Fun with Fintech (part 1)

“The stock market is a device for transferring money from the impatient to the patient.” — Warren Buffet

First part of a two part series. The second installment can be found here.

Among my range of interests, I’ve been passionate about finance & economics, particularly stock markets for quite a few years. This started when I lived in Singapore where there was easy access to technology, markets and no capital gains tax. Initially via reading, then great mentoring and finally a ton of trial and error, I learned technical analysis (pattern recognition) and quantitative analysis (algorithmic). I remain very interested in algorithmic approaches as the market provides a fairly continuous source of fun, technical problems. Another side benefit of this work has been how generalizable it’s been to other fields — especially the psychology of risk taking, how we interpret wins and losses, behavioral psychology and the wisdom (and madness) of crowds.

This is a fun area for me to write about so here is a two part series on Fintech, markets and a trading strategy I’ve been working on over the past year.


TLDR

  • With the exception of taking care of your health, getting a good education and fostering strong relationships, there’s few things as good for your future wellbeing as saving early and investing wisely
  • Compound interest works. It’s always better to save and invest early to benefit from the compounding gains over many years. This is always a true statement — meaning it’s never too late to start
  • A good investing strategy doesn’t require you to pick stocks, pay high fees or get expensive financial advice. There is now strong evidence that actively managed funds rarely beat the market. Buying and holding the S&P500 is the best strategy for the vast majority of people
  • There is still room for improvement on the buy-and-hold model. Some Fintech startups like Betterment and Wealthfront have made “dollar cost averaging” easy. I also developed a model which I’ll cover in my next post.

Just buy and hold the S&P

There’s a great story I recently heard about Warren Buffet, history’s greatest stock picker and currently the 3rd richest man in the world. Tim Ferris, who tells the story, was at a Berkshire Hathaway meeting where he managed to get to a mic to ask Buffet a question:

Ferris: “If you were 30 years old and had no dependents but a full-time job that precluded full-time investing, how would you invest your first million dollars, assuming that you can cover 18 months of expenses with other savings? Thank you in advance for being as specific as possible with asset classes and allocation percentage.”
Buffett let out a small laugh and began. “I’d put it all in a low-cost index fund that tracks the S&P 500 and get back to work…”

Apparently at this point, Buffer then turned to the second greatest stock picker in history, Charlie Munger and asked him if he had anything to add. “Nope, sounds good”.

And that was it — the world’s greatest stock picker’s advice is effectively “don’t pick stocks” and instead just buy and hold the S&P500. I love this as it boils down the complex into something incredibly simple, specific and actionable. It’s similar to Michael Pollan’s advice on nutrition, which distills thousands of hours of research into “Eat food, not too much, mostly plants”.

So — buy and hold the S&P500… Many questions often arise at this point. Does it really work? How does it compare to xyz approach? Are there risks? Can it be improved? I’ll try to share what I learned on this topic.


Buy and hold — does it really work?

Due to ETF’s, it’s remarkably simple to follow the advice of “buy the S&P500”. Specifically, you can just purchase an ETF in the same way you’d purchase a stock. The most popular ETF is probably “SPY”. Other options are IVV, VOO or if you have your 401k with someone like Fidelity then indexes like VFINX . Give or take, they all do mostly the same thing.

On a long enough timeline, buying and holding one of these indexes works exceptionally well. In the last 5 years, the stock market has been on a tear with SPY (the S&P500) returning around 13% a year. Factor in dividends which are paid out quarterly at roughly 0.5% a quarter and this ends up being 15% annually for the last 5 years. Because the growth compounds, that means $10k invested in January 2012 would be worth approximately $20k today — a 100% return.

That’s the last 5 years which has been a fairly ideal investment environment. It’s not always the case. Go back ten years and you’ll still be positive, but the annual gains are not as great as it starts to factor in the crash of 2008. The key though is the timeline — if you can wait it out, this strategy has always proved positive. I’ll cover later some specifics on timing.


How does the performance compare to funds?

Two of my favorite studies show that for the vast majority of people, Buffet is right. The first study shows that 65% of active fund managers do not beat a “buy and hold” S&P500 strategy over a one year period. Over five years the situation is even worse with 80% underperforming. So even though 19% of fund managers are good enough to outperform, there’s no guarantee that you’d be able to pick one of them.

The second example is more anecdotal but quite public and certainly symbolic. Nearly ten years ago, Warren Buffet made an open bet to the investment community, challenging anyone to pick a basket of hedge funds that would beat an S&P500 index over a 10 year period. Someone took him up on his bet for the now famous “$1M bet”. The results as of February 2017, 9 years into the bet are as follows:

After nine years, the index fund has registered a compounded annual increase of 7.1%. And the average for the five funds (whose names have never been made public) is 2.2%. In total gains, the index fund is up 85.4%. The average gain of the five funds is 22%

I thought Vanguard was the gold standard?

