly real estate can produce high income and gains for those who have the
capital to buy property and the time and money to manage it, but I do see his
point.

------
kia
Here is a recent thread about index funds

<http://news.ycombinator.com/item?id=1949158>

tl;dr Before IPO Google made several seminars so it's employees can get
investment advice on how to invest their future millions. The advice was to
invest in index funds.

------
Tichy
Who creates the indices, though? And if everybody would act like that, the
system would fail, because nobody would trade stock anymore.

~~~
rsepassi
Tichy is exactly right, and this point on its own makes passive investing
extremely dangerous (though I tend to agree that on average, putting your
money with an active money manager is even more dangerous). The indices are
rather arbitrary and set by institutions whose incentives have nothing to do
with investor returns. The securities included in the indices are in no way
selected for expected performance, and it's been well-documented that simply
being included in the index artificially inflates a company's stock price
(just as getting booted out artificially depresses a company's stock price),
mostly because so many people have shifted to blind passive investing that
there's just a bunch of forced selling and buying instead of thoughtful
analysis of business values.

Though Warren Buffett has indeed recommended index funds to individual
investors, he has repeatedly argued that the fundamental premise of index
investing (that is, EMH, the efficient market hypothesis) is fatally flawed
and that index investing is basically a stupid thing to do: "Naturally, the
disservice done to students and gullible investment professionals who have
swallowed EMT [efficient market theory] has been an extraordinary service to
us and other followers of Graham. In any sort of a contest -- financial,
mental, or physical -- it's an enormous advantage to have opponents who have
been taught that it's useless to even try. From a selfish point of view,
Grahamites should probably endow chairs to ensure the perpetual teaching of
EMT." Buffett basically says that if you don't have time to dig into stocks,
then index funds are the way to go - though they're still a terrible way to
go. I disagree. When you look at the academic literature as well as Buffett's
own philosophy (which draws heavily on the work of Benjamin Graham and David
Dodd), investing based on value works over time and handily beats the broad
indices. That is, if an investor buys what is undervalued, they will
outperform the market. Now, to truly understand if a security is undervalued
requires an enormous amount of knowledge and analysis, but it's been shown
that even rough proxies for undervaluation (i.e. simplistic statistical
screens such as price/earnings or price/book) work, and work well.

Joel Greenblatt, another very successful and highly respected investor (who
subscribes to the same investment philosophy known as "Value Investing" that
Buffett follows and Graham birthed), also disagreed with Buffett and he
proposed a system that does in fact recommend buying undervalued securities as
determined by statistical screens. Here's his site below:
<http://www.magicformulainvesting.com/welcome.html>

If you buy the index when the market is overvalued, you'll end up doing very,
very poorly. This is not about market timing; this is about valuation. You
could use a simple P/E or a Schiller P/E (<http://www.multpl.com/>) to
understand where the market stands on a valuation basis. This is the sort of
analysis that Jeremy Grantham, another very successful value investor, does
when he determines asset allocation and security selection
(<http://www.gmo.com/America/>). If a certain asset class is overvalued, then
why would you put the same amount of money into it? You want to put more money
into the asset classes that are undervalued. Asset allocation should not be a
static allocation; it should vary based one very important factor - value.

~~~
cloudkj
I think you're taking quite an extreme interpretation of Graham's/Buffet's
thoughts on index investing. It's a given that, with index investing, your
returns will match the market. Index investing isn't aimed at getting higher
returns. Rather, Graham actually spends more time discussing and
differentiating between different classes of investors.

For the "enterprising investor", s/he can afford to spend more time to find
undervalued stocks and possibly outperform the market. For the "passive
investor", to paraphrase Graham, it is good enough to simply invest in a
representative set of securities, such as an index.

In fact, if I remember my Intelligent Investor correctly, there are various
passages where Graham actually admits to the EMH being somewhat inevitable.
Note that there are different variants/degrees of the EMH, and Graham probably
subscribes to the weak or semi-strong versions.

Nonetheless, the point is that a belief in the EMH is not mutually exclusive
with value investing. It depends a little on the extent to which you believe
the market is efficient, and a lot on how much work you're willing to put into
it.

~~~
rsepassi
I did not intend to portray extreme views, and I believe that I've represented
their views fairly. Buffett recommends index investing, but also believes that
it provides great opportunity for the enterprising investor because of its
passivity and ignorance of security values. Graham did indeed differentiate
between the "enterprising" and "defensive" investor, but did not recommend an
index approach to investing, even for the defensive investor, as he
specifically recommends that no security should be bought at a price over 20x
its earnings (Ch. 5). Graham recognized that the "defensive" or passive
investor does not have the time, energy, or expertise necessary to engage in
rigorous security selection, but ignorance does not protect an investor from
risk - risk here being defined as risk of permanent capital impairment, which
is the risk of overpaying for a security.

My basic point is that every investor, passive or active, must protect him or
herself against the risk of overpaying. Passive index investing does not
protect you from this risk, and is therefore very dangerous.

Fully agreed that good investing is pretty much totally dependent on how much
work and emotional discipline you're willing to put into it.

~~~
wisty
I'm not sure that "risk" is the right word. "Risk" should account for both the
probablility of loss, and the magnitude of the consequences. You might overpay
a bit, but not too much, so the risk is small.=

------
seanahrens
very well written, and very clear. thanks for the good insight, jon and bo.

------
Eliezer
Two words: Berkshire Hathaway.

~~~
hugh3
Those are, indeed, two words.

They'd be more useful if placed into a full sentence, for instance "I think
you should put all your net wealth into shares of Berkshire Hathaway" or "I
think you should try to replicate Berkshire Hathwaway's investment strategy"
or "Hey, you should think about buying a little bit of Berkshire Hathaway as
part of a diversified portfolio which also includes other asset classes".

~~~
Eliezer
"Berkshire Hathaway is something you can defensibly buy that isn't an index
fund."

