#47 - Alex Shahidi: 4 Biggest Mistakes Investors Make

0:05Welcome to the Insightful Investor Podcast, a weekly series that seeks to share industry, investment, investment, and market insights. We define insights as concepts that are counterintuitive, widely misunderstood, or underappreciated. In other words, unique ideas that you probably won't hear elsewhere. I'm Alex Shahidi, the host of the podcast and co-CIO of Evoke Advisors, a leading investment advisory firm. Learn more about our show at insightfulinvestor.org.

0:38Welcome to today's podcast, where our main goal is to share insights that hopefully help you become a better investor. Today's episode will be a bit different. Instead of interviewing a guest, like I normally do, I'd like to share personal insights from my 25 plus years in the investment world. During this time, I've had the privilege of advising on billions of dollars in client assets through both roaring bull markets and some of the biggest bear markets in history. I've also had the honor of learning from some of the greatest minds in finance, many of whom have been guests on this podcast. We've certainly had some incredible guests and they've shared all sorts of insights on how to get an edge in investing.

1:17But here's the thing I've noticed. When you really listen to these great investors, there's a common thread. They're not just focused on finding the next big opportunity. More often than not, they're really good at avoiding the big mistakes that can really set you back. So today I want to flip the script a bit. Instead of chasing after that elusive edge, let's talk about the common pitfalls that even smart investors fall into. Because it may be easier for some to avoid these mistakes than to try and learn and maintain an edge. All right, let's dive in. I'm going to walk you through what I think are the four biggest mistakes investors make.

1:52I've seen these mistakes pop up again and again, no matter how experienced the investor. And I hope that by shining a light on them, you might recognize one or two that resonate with you and perhaps allows you to avoid making the same mistakes in the future. Investing at its core is guided by a set of fundamental principles, this is one thing that I've learned, that are completely logical and have withstood the test of time. These first principles form the foundation of sound investment strategy, in my experience. Yet time and again, I've witnessed investors from novices to seasoned professionals, even those who have been in the business a very long time, these people often make decisions that directly contradict these first principles.

2:36So what are they? Number one, don't put all your eggs in one basket. Seems very elementary, but I've seen so many people violate this very simple rule. And I think a lot of it is just unknowingly violating it, which we'll get into. Number two, buy low, sell high. These are very simple concepts. Everybody knows this one, but most do the exact opposite, and it's for understandable reasons. Number three, invest for the long run. We've heard this many, many times. The challenge is that the long run often extends beyond what many investors realize. And I've noticed its definition seems to be getting shorter over time.

3:17And the fourth one, which we'll cover today, is avoid overconfidence in your ability to predict the future. Everywhere I look, smart people are trying to predict what comes next, and they make a very compelling case. But I found that if you look at it objectively, they're often wrong far more than many realize. So we'll dig into that one as well. Don't put all your eggs in one basket. Buy low, sell high, invest for the long run, and be very careful about trying to predict the future. It seems very obvious, very logical, but these first principles are, in my opinion, far too often violated. Let's talk about the first one.

3:59Don't put all your eggs in one basket. Let's start with diversification. That's basically what that is saying. I think it's important to discuss why diversification is so important. We've heard of the saying, diversification is the one free lunch in investing. And the way to think about that is if you are well diversified, you can effectively get similar returns for less risk than if you're less diversified. And so think of that as the free lunch because you're not really giving up anything. You're not really giving up returns. You're just taking less risk to get to the same place. So it seems like that's something investors should think about taking advantage of.

4:38There's no reason not to. So that's why it's important. The next point I'll make is, and this is something that I think a lot of people don't fully appreciate, is that the conventional portfolio is not well-diversified. I'll start with a quick story. This was probably a decade ago. I had lunch with a portfolio manager who was managing a, air quotes, balanced portfolio. And the strategy was a 60-40 type of approach, meaning a target allocation of 60 % stocks, 40 % bonds. and that's commonly referred to as a balanced portfolio. That's very conventional and many investors use that as a starting point to build their portfolios.

