Don Phillips is a former CEO of the research firm Morningstar. In a recent commentary, Phillips discussed what he called the “four horsemen of the investor apocalypse.” I hasten to add that Phillips isn’t predicting any kind of apocalypse. Rather, he wanted to highlight factors that can cause problems for investors. Phillips’s four horsemen are complexity, concentration, leverage and illiquidity. Especially in today’s unsteady market environment, it’s worth taking a closer look at each.
Complexity. In the world of personal finance, two approaches to portfolio construction are equally revered but couldn’t be more different. On one end of the spectrum is what’s known as the Three-Fund Portfolio. Just as it sounds, it consists of just three components: All are low-cost index funds—the first two covering the U.S. stock and bond markets and the third covering international stock markets. Adherents of this approach believe that these three simple funds are all an individual investor should ever need.
At the other end of the spectrum is what’s known as the Endowment Model. Pioneered by the late David Swensen at Yale, this approach represents everything that the Three-Fund Portfolio is not. It includes private equity, hedge funds and all manner of other complex instruments.
What does the data say? It turns out that both approaches have merit. In support of the simple approach is a study by Standard and Poor’s which has shown, year after year, that index funds have, on average, outperformed their actively-managed peers. But there is also data to support the Endowment Model. Over the past 20 years, through mid-2021, Yale’s endowment had outperformed the overall market by more than two percentage points per year.
As a result, despite the data supporting index funds, many individual investors struggle to keep things simple. Seeing the results of Yale and its peers, they worry that a simple mix of index funds might be too simplistic. And thus, they feel compelled to add more “interesting” investments to the mix.
The problem, though, as Swenson himself pointed out, is that what works for a multi-billion dollar endowment probably won’t work for an individual investor. A complex portfolio, in fact, is likely to be counterproductive for individual investors. Swenson dedicated an entire book to this topic. The primary reason Swensen cited is that the types of investments available to institutions like Yale simply aren’t open to individuals. And there are several other reasons why complexity can be a problem.
For starters, a portfolio of complex investments makes it difficult to see, at a high level, what you own. Does your portfolio consist mostly of stocks or of bonds? The simpler a portfolio, the easier it is to answer that question. And because research indicates that this high-level split is the most important factor for a portfolio, it’s critical to be able to monitor where your portfolio stands. The more funds you own, and the more complex each one is, the harder it is to monitor and to maintain.
Another issue with complex investments: They’re typically more expensive. That’s one reason why the Three-Fund approach is so popular. Its three components are typically the three least expensive options available from any fund company. That’s important because there is a correlation between lower cost and better performance. As the late Jack Bogle used to say, “you get what you don’t pay for.”
And finally, a complex portfolio is generally less predictable than a simpler one. That’s because newfangled investments, as well as private investment funds, offer less of a track record to evaluate. A related issue: Because it’s hard to know how a complex investment will perform, it’s also difficult to know how it will correlate with the other assets in a portfolio. The most recent example of this is bitcoin.
Bitcoin boosters like to point out that there is no Federal Reserve that can “print” more bitcoins. With a structural cap of just 21 million coins, bitcoin was perceived as a more stable store of value than the U.S. dollar and thus more immune to inflation. Unfortunately for crypto investors, however, this hasn’t been the case. Bitcoin has sunk in value this year—the opposite of what theory had posited. Perhaps crypto investors will know this for next time. But that’s precisely the point: New and complex investments carry danger because no one knows how they’ll behave in uncharted territory.
In contrast, simpler investments, including those in the three-fund lineup, have long track records and thus well established correlation relationships. As this year has demonstrated, it’s hard enough to know where markets are headed next. But if your portfolio is a black box, it will be that much harder.
Concentration. Phillips’s second horseman seems straightforward enough. Concentration is the opposite of diversification, and diversification is the golden rule of investing. Still, Phillips takes time to emphasize this point because diversification isn’t always easy. Consider the stock market as it stood at the end of 2021.
At that time, growth stocks—Apple, Amazon and so forth—had logged year after year of outperformance. Value stocks, on the other hand—including banks, utilities and manufacturers—had lagged, as had virtually all international markets. The result: Even though logic would have dictated buying more of the laggards, that would have looked like a losing bet and thus been very difficult. After all, investors had for years been punished for buying anything other than those big tech stocks. And yet, this year has seen a dramatic reversal. The S&P 500 index of growth stocks has lost more than 20% year-to-date. Meanwhile the S&P index of value stocks has lost just 6%.
Diversification also applies to bonds. Many investors prefer a total-market approach to bond investing. Trouble is, total market funds have an intermediate-term duration, meaning that they don’t fare well when rates rise rapidly. And that’s what’s happened this year, inflicting unexpected losses on bond investors. The alternative is to split up one’s bond investments among different corners of the bond market, including both short- and intermediate-term funds. In other words, avoid concentration wherever you can.
Leverage and illiquidity. Phillips’s third and fourth horsemen are related. Leverage—that is, debt—and illiquid investments are both factors that conspire against investors when the economy turns south. As we’ve seen this year, investment markets can shift quickly. Making matters worse, there’s the concept that in recessions, “all correlations go to 1.” In other words, when markets start to decline, everything declines together. That is, of course, not literally true, but there is a grain of truth to it. It’s important to understand why.
Consider an investor who needs regular withdrawals from a portfolio during a market downturn. When he considers what to sell to meet his withdrawal requirement, he’d likely avoid the investments that have performed the worst because selling them would mean locking in those losses. Instead, he’ll probably be more interested in selling things that have held up better. That makes sense. But if everyone does the same thing, the result will be downward pressure on those other investments due to the selling pressure. The result: Even the stocks of companies that are doing just fine will often get caught up in the selling and see their shares fall.
Illiquidity is an even bigger issue with private funds. Even in normal times, they limit liquidity by restricting the size and timing of withdrawals. But in times of market turmoil, it can get worse. Private funds often have provisions allowing them to impose, at their discretion, “gates” on investor withdrawals.
Bottom line: When markets are going up, it’s easy and inexpensive to borrow, and it might seem unwise to pay down debt with dollars that could be invested and “working harder.” When everything is going up, it might also feel safe to invest in funds that don’t offer great liquidity. That’s why the only silver lining, in my opinion, of a rocky market is that it provides a reminder—albeit unpleasant—that risk management should never be forgotten. In fact, risk management should always be an investor’s primary focus, with the pursuit of gains second. That can help you stay one step ahead of these four horsemen.