A few simple questions one should ask oneself before making any decisions in public markets (or that you should as your Advisor):

  1. What extra insight or intelligence do you possess that the person who will be selling the asset to you does not possess?

    Swept up in the excitement of a new investment concept, few investors want to contemplate this simple but critical question. Over 90% of assets are held in institutional portfolios managed by pension funds, mutual funds or hedge funds. There is a sucker on one end of every trade; what makes you think it isn't you?
  2. What non-diversifiable risk are you willing to endure from owning the asset, which other investors are not prepared to endure, and from which you can expect to derive excess return?

    The path to enduring excess returns must pass, every now and then, through a valley of despair. For example, stock investors earn excess returns over bonds because they must endure the misery and doubt of bear markets. But there are other risks that are rewarded in markets, such as the risk of under performing for a long while, or the risk of not participating in lottery payoffs, such as the rare instance where an individual stock experiences huge success. What risk factor are you harnessing with your investments in order to earn an excess return?
  3. What structural barrier is preventing other investors from pricing the asset appropriately?

    There are some corners of markets where there are few natural predators. For example, most institutional and retail portfolios are locked in policy portfolios with long-term strategic weights in stocks and bonds of specific geography, quality, etc. There is no mechanism for these strategic asset class weights to change materially through time in response to changing market conditions. All active investments in these portfolios take place within the individual asset silos, i.e. choosing specific stocks and bonds, rather than choosing how much overall stocks vs. bonds to own. For this reason, the great Paul Samuelson expressed the belief that markets are 'micro efficient, but macro inefficient'.

    As such, investors who have a mechanism to systematically alter exposures to stocks and bonds of various geographies and qualities, in response to changing value or momentum effects for example, can exploit this structural inefficiency. This is the underlying premise behind Global Tactical Asset Allocation strategies.

    What structural inefficiency exists that you are exploiting when you consider making an investment?

We contend that most investors, if they were honest with themselves, would acknowledge that they don't have good answers to these questions. As a result, most investors should default to a diversified passive portfolio, and/or seek out a strategy with:

  • a demonstrable edge;
  • which is exposed to observable non-diversifiable risks, and;
  • takes advantage of an enduring structural inefficiency in markets.

We know what our edge is - what's yours?

© BPG & Associates

Read more commentaries by BPG & Associates