Replace luck with fact not feelings

Investing isn’t a hard science like physics with its deterministic equations that can predict outcomes precisely.

24
Adodbe stock image of stacks of increasing coins

Towards the end of December, there’s a part of me that misses the pace and energy of a normal workday. I habitually check my phone every few minutes despite knowing that there’s little going on. Every year I promise myself that it’ll be different this time but somehow last year I was worse than the years before. I even went as far as to send myself a test mail to confirm that my inbox was still working. After this I needed a distraction, so I wandered over to YouTube.

Their algorithm suggested that I watch a video by Neil deGrasse Tyson (the director of the Hayden Planetarium in New York and part of the team that demoted Pluto from planet status) about why clocks run clockwise. Spoiler: in the northern hemisphere, it’s the direction that a shadow cast by the sun moves. This took me down a deGrasse Tyson wormhole until a short video caught my attention. He stated, with his inimitable enthusiasm, that eyewitness accounts don’t carry any weight in science. Science requires evidence and saying that you saw or heard something is not evidence. In science, evidence is something that can be measured in a controlled and repeatable manner. Contrast this view to the investment industry where we often rely on the art of persuasion and piece together a hypothesis with incomplete information.

Investing isn’t a hard science like physics with its deterministic equations that can predict outcomes precisely. This, as we operate in an environment that incorporates human nature, complex interactions and feedback loops and we need to extrapolate these into future expectations. But applying the rigours of scientific evidence is key, even if it may seem daunting, and it’s easy to instead fall back onto how we feel to rationalise a decision, not fact. It doesn’t have to be this way. While we must accept that there are limits to what we can know we also need to maximise the use of the information available to us.

I believe that the market is all-knowing; it never forgets and punishes the complacent. That sounds like a cult leader but unlike gurus in pyjamas, the market will reward your patience if you follow a few simple principles. We need to apply rigour and discipline to areas that we can control and exercise our best judgement in areas that we can’t.

The first and most obvious place to apply rigour is to fees. We all know that low fees are better and that costs must be managed tightly, but it’s more nuanced than that. Where you save fees is as important as how much you save. It is more important to manage costs on the highest-performing asset classes because the savings are compounded on a larger return. Lowering equity investing costs has a much greater impact than the same saving would have on cash or bonds.

Assume that you have R1 million to invest for 10 years and that the expected net annual return on bonds and equities is 8% and 14% respectively. Then, let’s measure the impact of a 0.2% pa cost saving pa on both portfolios. The cost-saving compounds to an extra 4% on bonds and 7% on equities. If we extend the period things get interesting; over 15 years the savings compound to 9% vs 19% and over 20 years 18% vs 49%. This is the power of compounding, and its implications are clear: managing fees, especially the pernicious effects of performance fees, has an outsized effect when applied to the highest-returning assets. This is the simplest yet most effective way to guarantee value-add to a portfolio.

Another area that is often underappreciated and punishes the complacent if it is ignored, is risk management. It is tempting to start portfolio analysis with return comparisons, especially to peers, but past returns can be the least dependable indicator of future outcomes. Returns are calculated using only two data points, the start and the end and ignore the rest. Risk measures are concerned with the journey and not just the outcome and make use of all data points between the start and end points.

Even something as simple as a three-year volatility number would use all 36 monthly returns and is thus far more informationally dense than the return over that period. Over a full market cycle, this information density can provide meaningful insights about how a fund manager has behaved under different scenarios and is a better foundation for inferences about the future than a return ranking table.

Effective diversification is also often neglected. Diversification is an efficient and effective way to reduce losses. Counter to what is typically believed, owning many different assets does not automatically imply that you are diversified. This is especially true in the South African context where it can feel like we have more fund managers than investable securities.

Table 1

Calculating the Effective Number of Constituents (ENC) value is a better metric than counting portfolio contents. This measures the amount of concentration in the portfolio and expresses this as a notional portfolio count. Imagine an equally weighted two-stock portfolio: the ENC would be two, ie the same as the count. The same portfolio with 99% in one stock and 1% in the other would have an ENC of close to one even though the count is still two.

TABLE_2_RHEZA

An even better measure would be the similar-sounding Effective Number of Bets (ENB). This is more computationally intensive but considers portfolio weight as well as how constituents interact with each other. Once again, imagine an equally weighted two-stock portfolio. If those two assets behave the same then the ENB would be one, despite the count being two, ie there is no diversification. If the assets have inverted behaviour (ie are perfectly negatively correlated) then the ENB would be two and the portfolio is diversified.

TABLE_3_RHEZA

TABLE_4_RHEZA

These are metrics that measure portfolio characteristics in a manner that rises towards scientific standards and provides an objective base from which we can add more colour. This is not an exhaustive list, just a place to start. Adding rigour to portfolio construction means that we rely less on chance and allows us to replace luck with something more absolute and enduring.

As 2024 gains momentum and my phone is beeping constantly again, I believe it is prudent to keep a scientific approach in mind when creating portfolio constructions. While science cannot forecast the future, it can mitigate against it. This is why we should take a rational, scientific approach to building and managing clients’ portfolios.

Reza Khan, CEO, Lodestar
Fund Managers
Reza Khan, CEO, Lodestar Fund Managers

Lodestar Fund Managers is a Level 1 B-BBEE provider. 100% Black owned. 100% Black managed. Lodestar Fund Managers (Pty) Ltd is an authorised financial services provider, FSP 49808.