Chapter 9

What is omitted from your rational portfolio and why

Avoid investments that require an edge or those you already have exposure to

It wouldn’t surprise me if the portfolio I have suggested has many sceptics. It probably looks too simple to make much sense, and leaves out several successful asset classes that have dominated not only the financial press, but also our popular culture. I live in London, a city which has seen an incredible rise in property prices over the past decades. Because of this most investors take for granted that any reasonable portfolio consists at least partly of domestic property. London is one of the places in the world that came through the 2008 crash relatively unscathed so the fans of property maintain their continuing belief.

The asset classes discussed in this chapter will undoubtedly make many investors phenomenally rich in the future, but those will either be investors who have a great edge, charge others a lot of fees or are lucky. Since you don’t want to count on luck, can’t charge other people large fees and have no edge – and probably have a lot of exposures anyway – you should stay away. The eliminated asset classes are still important because you need to be sure that you know they have been considered and that there are good reasons for leaving them out.

A few recurring issues with these other asset classes make them unsuitable for the rational portfolio:

• You don’t have an edge or special insight/knowledge to pick the outperforming subset of the asset class, just like you couldn’t pick outperforming individual stocks in the equity markets.
• The whole asset class does not necessarily have return expectations in excess of the minimal risk asset in future.
• You probably already have exposure to the asset class via companies represented both in your broad equity exposures. Do you really need to increase them further, typically at a much higher cost?
• The other asset classes can be very illiquid – do you get compensated with higher returns for this disadvantage?
• Other asset class exposures can be very expensive in fees and expenses. Unless you have a great edge in picking the right products this can destroy any return advantage.
• There is a marginal case for adding quoted property investments to the rational portfolio although only in limited size relative to the overall equity investment. But because it is small and you may already have this exposure indirectly elsewhere in your rational portfolio, and for the sake of simplicity, property investments have been excluded from the simple rational portfolio.

So, the excluded asset classes discussed in this chapter are:

• real estate
  • residential property
  • direct investments, private property funds
  • commercial property
  • quoted property holdings
• private equity, venture capital and hedge funds
• commodities
• private investments
• collectibles.

Mortgage-backed, mortgage-related and asset-backed securities, other types of quasi-government debt and other debt instruments issued by financial institutions are also excluded. This is because some of them fall into the property category, and others are alternatives to the minimal risk investment, particularly in cases where the investments are quasi government and there are tax advantages. Also, a lot of the exposures those kinds of debts give you are captured indirectly elsewhere in the portfolio, but they are without easy products to gain access to – so in the interest of simplicity and ease of implementation these additional investment possibilities do not add enough additional value to be included. Financial institutions’ debt is a gigantic market (bigger than the corporate debt market), but less of a relevant product for the rational investor as a lot of it relates to the wholesale funding market for financial institutions and there are no easily accessible products available to most retail investors.

Residential property – don’t do it unless you have an edge

Many people reading this book will own their house or apartment. It will often have been bought through the biggest financial transaction of their lives, and be the biggest asset they have. I’m not suggesting that you should sell your house to diversify away from this value concentration risk and put the money in global equities. But I am asking you to strongly consider at least not adding to this often huge concentration of your wealth that you already have in property investments, by adding further property investments to your portfolio of assets.

One of the reasons so many investors are fascinated by property investments has to do with physical proximity. People who are interested in investing often can’t help themselves spotting a great investment opportunity and where better to see it than right in front of you. You might see a decrepit building in a great location and wonder why nobody is fixing it up, and think that you might just be the best-positioned investor to do it. Or hear through a friend that planning permission is going through for an upscale development that would lift the value of an adjacent building, and so forth. Like a lot of people in London, I have been guilty of feeling like a property expert and thought I was an astute property investor until I realised that I had just been lucky and bought into a rising market.

I don’t doubt that many property investors are people with local connections or insight to do this well. Perhaps they have an edge, but unless you are one of those plugged in people, you probably do not have an edge in the property markets. And like the argument of picking active equity managers, picking property investment funds suggests an indirect edge if you claim to be able to pick a manager who has an edge.

