Who Is A “Good” Investor?
Who is a “good” investor?
Judging Investment Performance is akin to peering through a kaleidoscope. Turn the instrument a bit, and the view changes; quickly turning this process into a bewildering exercise.
How should one judge investors/investment performance?
Understanding an investor, or investment strategy style, is crucial for allocators.
This post takes a look at this critical nuance.
A look at two greats: Warren Buffett and Walter Schloss
To illustrate with an example, here is a look at the investment records of two greats: Warren Buffett and Walter Schloss.
Timeframe covers a 38-year period of overlapping years of investment performance for the two investors. S&P 500 index is also included for a comparative picture.
Buffett and Schloss had contrasting styles but followed the basic Ben Graham principle of buying securities at a discount to true (‘intrinsic’) value.
Buffett followed a concentrated portfolio approach in his early life. Schloss, by contrast, used to own hundreds of securities.
A few things stand out from their investment records.
Both investors generated superlative returns over this very long period.
Buffett had the highest overall return, but with a far higher Worst Loss profile. Schloss, by contrast, also generated a superlative return, with one standout.
Schloss’ Worst Loss profile is far lower than the broad market, and even Buffett ‘s risk profile.
Schloss’ approach is a standout even when compared with Charlie Munger: who also compounded at 20% p.a. between 1961–1975 but with a -53% Worst Loss.
The bang-for-the-buck (return per unit of worst loss) highlights the efficacy of Schloss’ approach compared to Buffett and S&P 500 index.
One of the most crucial aspects of generating superior long-run investment outcomes is Risk Control.
“Investment decision should be made on the basis of the most probable compounding of after-tax net worth with minimum risk.”
— Warren Buffett
Focusing solely on Returns is like looking at half the tapestry of a beautiful painting. What is unseen (Risk: Worst loss) is even more important in decision making.
Past worst loss does not help predicting how the next worst loss behaviour could be. Just as past returns are no predictor of future returns stream. However, the worst loss metric helps allocators/market participants grasp the true risk profiles of strategies under consideration.
Who is a “Good” investor?
This is a redundant question. But let us play along, to illustrate how most of us tend to think when faced with such nuances in investing.
Those of us bred on a diet of early Warren Buffett would point to Buffett as the better investor. After all, his concentrated portfolio approach indicates a finely honed punch card. Secondly, the higher overall return seems to make this an easy decision. They seem to know what they are buying (circle of competence, buy a few/bet big in each). As his balance sheet has grown, Buffett’s approach today resembles Schloss’ approach.
Schloss, on the other hand, has demonstrated tremendous Consistency. Schloss has owned a lot of names over his investing lifetime, and yet churned out an outstanding performance.
Buffett has a demonstrated talent for betting on a few winning horses.
Schloss has a demonstrated talent for betting on a number of winning horses.
Both are outstanding in their own way.
The Behavioral Question
As allocators/market participants faced with making decisions with capital, which approach should you prefer?
The choice reveals a lot about the profile of the allocator/market participant.
- Actives (Return Maximizers): Those of us who care only about maximizing return would prefer a Buffett-like strategy. This would be a perfectly valid decision, with crucial caveats included. One cannot accurately predict long-term future return with confidence. One must be willing to ride the periods of painful drawdowns, and potentially years of underperformance, in the aspiration to achieve the riches at the end of the journey.
- Passives (Fee Minimizers): This class of allocators/market participants believe strongly in a passive-only strategy. For those taking this path, it is crucial to understand that a passive-only strategy means fully embracing Market Beta (market worst loss profile, market return).
- Risk Optimizers (Internal Diversifiers): The value of a Schloss-like approach is not only in its potentially attractive odds of higher future return. The most crucial value add is in its aspects of risk control. True internal strategy diversification involves combining investment approaches (a Buffett + a Schloss + passive index) that behave in a complementary manner when taken together.
The decision to include active strategies is a function of the following crucial questions that allocators/market participants must ask:
Does the active strategy have the potential to:
- Meaningfully reduce potential Risk?
- Meaningfully increase potential Return?
- Ideally, both!
- Cost of accessing the active strategy (expenses)?
Summary
Often, the solution to such vexing questions is to compare a strategy with its own cohort. This makes it apparently easier to effect the cliched Apples to Apples comparison.
In many instances (e.g., illiquid strategies) there is not much of a cohort to work with!
Our heuristic nudges us to focus on the headline Investment Return as the overarching vector driving decision making.
Some pointers that could help make this decision easier for allocators/market participants.
- A long investment record.
- Strategy’s Worst Loss behavior.
- The investor’s personality type.
- The investment strategy behavior (potentially lower risk, potentially higher return).
- Minimizing the Big Errors, rather than aiming for a Big Return.
