by David Merkel, Aleph Blog
This is a special book. It’s special because it explains investment concept in simple language, and tries to give average people an ability to understand how the markets work.
The author shares from his life experiences, where not everything turned out right. With bonds in the 1970s, what was ordinarily a safe investment turned into “Certificates of Confiscation,” as inflation and interest rates rose.
The author is careful to point out the difference between fake diversification and true diversification. False diversification has a large number of positions that are related, like owning many tech stocks from 1998-2003, or many financial and housing stocks 2005-2009.
True diversification means there is not some hidden factor that can affect your whole portfolio. The author argues that we need a broad array of investments in the portfolio to diversify results, reducing volatility, so that the investment program can continue until the target is reached.
The author also argues that investors need to dig into the guts of what they are investing in. Who is the custodian? Are my assets safe from commingling with the assets of others? (Think of MF Global or Madoff.) Is there any factor that could cause a substantial fraction of my assets to be significantly impaired? As an example, what if you live to an old age? Will you outlive your assets? For most Baby Boomers, that is a significant risk that is under-appreciated.
The author, who managed two significant asset management firms in his career, encourages readers to do detailed checks on any active managers they hire (like me). Analyze their methods, their incentives, their character, and more. Passive investing does away with many of those questions, but still you have to set up an asset allocation.
As for active managers, they often buy and sell to make it look like they are doing something for clients, when frequently less activity would be in the best interests of clients. Active management often works better at lower turnover rates.
Investment performance analysis has its own pathologies. There is the need to buy an outperforming fund. Why buy a fund that has done poorly? An investor could ask two questions: 1) is the manager just benefiting from the current cycle, or are his picks good aside from that? 2) Has the manager gotten so large in that strategy that there is no place to place money to achieve an above average return.