So how do you know if you are one of these investors with an edge in property markets? As in the public equity markets it is not always easy to know if you have an edge. Those who perform poorly have a great excuse and those that perform well in the property market are unlikely to think it is luck and will always have other great reasons: they saw something others didn’t, knew something, understood something and heard something. Something. Just be honest with yourself as you consider your edge. It can be expensive to think you have it if you don’t.

Property investors often invest in the same geographical area as their other assets (job, investments, etc.), exposing them to a great concentration of risk in their overall portfolio as a result. There is a good chance that whatever causes the local/regional property market to decline could affect other local assets, in addition to the value of investors’ private homes. Unless you get compensated for this concentration risk by getting higher expected investment returns, the concentration is a risk worth avoiding. And since you as a rational investor are without an edge to outperform, you would not predict this local outperformance, just like you are unable to predict real estate’s outperformance as an asset class. One way to avoid the local concentration risk would be to buy exposure to a global residential real estate investment fund. While that would address the local concentration issue, you already have a lot of exposure not only potentially via your home, but also indirectly via many of the companies in the global equity index trackers (many companies have tons of real estate holdings, are construction related businesses, mortgage issuing banks, etc.). Besides, it is often not practically easy to find a low-cost investment fund with global exposure to real estate, and combining several adds unnecessary complexity in my opinion. Also, it is not clear that the expected returns from a broad investment in residential property are that great.

Has residential property really been that great?

The best estimate of residential property performance is the Case-Shiller House Price index which represents the price changes in US residential homes. Professor Robert Shiller describes the housing index along with other interesting ideas in his excellent book Irrational Exuberance (Princeton University Press, 2016). To my knowledge there isn’t a property index that covers all forms of residential property investment across many countries that goes back many decades for us to analyse.

Using the Case-Shiller index as a proxy for residential property investments since 1890 we can compare the returns of the housing market to an investment over the same time period in short-term US government bonds (see Figure 9.1).

The first thing to note is that over the past century we would have done far better investing in US government bonds than in residential property. It is of course easy to criticise analysis like this for not correctly incorporating rental income (or the ownership benefit of not paying rent), maintenance and improvement costs, transaction costs, insurance costs, and transaction and ongoing tax. Or not being international. I would agree that it is hard to claim that these things are an overly exact science, but this index questions the premise that property investments are necessarily a huge profit centre.

Figure 9.1 Inflation adjusted Case-Shiller House Price index versus short-term US government debt

Figure 9.2 Case-Shiller House Price index versus short-term US government debt and S&P, all inflation adjusted

However, we can also see why property was such a hot investment in the years before the sub-prime crisis (see Figure 9.2).

As property markets outperformed debt and equity markets, many saw this as a sign of things to come and jumped on the bandwagon, even as longer-term data did not suggest that residential property markets outperform in the long run. It’s always easier to sell an investment in something that has recently done well, and property investments certainly did well until the bubble burst. Keep in mind that many countries have regulations or incentives that promote house purchase. As a good friend commented, ‘Where else can you get a subsidised 90% loan-to-value investment with no taxes?’ Of course, all those things should help house prices, but should already be reflected in the prices.

A home

A friend of mine and I were having a conversation a couple of years ago, soon after he had lost his job. He did not have much in the form of savings, about £20,000, but could probably support his family for a year without lowering their living standards. Almost as an aside, my friend said, ‘Thank God we have the house.’

Figure 9.3 Net asset mix

Five years earlier he and his wife had put all their savings into the equity of their house, obtained a loan-to-value mortgage of 80% and bought the cottage of their dreams in South London for £200,000. They loved the house and financially it had been a huge success. An estate agent had told them that they would have no problems selling the house for £250,000 – a tax-free gain of £50,000.

In my view, their situation is fairly typical of a London couple; the vast majority of their wealth is tied up in London property (see Figure 9.3).

