Your New Investment Diet
Here’s one simple exercise for quickly improving your investment returns.
It’s New Year: Many of you are on new diets, or at least were for a couple of days three weeks ago. Because yes; most don’t last, and therefore don’t work.
But one type of diet does work: The Elimination Diet. It helps you to figure out what foods are hurting you. And once you know, say, shellfish knocks you flat for 24 hours, it becomes harder to eat it again knowing the pain that will follow.
It’s the same for investing. Once you work out the thing you’re doing that’s losing you money, it becomes harder to do that thing. So you’ll stop losing money. And what’s not to like about that?
I originally wrote this piece for Citywire in November 2021. It served me, and my investors, very well over the car crash that was 2022. I hope it helps you too.
One solution to recurring health problems is the Elimination Diet: remove all but the most basic foods from your daily diet and see if your health improves.
Then, from this pared-back diet, add back the eliminated foods, one by one. If the problems return, you’ve isolated the culprit, and can now avoid a serious cause of ill-health.
Elimination is also a fantastic investment exercise. It allows you to isolate and avoid your biggest causes of ill-wealth. It works on the principle that you’re more likely to improve something by removing unnecessary complexities than by adding more in.
It’s an exercise I undertook many years ago. The improvement was dramatic, and turned out to be the single best thing I’ve done for my investment returns, and with them my career.
As with health, investment problems come in different forms.
Some, like a severe allergic reaction, cause an obvious and immediate issue; a dramatic collapse in your wealth. It’s naturally easier to spot these, but that doesn’t guarantee you’ll learn the right lesson: it’s too easy to blame the prawn (the stock market) when really it was the peanut (being greedy when you should have been fearful).
Others problems are harder to isolate. They’re more like a food intolerance, causing a series of smaller but persistent problems that keep you permanently below-par. Excessive fees and closet tracking are obvious examples. They cause tired-looking returns, but never reveal themselves in outright collapse.
One shortcoming is that, while the food version takes five weeks, the reintroduction phase of the investment elimination diet could take five decades: many bad financial practices only reveal their true, painful nature in a crisis, and they don’t come along too often.
Thankfully, unlike an actual diet, for investments we can back-test; retrospectively removing parts of our portfolio to see if our choices are killing us slowly.
Back-tests aren’t perfect though, so you’ll still need to test carefully in live markets, but they can give you a great head start.
This was how I performed my own elimination diet: I threw out everything bar a global tracker, then built back in the stuff that helped and left out the things that hurt. The results were compelling: I was left with a simpler portfolio that went on to generate higher returns with lower volatility.
I’ll run through my investment diet, but first take note: these are my investment allergies and intolerances and, just as with food, they won’t necessarily be yours. Some are based on an honest assessment of my strengths and — particularly — weaknesses, and not on any shortcoming of the investment itself (others aren’t, but that’s for you to decide).
So what did I eliminate? And what stayed in?
Eliminated: Market timing
As a hobby investor, and early on in my career as a professional investor, I fully believed I could run a portfolio of passive funds, then simply switch them around to out-time the market: deftly entering an asset class, market, or investment style as it rallied, then cleanly exiting shortly before it retreated.
Experience soon showed I couldn’t, making this a costly idea. On top of that, everything I’ve learned from studying, or working with, genuinely great investors also suggests it causes more harm than good. So now I don’t do it. And my portfolio thanks me on a regular basis.
I also avoid fund managers who attempt the same. So ‘macro’ funds are no-go for me, and I work hard to avoid generalist funds that rely heavily on ‘the macro’ (aka market timing).
Eliminated: Direct securities
There are equities in my portfolio, and at a different time to this, I’ll hold bonds too. But I hold them all through diversified funds.
I’ve seen how hard the best managers work to select just a single equity, so I’d be foolish to think that I, with no specific experience or training, could do better in the scraps of time I have between my job and the rest of my life.
So, tempting as it occasionally is, I never buy individual stocks. Getting it wrong would leave a big, nasty mark on my wealth.
Eliminated: Structured products
These remind me of the posters you see in bookies’ windows: ‘£10 on England to win 3–1, and Kane to score first wins £100!’
That scenario sounds entirely plausible — likely even — but I (along with all other humans) am terrible at instinctively cross-multiplying the true odds of different probabilities.
