Why beating the stock market is a fruitless game

Book: The Geometry of Wealth: How to shape a life of money and meaning
Author: Brian Portnoy
Publisher: Harriman House Ltd.
Price: Paperback $26.54, Kindle $9.99

WHO IT’S FOR: Simple enough for kids to understand yet sophisticated enough or professional investors as well.

MORE SPECIFICALLY: Those interested in investment books that blend psychology, neuroscience and behaviour to give useful investment analysis as well as personal insight into money and behaviour. Anyone wanting to understand the deep connection money has to how they feel.

KEY INVESTMENT INSIGHT: That the list of stock market winners is very, very short. In fact, over a 90-year period, only 4% of companies explain the net gain for the entire U.S. stock market (See chart page 152).

WHY WE LIKE IT It’s a thought-provoking book that challenges the reader to think and feel about the role wealth plays to one’s own meaning of life. Portnoy does this by sharing behavioral economics and biases with a step-by-step system so the average person can fully understand them. He also gives methods to overcome these biases.

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ANY KEY MOTIFS? Yes, geometrical motifs throughout to explain his theories and concepts. For instance, the Circle, which connects money and happiness, the Triangle, for prioritizing money, the Square, which shows that simple is better, but not easy.

KEY CONCEPT: “Funded contentment” is the way Portnoy challenges us to think about wealth as it is specific to every individuals’ own circumstances, wants and desires. In a nutshell, it answers the question, “How do you strike a balance between striving for more while being content with enough?”

PRAGMATIC TAKEAWAY: Portnoy shows us the strategy on how to think about what matters, how to set priorities in your life, make meaningful decisions, think in probabilities and find a balance between more and enough. It encourages us to ask ourselves, “What are the touchstones of a meaningful life, and are they affordable?”

WHAT’S SURPRISING? How philosophical this book is with insights from De La Soul, DuFresne, Dostoyevsky, Marx, Marks, Munger, and many more. Portnoy shows how tackling the big questions about a joyful life and tending to financial decisions are complementary, not separate tasks.

SOME KEY QUOTES:

• “Beating the market. That’s a silly and fruitless game. It’s not tied to your real needs. It’s attached to your ego.”
• “Most people view experiences as more self-defining. What we ‘do’ is more closely tied to who we are than the things we have.”
• “The long-term is fuzzy at best. Practically speaking, it might not exist. All we have, really, is an infinite series of short terms stapled together by circumstance and choice.”

KEY TAKEAWAY A better experience with money is within everyone’s reach. This book shows you the roadmap to how to achieve that by offering the reader a one-stop, all-encompassing guide to money— and a more meaningful life.

Excerpt from The Geometry of Wealth

Underneath the expansive sky of behavior, on the broad terrain of traditional finance, there are three paths toward making skillful investment decisions: Choosing the right markets, choosing the right components within those markets, and choosing the right times to enter and exit those markets. In wonkier terms, these are known as asset allocation, security selection, and market timing.

Let me quickly dismiss the third by stating, unequivocally, that market timing is impossible. Period. Guessing correctly on occasion about markets moving higher or lower is not a demonstration of market timing skill. At the very most, there are some professional traders, or speculators, who can make good tactical buy and sell decisions. That’s a different game than what any individual investors or financial advisors are, or should be, playing. Beyond that qualifier, market timing is a fool’s errand.

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That leaves the two other sources of smart investing: Properly allocating assets and selecting individual securities. Asset allocation is the more important, mainly due to one factor: Dispersion. This statistical concept looks at how much elbow room one has when making any sort of decision. It is defined as how much difference exists among the particular choices on a menu. When many disparate choices are available, there is the opportunity to exercise skill in making the “right” choice. With fewer choices, that opportunity is limited.

A food court at an airport or a local mall provides an off-beat but apt lesson in asset allocation and security selection. I travel through O’Hare Airport all the time and these are my choices in the Terminal 3 food court: McDonald’s, Burrito Beach, Dunkin’ Donuts, Reggio’s Pizza, O’Brien’s, Manchu Wok, B-Smooth Smoothies, Prairie Tap, and Tortas Frontera. These nine spots differ widely in their focus: Burgers, Chinese, Mexican, pizza, deli sandwiches, salads, and so forth.