5:19And so we were having lunch and I asked them, I said, you know, I just have a very simple question. And by the way, he'd been managing this fund for 30 years. He'd recently retired and it seemed like he'd done well. Returns were good. The fund had grown significantly in size, well-known firm. And I said, let me ask you a simple question. why do you call it a balanced portfolio if it's not balanced? And he looked at me and he said, what do you mean it's not balanced? Everybody knows 60-40 is a balanced portfolio. And I said, yeah, but how can it be balanced if that 60-40 portfolio is 98 % correlated to the stock market?

5:55So he said, no, no, no, that can't be true. You have 60 % in one asset, 40 % in another asset. and on average, those two assets are not correlated to one another. Therefore, that 60-40 portfolio can't be almost 100 % correlated to one of those assets. He said, that doesn't conceptually make sense. And I said, no, I think you're missing something. The 60%, the stocks are far more volatile than the 40 % in bonds. And you're overweighting the asset that's far more volatile. Therefore, directionally, the volatile assets that you're overweighting essentially drives directionally how that portfolio does.

6:37If stocks do well, portfolio does well. If stocks do poorly, portfolio does poorly. It's almost 100 % correlated. He had this look on his face. Something was explained to him that he hadn't even thought about before, even though to me it's just very obvious. And he said, huh, I've never looked at it that way, but let's talk about it a little bit more. So we talked about it and I said, you can just do the math. You can open up an Excel spreadsheet, you can put 60-40 returns and you can calculate the correlation to the stock market over whatever timeframe you want, the longer the better. And the correlation is going to be in the high 90s.

7:13And I said, and if that's true, it can't be balanced. It can't be well diversified by definition. If you have a total portfolio that is almost 100 % correlated to any asset, that can't be diversified by definition. And he said, well, if that's true, I agree with you. And he said, you know, when I get home, I'm going to run the statistics myself. And he did. And the next day he called me and he said, I'm so embarrassed. I've been managing this portfolio all this time. It's almost too simple of a question to think about and to ask. And he said, I'm embarrassed. And I'm really glad we had this conversation, but I feel like I didn't do my job in making investors aware of this.

7:53Very, very simple measurement that you can do in minutes. It hit me that, wow, this was their life. For 30 years, they didn't see this very simple thing. And I think part of it is we get so caught up in our work and managing portfolios. And sometimes the most simple questions are never considered because you're just past that point. And I think it's easy to look around and say, this is the way everybody does it. It's probably the right thing. and every once in a while somebody comes around, oftentimes somebody who isn't steeped in all this, and ask these simple questions and it really makes you rethink it.

8:27And by the way, this isn't something that I discovered on my own. I learned this by talking to really smart investors. And once I learned it, it struck me as something unusual. So I spent some time thinking about it, researching it. It's one of those things that once you understand it and the light turns on, you want to share it with others because it's such an important concept that is widely misunderstood. So I think that's one of the big rules that are constantly violated is all the eggs are in the stock market basket. And that's a very risky basket in which to bet your portfolio on. And the reason isn't because stocks are volatile, everybody's aware of that.

9:07And it's somewhat because we know stocks can drop a lot. And I guess the philosophy is just don't sell when it drops and you'll be okay. But the part that I think most people miss, because they're probably too zoomed in, if you zoom out, it's more obvious, is the stock market can go through very long periods where it does poorly. And to give you an example of that, if we just think about the S &P 500, the beloved S &P 500 that has been on a long bull market for 15 years now, it's gone through long stretches where it's done poorly. So if we go back almost 100 years, we had a 20-year stretch from 1929 and 1949, where the S &P averaged 0 % a year for 20 years.

9:50Then it averaged 17 % a year from 1949 to 1966. So great bull market. Then from 66 to 82, it averaged 5 % a year for 16 years. And that 5 % sounds okay, but cash earned about 7 % during that time. So the S &P underperformed cash by almost 2 % a year for 16 years. Then from 1982 to 1999, we had a historic bull market for 17 years. The S &P averaged 20 % a year. It's hard to imagine an average of 20 % a year for 17 years. And just when you thought that stocks would go to the moon, you had a nine-year stretch where the S &P was negative 6 % a year from 2000 to 2009. And we had two 50 % drops. So you experience massive volatility and you average negative 6 % for nine years.

