The title could just as easily have been ‘The Problem with Market Cap Weighting’
When overvalued assets grow to be bigger and bigger parts of a market, or become the market, you no longer want to invest in that market. That, to me, is the biggest failing of buy and hold. It ignores common sense. Below is Japan’s historical CAPE. It is by far the biggest bubble we have ever seen. Our cute internet bubble in 1999 (CAPE of 45) is HALF the size of this one. Can you look at your client with a straight face and say it is just as good of a time to invest in Japan in 1989 as it is now?
Japan got to be nearly half of the world’s market cap. And if you believed the ‘efficient’ market, you just went along and invested half of your stock allocation in Japan. What did that cost you? About -4% per year real returns in Japan from 1990-2010. That’s 20+ YEARS of negative returns.
What is the biggest market cap in the world now? The US (at half). What is the 2nd most expensive country in the world? Yep, same. Now there is a big caveat and that is the US isn’t in a bubble. Nowhere near it. But the US isn’t cheap like the rest of the world. So you are still depriving yourself better opportunities elsewhere.
I’m going to do a series for readers of The Idea Farm where I identify and chat about my 20 favorite hedge fund managers to track via 13Fs. Below is an example, Michael Price. He ran money at Mutual Series with Max Heine before merging with Franklin and starting his own family office. (Seth Klarman cut his teeth at the firm.)
How does investing alongside Michael Price work historically? Great! Below is what happens when you follow his top 20 holdings through 13Fs, and you see some of the stocks he mentions in the video. From AlphaClone:
The biggest mistake investors can make that risks them blowing up is concentration, especially coupled with debt/leverage. One would think that, at the time, a top 10 world’s richest man would learn some of those lessons, but below is a must read on how not to invest. Especially once you have some money.
Lots of “smart money” lost a ton investing alongside Francisco d’Aconia, err, I mean Eike Batista.
“Investors have been overpaying for dividend stocks while undervaluing companies that are buying back shares, Oakmark Fund’s Bill Nygren said Tuesday.
“One of the things we think investors have gone a little excessive on is bidding up companies that pay high yields, good income generators,” he said.
“And we think it’s interesting that companies that have been large share re-purchasers — effectively, it should be the same to an investor whether the money comes back as money or share repurchasers. But those stocks aren’t as expensive, so we like the big share repurchasers.”
Maybe the combination of two seemingly unrelated things will make the whole more complete?
Much like the Merkel shirt on a plumber, the above phrase is really asset allocation summed up in a nutshell. Add assets that should pay you cash flows, and do so in different environments. We did a few posts on this already, and I added a new one after reading the new edition of Gibson’s Asset Allocation book.
“Let every man divide his money into three parts, and invest a third in land, a third in business and a third let him keep by him in reserve.” -Talmud
So I added a column for 33% REITs, 33% US stocks, and 33% in 10 Year US Bonds. How did it perform?
Basically the same as all the other asset allocation strategies. Buy and hold asset allocation is great, you just shouldn’t be paying people much for it…
My buds Wes Gray and Jack Vogel just put out a killer new paper where they asked the above question. The simple answer is “yes it does”.
The more interesting answer is 1) there are other cyclically adjusted measures that work better and 2) there is some other factor (you know I like) that reaaaalllly gets the returns flowing. Our friends at O’Shaughnessy should like this one too.
Enjoy! (and if you email Wes please shame him for canceling on our Morningstar panel at the ETF conference next week!)
I enjoyed reading Phil DeMuth’s recent book The Affluent Investor. It’s a good overall read on asset allocation for the individual. At one point he mentions an all market portfolio (from Picerno) that invests in all of the world asset classes in proportion to their market cap.
I thought I would add the allocations to the other allocations we posted a few months ago. The All Market Lite is a simplified version with only three holdings.
He also talks about cloning Pabrai in a recent Forbes article. Out of curiosity, I tested Pabrai’s top 10 holdings courtesy of AlphaClone and found outperformance of about 8% since 2004 (although his fund started in 2000 I believe). Not bad!