3 controversial investing strategies

May 22, 2018
John Rekenthaler, Morningstar Vice President of Research, talks about three investment miracles.

How does investing work?”

“You put $1,000 into a fund and wait. Eventually, the fund will be worth $2,000.”

“How long does that take?”

“Oh, it depends. Maybe 10 years or so.”

“Ten years! I don’t want to wait 10 years. What can I buy that will make $1,000 in eight months?”

Such went my conversation with a newly minted college graduate. Ah, the impatience of youth. We elders smile, indulgently, realizing that money trees do not bloom so rapidly. Most investment success comes from persistence--participating in the financial markets year after year, decade after decade. The typical large fortune consists of a small fortune compounded over time.

This column seeks the exceptions: occasions when investment shortcuts have worked. These are not recommendations. If getting rich quickly were a sensible, achievable strategy, then many sensible people would achieve that feat. It is not, and they do not. That said, it is useful to know what some have accomplished, both for understanding why those particular buyers succeeded and why most others failed.

1. Entering Las Vegas

The traditional method for accelerating the process is gambling. Once penny stocks and gold, then options and day trading, and today cybercurrencies. The vehicles change, but the path does not.

What they all have in common is their resistance to financial analysis. Buy a high-quality bond and hold it to maturity, and you know almost exactly what your nominal return will be. (The return after inflation, granted, is another matter.)

The math is less certain with stocks, but for profitable, ongoing enterprises, rough calculations are possible. The stock of a company with earnings of $200 million and 100 million shares outstanding, growing at 5% per year during a low-inflation environment, will likely trade somewhere between $30 and $70 per share. Barring highly unusual circumstances, it won’t be $10. Nor will it command $100.

With the gambles, who knows? Penny stocks are such because the businesses don’t really exist. On rare occasion, that changes, thereby rewarding that lottery ticket. The stock then reaches a new and better stage, where it can be analyzed. With gold and cybercurrencies, the guesswork is even greater. As with tulip bulbs, they are worth what somebody will pay for them. It is difficult to say more than that.

(Perhaps I'm being slightly harsh on bitcoin. I am willing to grant that when bitcoin was launched, somebody brighter than I am foresaw that it would generate genuine demand, so that whatever their early price, bitcoin units were a worthy risk. But now? Should bitcoin be valued at today’s $8,700 quote, the peak price of $19,700 that it recorded in December, or something else? Should that something else be higher or lower? I do not know how such tasks can be done.)

2. The Single Egg

A different flavor of gamble is to ignore financial theory by eschewing diversification. Last week’s column mentioned a middle-class couple that accumulated $750 million by investing primarily in the stock of a company, Berkshire Hathaway, that was owned by a longtime friend. Meeting a spectacularly successful corporate owner very early in his career and then entrusting him with your retirement savings is a fine thing, but I do not think it is a practical investment strategy.

Still, possessing but one egg is the most common way to beat the odds. Over the years, millions of American workers have grown their wealth faster by owning company stock than they would have by purchasing a market index fund. That includes yours truly, who pays some attention to financial theory but who nonetheless possesses an oversized position in his employer’s stock, which is Morningstar. (My ophthalmologist swears that the heaviest smokers among his patients are M.D.s.)

The drawback, of course, is obvious. That egg could splatter rather than expand. It is tempting to believe that if we watch an investment very carefully, that we can anticipate problems before they occur. Many have thought that way, but few have been correct. Back in the day, I knew several people at a Silicon Valley firm that, within three years, went from $1 per share to $100, and then collapsed. One employee cashed out on the way up. The rest rode their stock options to zero.

3. Fewer Bucks, More Bang?

The soundest of these unsound paths, I believe, is employing leverage. Not by purchasing securities on margin, at retail interest rates. Doing so is wiser than renting furniture with monthly payments--but only barely. Nor would I advocate holding leveraged exchanged-traded funds. Such funds can be useful tools for institutions, but as the SEC writes, they are ill-suited for everyday investors.

Rather, I mean indirect leverage: investing in securities that carry greater risk, but potentially also greater returns, because they put more than 100% of their assets to work. Such has been the case with the aforementioned Berkshire Hathaway. It effectively invests 160% of its capital because its insurance operations provide loans, in the form of premiums paid today by insurance customers, for benefits that are repaid later. Better that form of leverage than paying a broker 8.5%.

While there is but one Berkshire Hathaway, there are thousands of unregistered funds that use leverage. (By “unregistered,” I mean private funds, as opposed to public mutual funds and ETFs.) This number includes hedge funds, private-equity funds, and leveraged-buyout funds. Although collecting data on such funds is difficult, academics that have accomplished the task tend to arrive at two conclusions. First, unregistered funds do tend to have strong returns. Second, most if not all of that advantage owes to their leverage and not to their managers’ brilliance.

Unregistered funds are not for everybody. By law, they can be sold only to institutional and high-net-worth buyers. No joy here for our restless college grad, with her $1,000 at hand. Should she eventually possess a great deal more money, she might reasonably dabble in such funds. Until then, though, her wisest course is the slow road: the power of compounding, used on conventional assets.

This post initially appeared in Morningstar.com

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