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Investor 500: So crazy they just might work

If the 2008 crash left you doubting the conventional wisdom, consider these three heretical strategies.

They say rules are meant to be broken. Yet there are some sacrosanct investing principles that seemingly should never be violated. Among the commandments: Diversify thine portfolio, and gamble not using borrowed money. All three of the following investing ideas flagrantly violate key principles you’ve likely read about in sensible texts or had drilled into your head by earnest friends and relatives. We explain why these ostensibly crazy ideas might just work – and why following them might prove the stupidest thing you can do with your money this year.

Crazy idea No. 1:
The 100% Equity Portfolio

The idea: Ignore everything you’ve heard about maintaining a balance of stocks, bonds, gold and other instruments. Stuff your portfolio entirely with equities. One proponent of this concept is Stephen Jarislowsky, the chairman of Montreal-based investment counsel Jarislowsky-Fraser and an eminence grise of Canadian investing. In his 2005 book, The Investment Zoo: Taming the Bulls and the Bears, he suggested that Canadians “invest only in top-quality, largely non-cyclical growth stocks that have a predictable high rate of earnings and, hopefully, dividend growth.”

Why it might work: This approach rests largely on a single observation: that over time, stocks generally provide superior returns to other instruments. Data from Barclays Capital, for example, show that U.S. and British equities provided returns averaging more than 5% a year over the past 50 years, more than double U.S. government treasuries and U.K. Gilts. Given the widely recognized relationship between risk and return, this is not surprising. Taking past as prologue, some suggest the only sensible thing to do is buy equities and ignore everything else.

Jarislowsky argues there’s little profit in the bond market – inflation and taxes swallow most of the returns. “Bonds may have a place in your investment portfolio but are not very appealing over the long term,” he opines. By contrast, stock dividends are taxed less, and corporations also invest in themselves to keep growing. “The crux of your success will be selecting leading companies’ stocks and then holding onto them for many years,” Jarislowsky declares. The all-equity portfolio has the added attraction of being relatively simple and straightforward.

Pitfalls: There are good reasons why many advisers suggest holding a mixture of asset classes. Economist Harry Markowitz explained why in the 1950s. While reading a popular book on valuing investments, he came across the suggestion that a stock should be valued by its expected future dividends. “If the investor were only interested in expected values of securities, he or she would only be interested in the expected value of the portfolio; and to maximize the expected value of a portfolio one need invest only in a single security,” Markowitz later explained. “This, I knew, was not the way investors did or should act. Investors diversify because they are concerned with risk as well as return.” He realized that while securities are typically correlated – that is, they typically rise and fall in tandem – this correlation is imperfect. “To reduce risk, it is necessary to avoid a portfolio whose securities are all highly correlated with each other,” he reasoned.

Since stocks and bonds often behave differently under the same market conditions, they can be used in tandem to reduce investment risk while still achieving the same return. Better still, the benefit can be had without sacrificing returns. Here’s a modern take on Markowitz’s insights: “If you follow basic investment principles – and in particular are well-diversified within each category – you will eliminate many of the specific risk characteristics that are unique to a single investment,” says the American Association of Individual Investors.

Diversification is still possible in equity markets. But if you insist on the 100% equity portfolio, you’d best make your time horizon a long one. Looking back at the annual historical returns of various asset classes – as large investment firms routinely do in sales literature – the inevitable conclusion is that guessing which asset classes will outperform in a given year is a crapshoot. The upshot? The 100% equity portfolio is dangerous for short-term investors and those with weak stomachs. A final word of caution: historically, equities have suffered lengthy periods of poor performance – the past decade, for example.

Crazy idea No. 2:
Invest using borrowed money

The idea: Borrowing to invest has long been a controversial tactic. It’s all the more so in the wake of a financial crisis spurred in part by skilled financial engineers who created highly leveraged derivatives and either failed to comprehend, or were indifferent to, the inherent risks. So this crazy idea might sound particularly unhinged: invest using other people’s money.

Why it might work: Leverage is popular because it allows those with little money to behave as if they have a lot more. (Covet not thy neighbour’s Lexus, for it may in fact belong to his banker.) In the hands of a disciplined investor, other people’s money can be used to supercharge a portfolio. Some argue it can even reduce risk.

Even enthusiastic supporters of leverage seldom counsel reckless use. Talbot Stevens, an author and financial educator, advocates what he calls “conservative leverage.” Many debt-averse investors already use relatively inefficient leveraged investments, such as mortgages and car loans. In his book Dispelling the Myths of Borrowing to Invest (a good starting point if you can find a copy), he argues that a leveraged portfolio of diversified investments can be less risky than a mortgage or car loan. “Used responsibly, borrowing can also be a strategy for achieving investment goals, where you pay lower, tax-deductible interest rates to purchase investments that grow in value.”

The trick, naturally, is to manage the risk and still earn sufficient return to justify the costs of borrowing. A common fallacy is that the return must be greater than the interest rate on the loan. “This is true only if the investment returns are taxed at the same rate, and at the same time, as interest,” Stevens wrote. “Investments that are largely capital gains, like equity mutual funds, have tax benefits that render the myth false: tax deductions, taxed less, and taxes later.”

