Simple Beauty

Simple Beauty

Published On: September 9, 2021

Written by: Ben Atwater and Matt Malick

That’s been one of my mantras – focus and simplicity. Simple can be harder than complex: You have to work hard to get your thinking clean to make it simple. But it’s worth it in the end because once you get there, you can move mountains.” – Steve Jobs, 1998 Business Week Interview

We have written extensively about the effectiveness of a simple, understandable, transparent and low-cost investment philosophy. The way we invest, which we outlined for the first time in September 2008, stems from the discomfort we experienced while watching our industry slip into the opaque.

For the ten years ending August 31, 2021, the most basic index of worldwide stock exposure, the Morgan Stanley Capital International All-Country World Index (ACWI) tripled the annualized performance of the Hedge Fund Research Incorporated Fund Composite Index – 11.27% versus 3.73%. This means that a passive basket of the worldwide stock market dramatically outperformed the sophisticated, “go anywhere” strategies that the most brilliant practitioners on Wall Street conceived.

We sometimes receive inquiries about alternative investment strategies to manage risk. It seems to us that despite all the evidence to the contrary, investors are still searching for something that doesn’t exist – a formula to sidestep market losses while also getting a better return than bonds offer.

Even with the hedge fund industry’s subpar performance, 2021 has brought renewed interest to the hedge fund space. 2021 inflows have brought hedge fund assets under management to an all-time high of $4.146 trillion.

In reference to stock investing, the legendary Fidelity Magellan Fund manager, Peter Lynch, said, “The simpler it is, the better I like it.” We think this sentiment applies to investing in general. You can observe a great example of this in 2008, a terrible year for the stock market, and the ensuing market recovery in 2009.

In 2008, the S&P 500 fell a whopping 37%. But interestingly, the Barclays U.S. Aggregate Bond Index rose 5.24% that year. So, if you had a 50% stock and 50% bond portfolio, you would have lost 15.88%. Not good, but far from devastating.

Then in 2009, the S&P 500 rose 26.46% and the Barclays U.S. Aggregate Bond Index rose 5.93%. The same 50 / 50 portfolio would have gained 16.20%. If the portfolio was rebalanced annually, then less than a year removed from the financial crisis and Great Recession, an investor in a plain vanilla balanced portfolio would have almost fully recouped all losses.

Lastly, in 2010, the same 50 / 50 portfolio would have generated 10.8% returns, putting the portfolio back in the black and well-positioned for robust returns in the years since. (Even without annual rebalancing, a 50 / 50 portfolio would have produced positive three-year returns from 2008 through 2010, a period fully encompassing the financial crisis.)

The financial crisis is a great portfolio “stress test.” And it offers strong evidence that risk mitigation techniques do not need to be fancy, overly complex or expensive. Frankly, in our experience, the more esoteric these schemes, the less effective they are. Make no mistake, finding the proper allocation to high-quality bonds to complement your stock exposure is the best risk management strategy – it is straightforward, transparent and low-cost.

Even during a protracted bear market for bonds (1941-1981) – a time when interest rates rose, and bonds prices fell – they still proved an excellent risk manager. The standard deviation (a statistical measure of variation around the mean) for a 50% stock / 50% bond portfolio was half that of an all-stock portfolio, or half the risk (standard deviation of 7% versus 14%, respectively).

Risk reduction always has an opportunity cost. The all-stock portfolio returned an average annual 11% per year, while the 50% stock / 50% bond portfolio returned 7% per year. Even in a rising interest rate environment, bonds served to dampen volatility and still resulted in a respectable return for a balanced portfolio.

As you can clearly see, a balanced portfolio certainly seems like a better alternative to so-called sophisticated hedge-fund investments.

Ignoring the advice of Leonardo de Vinci that “Simplicity is the ultimate sophistication,” many risk-averse investors will buy anything if it sounds sophisticated, regardless of whether they understand it.

Or maybe the fact that they don’t understand it gives a certain level of comfort – if it is complicated, it must be good!

The old economic axiom, “There’s no such thing as a free lunch,” provides a cautionary message to people looking to manage risk via magic tricks. Investors are naïve to believe strategies exist that can consistently shuffle money from one asset class to another with precision, or predict which stocks will spike over the short-term even when the market declines, or that can use options to truly protect against the downside without considerable cost, etc.

The martial artist and movie star Bruce Lee believed, “It is not a daily increase, but a daily decrease. Hack away at the inessentials.” From an investment standpoint, be honest with yourself about what you are trying to accomplish. Do not subscribe to the myth that a black box exists that will protect you from high stock prices and low bond yields. Instead, avoid the temptation to purchase investments that are supposedly sophisticated enough to outperform the tried and true.

A final thought from Peter Lynch: “All the math you need in the stock market you get in the fourth grade.” This may sound unreasonable, but it is surely true. A simple investment discipline will outperform all the gimmicks over the long-term.

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