Not only were my friends dependent on London property, but with their mortgage they were heavily geared. A decline in the London housing market could have a very significant impact on their net assets, the success of the house purchase not withstanding. Table 9.1 shows how this couple’s net assets of £110,000 (house of £250,000 less £160,000 mortgage plus £20,000 other savings) would be affected by different movements in London property prices, assuming their house moved with the market.

Table 9.1 London house price decline

In essence, my friends were taking an incredibly concentrated bet on the London property market. If the housing market in general, and their home specifically, suffered a decline of 20% they would see their assets decline by 45%; a 40% decline in the value of the house and my friends would almost be bankrupt.

I thought I was stating the obvious, but my friend saw no sense in my argument. He pointed out that if they had taken the £40,000 that they put down for the house and put it in the bank instead, their life savings would be £60,000 today instead of £110,000. Where was the sense in that? I mentioned that if you ignored that a lot of people thought there was a lot of additional quality of life from owning where you live instead of renting, they had essentially taken a geared bet on London property and been lucky. Again my friend thought I was wrong. He felt that they knew the local market and had been able to find an extra-attractive house and that when they bought the house the local property market was about to take off. Instead of luck, they had been astute house buyers. At this point I kept my mouth shut.

I understand and appreciate the desire to own your house instead of renting, and also understand that we badly want to believe that we have made an astute purchase with what for many people is the largest investment of their lives. But buying a property may mean compromising the portfolio of our total assets by increasing concentration risk in a leveraged way, so I would strongly suggest that any house owner takes a look at the fraction of total assets that local property constitutes.¹ Then question what would happen if your local property market dropped in value by various double-digit percentages. Would it matter? Is this likely to happen at the same time as you lose your job or other savings? Would this decline in house prices mean that very few houses were bought and that the resulting lack of liquidity meant that you weren’t even able to realise a lower value of your property if you had to, causing further hardship?

A major part of good portfolio management is about not putting all your eggs in one basket and subjecting yourself to the risk of bad things happening all at once in an unpredictable fashion. For many who were hurt in the recent property bubble, this was what happened. But I do understand why individual investors put great intangible value to owning their own house on top of the large monetary value many have realised over the past decades. My parents have lived in the same house for about 40 years. Their house is not an integral part of their portfolio or an investment – it is a home. If that is somehow sub-optimal from a portfolio management perspective, so be it.

While real estate (broadly defined) is generally considered the world’s largest asset class and therefore impossible to ignore, in summary there are a couple of main reasons to leave residential property out of the rational portfolio:

• You already have a lot of indirect exposure to the sector via your world equity tracker, and potentially you have a huge additional and geared exposure via your residence.
• While the data is fairly poor, it is not clear that the asset class has done that well or can be expected to do so in the future, particularly when you consider the various associated expenses.
• It may not be easy to get the kind of cheap and internationally diversified index tracking exposure to the sector that a rational investor should be looking for.

Private investments (or ‘angel’ investing)

In my personal life, the main way I differ from investing like the rational portfolio is through private investments. I’m incredibly lucky to have a group of talented friends and acquaintances who are doing very exciting things with their careers. Because of my background in hedge funds and finance, a large portion of this group is involved with finance, but certainly not all. Some are involved with various technology or related businesses. And quite frequently I’m approached to invest money as friends or acquaintances start something new or expand an existing business.

Private investments are perhaps an area of finance where we can slightly suspend the rational investment thinking. If you are approached by a friend to invest in her business you may have a lot of insight that other investors do not have. You know a lot about the principal and her history. You will also have heard her talk about the investment before she was trying to sell it to you so you have more of the real story. It could also well be that you are one of only a handful of people who was approached to invest money in the venture. As a result there is no real ‘market’ for the investment, but if there is then perhaps you are the investor with the most edge in that market. Since it’s essentially the presence of an active market for securities that leads to a price that we don’t think we can predict better, in the absence of that market there could be an opportunity for investing at favourable prices.