What’s going to drive a satisfying decision? First and foremost, it will be based on which of the nine restaurants I choose. I have many distinct choices and my preferences are what they are—I prefer Mexican to burgers, for example. Thus, I vote for Tortas Frontera over McDonald’s. Either of those two restaurants has a dozen or more individual choices, but generally whatever I choose from either menu will be representative of that cuisine. Whether it is the Big Mac or Quarter Pounder at one, or a choriqueso torta or a smoked pork molette at the other, the key driver of a good meal is the restaurant and the secondary driver is the specific menu selection. The difference—or dispersion—in utility between McDonald’s and Tortas Frontera is wider than the difference amongst the menu items at either of the respective places. Getting the restaurant right is more important than picking the right dish.

Choosing investments works similarly. The big choice at hand is one of “asset classes”—broad categories of investments that tend to work by their own distinct logic. The primary asset classes are stocks, fixed income, real estate, commodities, currencies, and cash. As a practical matter, the three “biggies” are stocks, bonds, and cash. Within each of those categories are many broad and fine distinctions. With stocks, for example, we can distinguish between domestic and overseas companies, big companies and small ones, and different sectors such as technology, healthcare, or industrials. Same thing with fixed income, where the global marketplace is much larger and more nuanced than the equities markets: government bonds, investment grade corporate, high yield, asset-backed securities, mortgages, and on and on. The purpose of the forthcoming section on the square is to help you navigate both the linguistic and analytic confusion of all these choices, so don’t feel overwhelmed by this. We’re going to simplify it all shortly.

Portfolio needs are largely determined by life circumstances. For goals further out in time—as measured in decades—we typically want to own stocks. With nearer-term goals—within a few years and certainly for generating current income—choosing grows more complicated. All else equal, more conservative investments make sense for nearer-term goals.

Seminal research has conclusively shown that building your portfolio around the right asset classes is more important than the individual pieces. A 1986 study led by Gary Brinson analyzed why some institutional investors put up better results than others. Among the three potential drivers of performance—asset allocation, security selection, and market timing—they concluded the first was by far the most influential. Differences in asset allocation explained about 94% of the differences in results. Security selection and market timing were not meaningful contributors. It’s a remarkable finding, one that has been subject to intense debate, but still generally holds.

A follow-on study in 2000 by Roger Ibbotson and Paul Kaplan corroborated that “about 90%” of the performance differences among investors could be explained by asset allocation (or in their light prose, “the variability of the fund’s policy benchmark”). Once you’ve settled on making U.S. big company stocks an important portfolio allocation, which specific large-cap U.S. equity fund you own is of secondary importance. It’s not unimportant, but it isn’t the primary driver of results. If you choose Mexican over burgers because you know you prefer it, regardless of whether you order the choriqueso torta or smoked pork molette, you’re going to have a better experience at Tortas Frontera than McDonald’s.

Putting a proper asset allocation in place is mission critical, but don’t fetishize precision. It is the job of financial experts, institutional investors, and investment consultants to come up with pinpoint portfolio recommendations. An expert might see an actionable difference in a portfolio with, say, a 69% versus 71% allocation to stocks. But as a practical matter, in finance, we often make distinctions without a difference. For most portfolios, that shift wouldn’t be worth it in terms of taxes, transaction costs, time, or mental energy.

A fantastic story about the father of modern portfolio theory, Harry Markowitz, brings this to life. Markowitz considered the optimal mix of assets for his personal portfolio but found it all too complicated to wrap his prodigious brain around. “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier,” Markowitz recalls. Instead, he went the simple behavioral route: “I visualized my grief if the stock market went way up and I wasn’t in it—or if it went way down and I was completely in it. So I split my contributions 50-50 between stocks and bonds.” Markowitz couldn’t apply his landmark theory to his own money. “Good enough” portfolio planning was okay for this Nobel laureate. It’s good enough for us, too.

About the Author:

Brian Portnoy, PhD, CFA, is an expert at simplifying the complex world of money. In his two books, The Geometry of Wealth and The Investor’s Paradox, he tackles the challenge of not only making better investment decisions but also how money figures into a joyful life. He is currently the Director of Investment Education at Virtus Investment Partners and has spent the last 25 years as an educator, investor, and strategist. He holds a doctorate from the University of Chicago and currently lives on the north side of Chicago with his wife and three children. For more information, please visit his site and follow Brian on Twitter.