10:38And since the global financial crisis lows in March of 2009, the S &P through September has averaged 16 % a year for 15 years. So you go through these long periods where great returns and long periods through terrible returns. And the average over that full period has been about 9%. During the bull markets, those long-term bull markets, 18 % has been the average. And during the long-term bear markets, the average has been zero. And so in some ways, you could think of it as a coin flip because those bull markets and bear markets each have made up about half the time since 1929. So if you think about it from that perspective, it's almost like a coin flip.

11:17Heads you win, tails you lose. And it's not that clean because those timeframes, it's hard to know when you're in a bull market and when you're in a bear market until time has passed and you can look back and see the clear inflection points. But if you just look at that data and you're thinking about the bet that you're making in investing, and if all your eggs are in that stock market basket and you just happen to get tails and it's a bad 10, 15, 20 year period, that's really hard to recover from. I think the main point is you don't have to take that risk. My sense is that many investors, many professionals are taking that risk, not fully appreciating how big of a risk that is.

11:57And so I think that's part of the reason this rule of don't put all your eggs in one basket persists, is there's just not a full appreciation that that risk is actually being taken. So let's talk about how do you conceptually get more diversified than basically betting all of it on the stock market. Conceptually, the way to think about it is to invest in multiple return streams. Think of each of these asset classes or managers or strategies as return streams. It's a stream of returns that is unknown what it'll be, but you have some sense based on history and understanding of how the fundamental pricing works.

12:37But they're each streams of returns. And what you want is a bunch of return streams that are individually attractive, but diverse to one another. And part of that analysis is backward looking. How have they done in the past? What has been their diversification in the past? But you also have to consider what the future may bring in terms of those returns. And I'm not talking about predicting the future. I'm talking more about appreciating what caused those returns in the past. And are those causes going to be the same or different in the future? So part of it is understanding the environment? Was it during a falling rate environment?

13:14Was it during an inflationary environment? Was it during an economic boom, et cetera? So you got to look at it through those lenses. But if you can find individual return streams that are attractive yet diverse, because what drives their returns is diverse, the drivers, that's the key. If you can put all that together, then theoretically, and we're still talking at the conceptual level, you can build a really well-diversified portfolio of these individual return streams and benefit from that free launch of diversification. So if you just think about it, if you can find 10 things that have an equity-like expect to return, but don't necessarily go up and down with stocks, so they go up over time, but they go up and down at different times, that should produce a more consistent return through time than one that has all its eggs in one basket.

14:04Okay, so let's go one level down from there. The way I think about all these return streams is to categorize them into three different categories. Category one are public markets. So these are investments that are easy to access. They're relatively low fee. If you're a taxable investor, you can access them through ETFs where you have very low taxes. And the goal there is to try to find a diverse mix of those asset classes. So that's category number one. Category number two, I call them hedge funds that hedge, strategies that are going long and short markets. Some are public markets, some are private markets.

14:44But the key is that they're hedging the market risk so that you're not just investing in something that goes up and down with the stock market and you're paying more fees and getting worse terms, but something that is truly differentiated. I'll call them low correlated or uncorrelated to public markets. The third category are private markets. So that falls into the groups of private real estate, private equity, private credit. There's a lot of other truly uncorrelated private markets. So those are the three categories. So let me zoom in on each of them one level further. Public markets, most people think about stocks and bonds, and they try to diversify across stocks and bonds.

15:21I think you can even get more diverse than that. And this is relatively easy to do. So stocks, there's global stocks, not just US stocks. So you can diversify across US, non-US, emerging markets, and so on. There's maybe 13 ,000 or so stocks and being more diverse, I feel is better than trying to be more concentrated. Now that hasn't been the case for a while as US stocks have been the place to be, but that doesn't persist through time as market cycles play out. So diversified portfolio stocks. Bonds, there's a wide range of bonds. I like to emphasize high quality bonds because what you want the bonds to do is outperform when growth is weak, when stocks fall, and you want them to provide that diversification benefit.