There’s a lot of firms with very smart people who create their own indexes / ETFs with the goal of providing better returns to their customers than the general stock market. A strategy might start with large caps, remove companies who have an overexposure to certain types of risk or markets and then are monitored daily by a team of experts. However, when you stack up the best of these indexes against the market, the results are strikingly similar. For example, a quick Google search of “best index ETF’s” yields an article on Investopia titled “Top 3 ETFs for Long-Term Investors”. SPY is one of the three, with the other two options being from Vanguard (VTI and VIG). When you overlay their performance from the last 10 years, you see a striking similarity. SPY (S&P500 is in blue below), the other two are red and green:

There’s a good reason for this similarity and it’s not a coincidence. The great thing about the transparency of ETF’s is that you can see what the exact % allocation of the index. So taking VTI as an example, the exact portfolio composition is detailed here. This can be compared against SPY’s portfolio composition here. When you put them side by side, we see very similar allocations in their top 10.

Portfolio investments, ordered by size of allocation between SPY and Vanguard’s VTI

Pretty similar — a slight change in the % holdings, but basically the same set of companies. We can say this is by design (i.e. Vanguard / VTI have the good sense to do this) but I also think it reinforces the fact the market is very very hard to beat. You either try a very different stock mix with a high likelihood of losing, or a similar mix with very similar results.


Are there any downsides to buy and hold?

OK so everyone by now should have read disclaimers that go along the lines of:

Investing involves a great deal of risk, including the loss of all or a portion of your investment, as well as emotional distress

This is true irrespective of any investment strategy and any approach which makes a claim otherwise should be avoided. With the buy-and-hold-the-S&P500 approach, there are substantial risks. This is what this strategy looked like over the past 25 years or so:

Things were great if you bought in 2009 when no one wanted to touch stocks. A $10,000 investment then would be worth over $30,000 today. However, as you can see from my annotations on the chart if you bought in 2000 or 2007, it might have taken you more than 5 or even more than 10 years to get your money back.


Can anything be done about the risks?

While we can’t remove these risks entirely, there are things that can be done to reduce the downside. One popular technique is something called “dollar cost averaging”. This means you buy on a regular interval — even when the market is falling. That way, if the market drops, you are actually buying at a discount so that your gains are correspondingly larger when the market rebounds. This strategy, while not perfect, is widely used and Betterment and Wealthfront make it easy to execute. There is of course the risk that the market never peaks again, but this has never happened to the overall US stock market. It has happened to countless individual stocks (RIMM, Nokia, etc), to some sectors and to entire markets abroad. So while unlikely, it’s a possibility. Hopefully we never experience something like the Nikkei 225 in Japan (still below its peak 25+ years on).

Edit — For more information on dollar cost averaging, read this excellent post by Emmanuel Marot.


You mentioned Fintech?

Right, so despite everything I’ve written above, I’ve never been 100% comfortable with buy and hold for my own strategy. I watched the 2001 and 2008 crashes in excruciating detail and saw many people simply fold when the market swung lower, dropping 20%, 30% and even further. Dollar cost averaging works extremely well in principle but it takes psychological resolve to buy into a market that is precipitously falling. Many simply can’t do it and so suffer the downswings without much of the upside.

So while I’m a strong believer in the S&P500 as the best approach to picking stocks, I’ve always wanted an investment product that would signal whether we’re in a market uptrend or downtrend and allow me to take appropriate action. One of the foundational beliefs of the stock market (called Dow Theory) is that it moves in trends. That is, when it goes up, it goes up for a while and similarly the reverse is also true. A trend could be defined as a series of higher highs, and lower lows. So while it’s not possible to predict or perfectly time the market, it should be possible to tell which way we’re trending and then to take informed actions based on this. From a personal perspective, my ideal would be to hold / buy the S&P500 while in an uptrend, and be out of the market altogether during long downturns.

This desire led me down a long journey of research and in my next post, I’ll cover my own work in this area and what I went on to build.


Disclaimer

This post is for education and informational purposes only and is not general or personal investment advice. Under no circumstances does this information represent, nor should it be interpreted as, a recommendation to buy, sell or hold any security, index, ETF or fund. Be aware that all investments carry risk. Investments may lose significant value. Users of these sites should consult an independent investment advisor before conducting any investment. Anyone using this site to inform their own investment choices does at their own risk and assumes all responsibilities for their choices and actions.