Great Investors Set The Bar High

“Investments are like a bar of soap. The more you handle them, the smaller they get.”

– Warren Buffett

In last month’s article, we discussed an important anniversary that all great investors celebrate. This month, we contemplate how to evaluate trendy, “hot” investment opportunities.

The Goals of Investing

Because most of our clients are successful business people, and well connected, they are often approached by friends, family members, or colleagues with “great,” new investment opportunities. Naturally, they then turn to us to help them evaluate these offers, which range from proprietary high-tech alpha funds, new trading strategies, sophisticated new hedge funds, real estate deals, startups – or even just a stock tip. Regardless, they always seem compelling, and it can be difficult to distinguish the sales fluff from the real substance. There are only four legitimate reasons to invest your hard-earned wealth. Any investment in your portfolio should serve to:

• Improve your returns
• Diversify and/or reduce your risk
• Improve the chance that you will achieve your goals
• Reduce your taxes and/or fees

When contemplating a new investment, the first filter should be that it should help you to do at least one of these things listed above better than your current portfolio. If it doesn’t do this, it’s best to take a pass.

Setting a High Bar

Let’s take a look at an investment that all of these opportunities should have to compete against. Here’s what you get when you invest in this simple, default portfolio:

• The historical performance has been great. This investment has been around for over 70 years, and it has risen 200-fold over that period of time, producing an average annual rate of return of just about 10 percent per year.
• This portfolio consists of partial ownership of a diverse group of 500 of the most-profitable and best-financed companies on earth. Because it consists of ownership of actual companies, you are afforded the same protections as the largest institutions in the world.
• The total combined market value of these 500 companies is just about $22 trillion, and the smallest company in the group is valued at just about $6 billion.
• Most of these businesses are household names you would recognize, and you most likely patronize.
• The earnings of these companies increased by just about 18 percent in 2018, and this group is earning just about 5 times more today than they did 25 years ago.
• The roster of 500 companies owned in this portfolio is constantly being finetuned in order to keep pace with the economy.
• These companies consistently reinvest their extra cashflow in their business or in acquiring other businesses. When their management teams don’t think they can do that, they will find other uses for their cash, like paying you a dividend or buying back their shares.
• Last year the companies disbursed a total of $456 billion in dividends, which was just about 7 percent more than they paid out in 2017. Importantly, these dividend streams can grow as the companies earn more every year.
• These companies also repurchased a total of just about $1 trillion in stock from their shareholders in 2018. This action served to significantly boost the companies’ earnings per share because there are now many fewer shares outstanding.
• Finally, this investment is incredibly tax efficient. The investor only has to pay capital gains tax on this investment when they actually sell it, which could be many years in the future. If they hold it for life, their heirs can actually sell this investment for no tax at all! Given the fact that taxation is one of the greatest thieves of wealth for most investors, this portfolio is incredibly efficient.

If you haven’t figured it out by now, the investment we are describing is the most popular and most easily accessible portfolio in the world: the S&P 500 stock index, owned in the format of an Exchange-Traded Fund.

So, what kind of a “bar” is set by this simple, accessible, low-cost portfolio? Historically this portfolio has returned just about nine percent per year over the last 45 years and has had 8 percent volatility. It has turned in positive performance in over 66 percent of the months since then, and it has turned an investment of $100 into more than $5,000 today. It can be obtained for almost no management cost, and it is incredibly tax efficient for the long-term holder. It’s a pretty solid investment, and it’s not easy to beat.

Hunting “Alpha”

As we have written so many times in the past, so many investors have a misguided obsession with “Hunting Alpha’” finding that magic strategy or set of portfolio holdings that will enable them to consistently beat the market. Popular culture has led us to believe that the only way to achieve long-term financial success is to find that hot money manager, hedge fund, angel investment deal, or real estate partnership that will lead to the Holy Grail of consistent outperformance of the global asset markets.

In this obsessive hunt, it is easy to forget that a diversified investment in the global asset markets is not such a bad deal after all, and it is perfectly capable of carrying you where you want to go financially. When we are obsessively trying to “beat the market,” it is easy to lose track of the reality that the market actually sets a pretty high bar to overcome when it comes to our four investment guidelines:

• Improve your returns
• Diversify and/or reduce your risk
• Improve the chance that you will achieve your goals
• Reduce your taxes and/or fees

Does your hedge fund check that box? Unlikely. Does your flashy new thematic sector fund check any of the boxes? Fat chance. What about investing in your cousin’s hot new startup? Probably not.  What about taking a flyer on your neighbor’s favorite stock pick? No way.

Our collective experience has taught us something very important about these slick ideas and overhyped sales pitches. The odds are much greater that the higher fees, overactive trading, tax inefficiency, and performance disappointments, which are common in these deals, will probably turn your portfolio into a bar of soap – much smaller thanks to too much handling.