16:06So assets like treasuries, I think are interesting in terms of a diversification tool. Inflation link bonds is another important asset class. I think that's heavily underutilized in portfolios. You think of that as a hedge against rising inflation, which can cause both stocks and bonds to do poorly at the same time. So inflation-linked bonds are TIPS. Assets like gold, which has been around a long time, and you have to look at the returns since 1971 when we came off the gold standard. It's a lot better than most people realize. It's not that far off as stocks for 50 plus years. And then commodity producer equities, the companies pulling the commodities out of the ground, returns have actually been very high.

16:44It's a really good diversifier. So those are just simple examples of other assets that are publicly traded, easy to access, and they're the focus because it's a relatively efficient space, public markets. It's hard to outperform because there's just a lot of information. There's a lot of players competing. So there I tend to focus on minimize fees, minimize taxes if you're a taxable investor and maximize diversification. To me, that's low hanging fruit. And if you can do those things, then you'll probably be ahead of most people because in my experience, most try to be active. So their fees are higher, their taxes are higher and their diversification isn't as good as it could be because it's mostly concentrated in stocks.

17:26So that's public markets. Hedge funds that hedge look for strategies that exhibit low correlation and understand what drives the returns and why you should expect low correlation. And very good stress test is periods like 2022 when both stocks and bonds fell considerably. Managers who were up during that time or held up really well, it's a good stress test. 2008 is another good stress test. First quarter of 2020 when COVID hit is another good stress test. And then just understanding fundamentally how they manage the portfolios. But the focus there is things that are diversifying to public markets.

18:01And then private markets look at all these different segments in less efficient spaces. My experience with private markets is there's a lot of room to have operational efficiency beyond what the average investor does to generate excess returns. There's less liquidity. The market's more fragmented. There's just more opportunity to have an edge. It takes a lot of underwriting, but there's potential to add returns through time and you can be diversified. So think about it if we take a step back. Public markets, be diversified within public markets. Hedge funds focus on strategies that exhibit low correlation.

18:39Private markets, a lot of opportunities there. And you put all that together, that portfolio is far more diversified than one that is effectively putting all its eggs in the stock market. And the way to conceptually think about it is you have a spectrum. On one end, you have what everybody else does, which is think of it as a 60-40 type of framework, where all the eggs are in the stock market basket. That's conventional, but it's not that well diversified for the reasons that I described earlier. On the other end of the spectrum, On the far other side, you have a super diversified portfolio that includes all these return streams that I described.

19:17Diversified public markets, hedge funds, private markets in a diverse way within each of those. And that portfolio is way more diversified than one that is basically putting all its eggs in the stock market basket. And so think of that as a spectrum. Each investor should understand two things. First off, that there is a spectrum. It's important to know that you have choices across all these things and to recognize that there is a spectrum. So I think that's number one. Number two, and I think professionals also have this responsibility, is to think through where along that spectrum is the right point for each investor.

19:53And it's not as simple as saying, on paper, more diversified is better because we don't live on paper. We live in the real world. And people have biases. They have reference points. Where are you comparing yourself to? They have various time horizons, different levels of sophistication, different levels of access to all these things. So each investor should recognize there's a spectrum, try to figure out where along that spectrum is the right point for them, because you have to factor in all these other influences in determining whether you have a successful investment journey or not. And so, for example, if you're constantly looking at the stock market, like most people are because that's what's on TV.

20:36It's what's in the paper. It's what people talk about. You ask somebody, how is the market doing? You're asking about the stock market. You're not thinking about the bond market or the real estate market or any other market. It's usually referencing the stock market. So if that's your reference point, the stock market is up 20 and you're up five, are you okay with that? If the stock market is down 20 and you're down 15, are you okay with that? Those are important questions. And if you're referencing to the stock market to judge success or failure, then you should be closer to that side of that spectrum, more market-oriented portfolio, more conventional, less diversified.