Two Yale professors suggest leverage can actually reduce risk. That may sound strange, but makes sense once you consider another, almost universal strategy: to lean one’s portfolio heavily toward equities when young, and then gradually shift into less risky, lower-return instruments with age. The problem is that a typical person has less available capital to invest in youth and more later in their careers; therefore, a person following this approach can wind up investing disproportionately in fixed-income instruments over their lifetimes. In a 2008 paper, Ian Ayres and Barry Nalebuff proposed a solution. “Buy stocks using leverage when young,” they counsel. “Following this advice leads to higher returns with lower risks.”

Stevens posits an additional, and perhaps unexpected, benefit. Unlike the “pay yourself first” strategy advocated by David Chilton in his famous The Wealthy Barber, payments on investment loans cannot easily be suspended to pay for a vacation or luxury vehicle. Thus borrowing may effectively compel an otherwise undisciplined person to save.

Pitfalls: Leverage has several obvious hazards. One is that it cuts both ways. Since it also magnifies losses, improper use can result in destitution, leaving the unwary borrower living in a cardboard box beneath an underpass. Given the hazardous nature of leverage, Ayres and Nalebuff suggest a maximum leverage of 2:1 ($2 in debt invested for every $1 in cash) – considerably less, they point out, than the leverage typically employed in home-buying. Further, they advise leveraging retirement funds only in youth, when the investor has time to rebuild if things go wrong.

Even 2:1 leverage may be inappropriate for many Canadians. The average debt-to-income ratio in this country now exceeds 145%, a level many regard as reckless. How much leverage you take on is a matter of personal comfort, common sense and a host of other factors. Piling investment-related loans on top of already significant mortgage and consumer debt could well amount to financial suicide.

Leveraging demands a certain inner calm that eludes many investors. Watching portfolios gyrate wildly (as they have in recent years and throughout modern history) can be stressful enough; using borrowed money can make it downright terrifying. Anyone attempting this should first ask themselves how they’ll feel when they receive their first margin call.

And that leads to a final observation. Leveraging adds an additional layer of complexity to investing, including some intermediate mathematics. If you want to keep things simple, consider giving borrowing a wide berth. There are, of course, many ways to use leverage to invest, from short-term RRSP loans to using lines of credit to buy non-leveraged investments. It’s complicated – and Stevens strongly recommends that anyone employing leverage do so with the help of a trusted financial adviser.

Crazy idea No. 3:
Concentrate your portfolio

The idea: In his 2008 book The Investor’s Dilemma, the late author Louis Lowenstein suggested mutual fund investors look for equity funds with “a tightly constructed portfolio of perhaps 30 to 40 stocks” – as opposed to the typical fund, which can have four times as many holdings. Do-it-yourselfers can apply the same principle.

Why it might work: Warren Buffett put it this way: “Wide diversification is only required when investors do not understand what they are doing.”

Lowenstein wasn’t against diversification per se. Rather, he objected to diversification as practiced by many mutual fund managers. (Lowenstein’s book was about American mutual funds, but the same observations apply to their Canadian counterparts.) A highly diversified portfolio mightn’t be so much an indicator of sound risk management, he suggested, but rather of cowardice. “A typical stock fund, with 160 stocks, has scattered its shots, hoping that its mistakes won’t hurt it,” he alleged. No wonder, he scoffed, so many mutual funds track the broad market closely – only lower, naturally, on account of their various fees and expenses.

Let’s face it: unless a manager has superhuman powers or a large staff, he isn’t likely keeping a close eye on the financial statements and corporate developments of 160 companies. For Lowenstein, a big fan of deep value investing, the mark of a good manager is one who conducts rigorous analysis and “backs up the truck” when that rare opportunity presents itself. “The huge bonus of a concentrated portfolio is that you can buy a large amount of what you really like,” he wrote.

Moreover, there’s a law of diminishing returns when it comes to diversification. In an article published in 1999, Canadian academics Sean Cleary and David Copp studied returns of different sized portfolios of TSX-listed stocks between 1985 and 1997. Unsurprisingly, the results demonstrated that the standard deviation of monthly portfolio returns declined in a randomly selected equity portfolio as more stocks were added. But this decline isn’t uniform; it’s much more pronounced in the first 10 stocks than it is for the next 10, and so on. “It appears that 30 to 50 Canadian stocks are required to capture most of the benefits associated with diversification,” the professors observed. “However, substantial benefits occur by diversifying across as few as 10 stocks.” The question of how many stocks is enough is obviously highly subjective.

For investors in Canadian stocks, this approach has additional appeal. Toronto isn’t New York or London; Canadian equity markets are small by international standards, suggesting fewer investment opportunities are available here. A portfolio of 100 Canadian stocks runs a great risk of holding illiquid junk. And one might ask why some stock funds hold three, four or even all five of Canada’s largest banks in their top 10 holdings. Clearly, the manager is not backing up the truck.

Pitfalls: Whether this crazy idea is for you or not depends on how you view markets. Modern investors can be divided into two categories: Those who believe smart managers can beat the market, and those who don’t. Many in the latter category point to the incontrovertible evidence that the majority of mutual funds underperform their benchmarks. But then, if that’s how you feel, perhaps you should fire your portfolio managers, abandon stock-picking and invest in indexes instead. It’s cheaper, and this suggestion certainly doesn’t apply to index investors. But if you’d rather have a managed portfolio – by a professional or yourself – then you’ll have to confront the issue of how much diversification is enough. Finding the answer is anything but straightforward. But if you do that, you’ll have a better sense of which rules can safely be broken.