There is unfortunately not a great amount of good and reliable data on private investments (outside the more institutional methods like venture capital, etc.). Many involved with private investments are notoriously bad at sharing performance data with the wider world. This is probably because many high-net-worth investors are reluctant to share information about their private portfolios, although exposure to the tax authorities may also play a role.

Poor information non-withstanding, according to a recent survey of studies on angel investing² the average annual return to angel investors was 27.3%, which is obviously phenomenal. I would, however, suggest that there is an extremely heavy selection bias (only good results get reported, or people start reporting only after getting good results), and that if you had blindly invested in all angel deals the returns would have been substantially lower and perhaps fairly unimpressive. The report also states that 5–10% of the investments make most of the profits and the majority fail.

We all live in hope of being the first investor into the next Google or Facebook, but reality is probably far less glamorous. For most investors, making that investment has the probability of a lottery ticket even as many recount their near misses. But of course some people have become rich buying lottery tickets. I was president of the Harvard Club featured in the movie about Facebook (The Social Network) – the Phoenix Club – and know several people close to the founders. The endless ‘could have/would have/should have’ stories have inevitably followed.

The emergence of peer-to-peer (P2P) or crowdfunding platforms like Lending Club or Seeders has provided investors with a new path to get loan or equity participations across a broader range of projects and companies. Although still in its nascent stage, the growth rate of this new form of raising money has been impressive. To my knowledge the track record of performance at least among the debt platforms has been very decent while giving you the ability to create a diversified portfolio of small private investments – the performance data in the equity crowdfunding space is less robust. If you do invest via P2P or crowdfunding, make sure you have considered your edge (reason why you should be the investor), and concentration risk in your investments. Many of the equity crowdfunding businesses will ultimately fail. Also some of the platforms themselves may be at risk of failure in the future, so make sure you know where you stand with your investments if that happens. That said, P2P and crowdfunding is still a miniscule fraction of capital invested in the overall context of the financial markets so don’t worry too much about missing out if you give it a miss.

Generally, and beyond the scope of this book, here are a few things to think about if you are considering potential private investments:

• Edge Are you in the analytical or informational position where you are the right person to be making this investment? A private investment may be a bit like buying a lottery ticket – a bad idea if you have average odds, but potentially interesting if you can better your odds somehow. But someone who is without an edge or advantage who blindly invested in every private deal that came her way would see a queue of people trying to take her money and would soon run out.
• Portfolio How does the investment fit in with your other assets? Would it tend to go wrong at the same time as everything else? Is it related to your job or area you live in? If you have several of them do they represent a substantial portion of your assets that may act similarly to each other?
• What do you invest? A lot of private investments become very time consuming in addition to the money invested. Are you getting paid for the time and expertise? Of course you may think it’s fun and could lead to future opportunities.
• Liquidity Private investments tend to be very illiquid and there will often be no ‘bid’ for your stake. At least for short-term financial planning you should probably treat a private investment as ‘dead’ money.
• High failure rate There may only be a 5–10% success rate in angel/private type deals. While the pay-out in case of success may be great you should be ready to lose the entire investment. Think about how this extremely high risk/return profile will affect your portfolio and investing life in general.

If you overcome some of the issues involved in making private investments there are some potential great advantages including:

• There are often tax advantages to private venture-type investing, particularly in development or clean tech sectors. Use them!
• You can use your expertise and skillset to add to your profits.
• Depending on the investment there are potentially large pay-outs that an investor investing in broad indices will not have in general (markets don’t go up 100 times). In a book that is extremely anti-get-rich-quick, for the lucky/skilful few, private investments can offer the rare exception.
• If private investments are not dependent on general economic conditions, etc. they may be a good diversifier to the rest of your portfolio where the various assets will generally be correlated.
• If you make a private investment, despite being a rational and cautious investor, you will probably only do so after long study and serious consideration. This will serve you well. Good luck!

Other asset classes left out

As mentioned earlier there are several additional asset classes left out of the rational portfolio. A full discussion of omission for each class can be found in the Appendix, but here is a brief summary of the logic for leaving them out.