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. It’s worth taking a closer look at each, especially amid today’s rocky financial markets.
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 only 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 at Yale University by the late David Swensen, 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 S&P Global which has shown, year after year, that index funds have, on average, outperformed their actively managed peers. But there’s also data to support the Endowment Model. Over the 20 years through mid-2021, Yale’s endowment had outperformed the overall market by more than two percentage points per year.
One 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 portfolio of index funds might be too simplistic. They feel compelled to add more “interesting” investments to their mix.
But as Swensen himself pointed out, 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. Swensen dedicated an entire book to this topic. The primary reason cited by Swensen: The types of investments available to institutions like Yale simply aren’t open to individuals.
There are other reasons complexity can be a problem. A portfolio of complicated investments makes it difficult to grasp what you own. Does your portfolio consist mostly of stocks or mostly of bonds? The simpler a portfolio, the easier it is to answer that question. Research indicates that this high-level split is the most important factor in driving a portfolio’s risk and return, so it’s critical to monitor where your portfolio stands. Owning more funds—and more complex ones—makes that harder to do.
Another issue with complex investments: They’re typically more expensive. That’s one reason the three-fund approach is so popular. Its three components are typically the three least expensive options available from major fund companies. That’s important because there’s a correlation between lower cost and better performance. As the late Jack Bogle used to say, “You get what you don’t pay for.”
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 a portfolio’s other assets.
Take bitcoin. Its boosters like to point out that there’s no Federal Reserve that can “print” more bitcoins. With a structural cap of 21 million coins, bitcoin was perceived as a more stable store of value than the U.S. dollar and thus more immune to inflation. But unfortunately for crypto investors, 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.
By contrast, simpler investments, including those in the three-fund lineup, have long track records and 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 year-end 2021.
At that time, growth stocks—Apple, Amazon and so forth—had logged year after year of outperformance. Meanwhile, value stocks—including banks, utilities and manufacturers—had lagged, as had virtually all international markets. Result? Even though logic would have dictated buying more of the laggards, that would have looked like a losing bet and been difficult to do. After all, investors had for years been punished for buying anything other than the big tech stocks. And yet, this year has seen a dramatic reversal. The S&P 500 index of growth stocks has lost 23% year-to-date, while the S&P index of value stocks has slipped just 6%.
Diversification also applies to bonds. Many investors prefer a total market approach to bond investing. Trouble is, total bond market funds have an intermediate-term duration, meaning that they don’t fare well when interest rates rise. That’s what’s happened this year, inflicting unexpected losses on bond investors. The alternative is to split up your 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’s not literally true, but there is a grain of truth to it. It’s important to understand why.
Consider an investor who needs to make regular portfolio withdrawals during a market downturn. When he considers what to sell, he’d likely avoid the investments that have performed the worst because selling them would mean locking in those losses. Instead, he’d 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 these other investments. The upshot: 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. In normal times, private funds limit liquidity by restricting the size and timing of withdrawals. But amid 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 the four horsemen.