Investing Is Over-rated

In theory, investing is amazing.

You ‘spend’ money today that turns into more money (at a rate greater than real interest rates) in the future. And because “happiness” isn’t time-discounted, this can be turned into more “happiness” than spending said money can today.

But it gets better. Because of compounding, the longer you wait to spend this money, the more money you have – in a non-linear, exponential way. Meaning that waiting 10 years rather than 5 to spend this money doesn’t mean you’ll have double the returns to play with. In fact, at a 10% RoR, it’s more like 4x the returns. This is difficult to appreciate – just think of the king who agreed to pay the inventor of chess double the grains of rice on the previous square for all the squares on the whole board, starting with one single grain. He owed eighteen quintillion grains of rice.

These first-level problems are known. They have been discussed in-depth and basically solved elsewhere on the interwebs.

We’re here to talk about second-level problems. Problems that aren’t discussed. Problems that mean investing ain’t all it’s cracked up to be.

Nothing to Invest In

All assets suck

Every asset has problems.

This is necessarily true – otherwise everyone would invest in the “best” asset and the price of the “best” asset would continue to rise to astronomical levels well above its fair value – to levels at which the yield of the “best” asset would look simply pathetic.

Stocks (or shares – I still haven’t decided what to call them) are the most popular and probably, overall, in the long run, in most cases, [insert other caveats and qualifiers here], the best. But they are no guarantee. What happens when the management of a company collectively wet the bed? What happens when an industry perpetually declines? What happens when the population reduces? All these things make stocks go down.

What about bonds? Guaranteed returns. Guaranteed yield.

But you know companies can go bust, right? 10% of US companies disappear every year.

Governments fail, too. Sure – if their debt is domiciled in the domestic currency, it’s probably going to be repaid. Because the genius central bank can (with a figurative gun to their heads held by the government) simply print more of the domestic currency. But only to a limit. This cycle:

printer go brrr → inflation → economic instability → more % yield required on gov debt → print more

is hard to reverse. And that’s assuming the debt is in £££ or ¥¥¥ or ₹₹₹. Debt in a currency that you don’t control like €€€ or $$$ is a different issue. And don’t get me started on inflation and the catastrophic effect that can have on real bond returns. Index-linked bonds might not be that effective against it, either.

What about alternatives?

Real estate, for example. Performed well, sure. But again – what happens when the population declines or the government decides to build lots and lots of new houses? Or the location simply becomes less popular?

Why not just hand money over to the experts? Surely they can do a better job? The problem with this is that active managers are 1) unlikely to beat the market 2) unlikely to maintain this performance when they do and 3) very difficult to select before this period of out-performance. The same logic applies to HFs, PE, VC, and any other 2-letter-acronymed industry that manages your money. Investing is very hard and it’s near-impossible to tell who’s actually good at it and who’s a bullshitter.

There are of course a million other things for you to buy. Commodities – how do you know what price they’re going to be in 50 years? Crypto – maybe, but might go to 0.00. Derivatives? Good luck. Some other rogue asset that your mate told you about or has exploded in price over the last 5 years? How do I short it?

This stuff is risky. This stuff requires knowledge. This stuff is not to be messed with.

Just look at the data

Let’s pretend you didn’t know any of that. Let’s pretend you didn’t – gasp – read the above.

What if we just look at the data? This would tell us what has performed well and is thus a good bet for what will perform well, non?

Those on the left of the statistical naivety spectrum might do something like look at stock returns in the US over the last 10 years and think oh my ok let’s go, funnel all funds into S&P 500 please and thank you. Or something else that is similarly geographically or temporally biased. Obvious biases aside, the main problem with these approaches is sample size. Simply, there isn’t much data for 50-year+ periods of returns for any asset. We can sample with replacement and overlay return periods, but it’s not the same thing as IID samples. 

Others might take a marginally-better approach in which they gather all data possible and analyse it using various statistical techniques. They would then construct an ‘optimal’ portfolio using correlation between assets and historical returns. They might even chuck in some volatility, some beta, some CAPM, even some MPT. These portfolios sound smart and look very good on paper.

But what they fail to account for is the complexity of financial markets. This analysis is backward-looking. Markets are essentially living organisms – these are very difficult to characterise statistically.

Ok fine just diversify then?

We know very little – deductively or inductively. We are uncertain.

It seems sensible, then, to diversify in a 1/N-type manner. Just buy all the assets in equal amounts and hope that results in a satisfactory return.