21:14If you're truly a long-term investor, you appreciate a more diversified portfolio, you can get you to the same place through a smoother path. You've tested yourself. It's one thing to say it. It's another thing to actually do in a practice. You've tested yourself. You've been through three, five, 10-year periods where being more diversified gave you worse results than if you were less diversified. The last 10 years is a very good example of that. If you've tested yourself through those periods and you've held on and haven't changed your approach, then maybe you can be more on the fully diversified portfolio.

21:48And most people are probably somewhere in the middle. And so I think it's this personal journey. As an advisor, I'm thinking about what's the right point for each client. And you go through time and you're always trying to optimize for the right point along that spectrum. And the more education there is, you can probably be more diversified. The less emotion there is, probably more diversified. The less focus on near-term results, the more diversified. But there is probably a right point for each person. And so that's conceptually how I think about implementing all the thoughts that I just shared with you.

22:20Okay, so let's go to mistake number two. This sounds very obvious. Buy low, sell high. If you're an investor, it makes sense. You buy things when they're down and you sell them when they're up. And that sounds like a pretty profitable strategy. I don't know if anybody would disagree with that. But the investment industry is unique compared to other industries. And one of the reasons is that markets and even managers are reliably mean reverting over time. And it's also very difficult to distinguish luck from skill. Particularly public markets are relatively efficient. So all of that introduces a lot of complexity.

23:00So what most people do, in my experience, is there's a tendency to follow momentum and chase returns, as opposed to being attracted to lower prices. And that's unique to the investment world. So if you think about it, if you're out shopping and something's on sale, you look at that and say, oh, it used to be$40, now it's$30. I'd rather pay$30 and$40. So that's pretty obvious and intuitive. In the markets, when something goes down, what people tend to do is they extrapolate past returns into the future. So if it's been going down, they'll look at that and not say, oh, it's on sale. They'll look at that and say, it's going to continue to go down.

23:42And I don't want to own that. So that is very interesting. Even though they know buy low, sell high, most people do the opposite. They buy high and sell low. When something has gone up a lot, whether it's an asset class or an individual security or a manager who's been outperforming, it's easy to look at that, look at the past returns and extrapolate that into the future. And so people tend to buy high and vice versa. When something's doing poorly, it's easy to extrapolate that into the future and want to sell that. Even though we know we should be doing the opposite. It's just really hard to do it in practice.

24:18And I think part of it is we see past returns that's published. It's in front of us. We see those numbers. We don't see future returns until they happen. You have to, in some ways, try to predict what the future returns are going to be. Part of the challenge is not fully appreciating the cyclicality of these returns, meaning there's a warning out that's ubiquitous. It's past returns are not indicative of future results. We see that everywhere. Anybody who publishes returns, they are required to include that disclosure. It's often ignored in my experience. And I don't think it's intentional. I think it's just part of the way humans are hardwired.

24:58I'm sure many of us would nod our heads to, yes, I've seen that happen. I've probably done that myself. But the data also supports this. If you look at funds, they tend to grow in assets after a period of great returns and assets tend to shrink after a period of poor results, whether if it's absolute or relative to some benchmark, whatever that reference point is. And I think the point of talking about this is people should just be aware of that natural tendency. And I think a lot of it is just emotionally driven. And it's also driven by the lack of appreciation that markets go through cycles.

25:36So usually the best periods follow the worst periods and vice versa. And I think it's because markets are relatively efficient and assets tend to be overbought and oversold. So those cycles tend to get exaggerated. So moving to implementing in practice, I'd say there's two ways to try to implement a process to buy low and sell high. First, which is probably more difficult, is to consider focusing more on adding underperforming asset classes or managers and reducing outperforming asset classes and managers. It can be very counterintuitive when you look at it in terms of backwards returns, but it should be more intuitive if you go back to the first principle of buy low, sell high, and also appreciating that markets tend to be cyclical.