The obvious problem with this is practical implementation. Are you really going to buy…everything? Ugandan government bonds? Pork belly futures? J D Wetherspoon plc shares (sorry, I mean stock)? How would that work? You are restricted in some way, therefore have to make a choice about which assets you will choose to invest in. Which brings us back to the problems already discussed.

Add to that smaller bits of admin. Do we invest equally or weighted by market cap? Do we rebalance the portfolio? How often? Do we choose investment platforms that give us the most options or just do the best with what we have?

choices choices choices

And if we restrict our investment universe to only the big boys – the main assets – we will be left with a false sense of security. Because the correlation between these assets changes all the time. And the world is becoming increasingly homogenised. This includes markets. Meaning that instead of hearing “stocks up, bonds down, gold flat”, we’re now more likely to hear “markets down”. This is especially true in bear market.

Your Life

Oportunidades

Investing makes money turn into more money, sure. But probably to a lesser extent than you think. Because money in the future is worth less than money today. This is primarily due to inflación: freddos cost 10p in 2000, 30p today, and will probably cost 40p in 2030. But this is also because money in real terms is worth less to future you. Think about it – is £100 more valuable to you today or in 20 years’ time? Today (I hope), even adjusting for inflation. Take this to the extreme: is £100,000 (again, in real terms) worth more to you when you’re 20 or when you’re 90? Or when you have 1 year left to live? Or when you’re on your deathbed?

I'm sure Warren Buffet would give up half his net worth for 1 extra rotation around the sun.

— Haydn Martin (@HaydnMartin_) October 8, 2022

Time is finite. It’s a precious resource. You can always make more money, you can’t make more time. Investing comes with an opportunity cost – the cost of spending money today. Of course, what I was alluding to in the intro was the fact that investments compound. You’re betting that this rate of compounding is greater than your rate of diminishing marginal utility of wonga (DMUW).

We must also sprinkle-in uncertainty. Because I know what I want to spend money on today. And I know how much it’s worth to me. Fuck knows how much it’s going to be worth in the future, in every sense of the word. For all I know my grandmother could have left me an absolute wedge (I am her favourite, after all). And so: were those missed holidays and missed events and not buying the new Mac, etc. worth it? Probably not. But I had no way of knowing that at the time.

Not a super forecaster

And if and when this inheritance materialises is veeeery hard to predict.

How much money you and I and whoever else will need, how big your investment pot will be, what you will spend money on and why, are all unknowns. You can have some idea of the above but being able to predict it with any type of accuracy is either naive or if possible just plain sad. From a previous post:

QUOTE: “People change. Are you the same person you were 10 years ago? I hope not. Is your life really that boring that you know for a fact that none of your plans will change over the next 10 years? Again, I hope not. Even if you are mentally composed in such a way, an exogenous event may force you to sell. If your ageing mother needs to pay for urgent medical attention I hope you don’t deny her this because it doesn’t fall in line with your investment strategy.”

Which is another reason why the inability to forecast diminishes the attractiveness of investing. Because you never know when you will need to sell. It’s all well and good having a plan but, from the same post:

QUOTE: “Things that happen outside of your portfolio are just as likely to determine when you liquidate positions as your strategy.”

Taleb expresses this (slightly) more eloquently:

Now, when you read material by finance professors, finance gurus or your local bank making investment recommendations based on the long term returns of the market, beware. Even if their forecast were true (it isn’t), no person can get the returns of the market unless he has infinite pockets and no uncle points. The are conflating ensemble probability and time probability. If the investor has to eventually reduce his exposure because of losses, or because of retirement, or because he remarried his neighbor’s wife, or because he changed his mind about life, his returns will be divorced from those of the market, period.

Nassim Taleb

Optimists vs. Pessimists

Pessimists are right, optimists are rich.

Or more accurately:

Pessimists are right most of the time, optimists get rich if they have enough attempts and don’t blow up.

Being blindly optimistic would mean you would probably blow up. At a minimum, this would mean you would take on too much risk. But being pessimistic comes with huuuge opportunity costs and probably negative real returns.

I would characterise the best approach to retail investing as being a paranoid optimist.

You have to be paranoid, recognise the flaws in each asset class, not rely on a set level of return, think about how you could possibly go bust or lose a lot of money or be forced into a certain action. But at the same time, you have to maintain some level of optimism. As much as I like cash, it’s not a viable long-term investment strategy, because it’s subject to negative real return.

You have to have faith, be optimistic, that the world is going to be a better place. Because growing the collective pie, improving global wealth, is a good thing for asset prices, and therefore your investment account.