So while England may well win 3–1, or Kane may well score first, the odds of both happening are probably a lot higher than the 10–1 being offered by the bookie (who, remember, understands those probabilities better than I do).
This means I have to rely on providers, most of whom are banks, not to load structured products with hidden risks, while stripping out potential returns for themselves.
Maybe they’re not doing that, and maybe, if I spent enough time analysing them, I could find that out for myself. But there’s only so much time in a day, and my returns vastly improved when I eliminated them. So, with regret, they’re fired.
Eliminated: Alternative assets
I’m sure I’ve thrown some babies out with the bathwater here, but my sense is this tub contains far more dirty suds than it does pristine nippers.
Rory Sutherland, the vice-chair of Ogilvy, provided a useful analogy for explaining my asset selection philosophy. He posed the question; how can you ensure all the utensils in your kitchen are dishwasher proof?
The obvious answer is to buy a load of new kit based on the manufacturers’ claims, but we know that’s not perfect. His solution is better: spend a year putting all your utensils through the dishwasher and, by the end of that year, you know everything left is dishwasher proof.
That’s why, for investment assets, I stick to the proven classics. Equities, bonds, property, cash and gold aren’t perfect, but they’ve survived enough market cycles to suggest they’ll survive a few more too.
But newer asset classes, such as cryptocurrencies, haven’t endured enough wash cycles to justify risking my capital, or that of my clients, finding out.
Sure enough, when I removed alternative assets from my portfolio, first via back test and then in real time, my returns improved greatly. Particularly through market crises, when these assets were supposed to shine.
Survived: Active funds
Thankfully (because otherwise I’d have had to quit my job and become a shepherd), some things worsened my returns when removed. In a nutshell, these were highly active, reasonably-priced, fundamentals-based stock-picking funds run by trustworthy managers.
When I back-tested a portfolio consisting solely of my top picks from this sub-set (with all the stuff above eliminated), my returns improved beyond those of the equivalent tracker. An experience that repeated itself in real time with my funds-of-funds too.
If I stick to this diet, ignore the siren song of ‘the macro’, and remain prepared to move differently to the herd, I expect to average an extra return of around 3% a year over a tracker. That may not sound much, but it will compound up to a huge difference over the twenty-odd years I have left of my working life.
This is why I’m such an advocate for active investing, and why I’m often accused of being biased in favour of active funds over passives. But if my experience is that, for me, they consistently improve my returns while reducing risk, why wouldn’t I be?
However, I’m no zealot. There are still a ton of mistakes you can make with active funds, such as buying one that’s too big, mistaking luck for skill, or mistiming your entry and exit.
So for some people, particularly inexperienced investors with no time or interest in assessing fund managers, it can still make sense to eliminate them from your investment diet, and to stick to the tracker (this is why Warren Buffett, despite being an excellent stock picker, advises most people to go with a basic passive fund).
So there you have it: the investment elimination diet taught me that a simple platter of well-run active funds was the best for my wealth, and for my investors’ wealth too. I recommend trying it yourself: you’ll like what it leaves you.
Here’s an example
I know that many of you, not least my editor, like working examples. So here’s a simple one showing how this can work in practice (and did — these were two of the long-term core holdings in one of my funds of funds).
Evenlode Income, run by Hugh Yarrow, is a multi-cap income fund that specialises in holding the highest-quality dividend-paying stocks. It’s a popular fund now, but it was just starting its journey when I first bought it as the previous decade kicked off.
Schroder Income, managed by Nick Kirrage and Kevin Murphy, has a very different approach. You might call it deeper value, but really they’re looking for perfectly sound dividend-paying companies that have fallen out of favour, and whose prices have therefore dropped too low. They buy them with the expectation of a recovery (this is a style that’s had a very tough time over the last decade).
These are two fairly simple investment approaches, although they require a lot of experience, knowledge and discipline to execute well. The results from putting half your capital in each, then rebalancing every quarter for the last ten years, is shown in the chart below:
You can see that this simple exercise — buying and holding these two well-run active funds — made 195% over the last 10 years (after charges), beating the index’s (and therefore the tracker’s) return by 84%.
This is simpler than my actual investment diet, as I’m happy to add more flavour through small-cap, international or specialist funds. I’m comfortable with their associated risks, and have found they add value beyond even these impressive numbers.
This, for someone of my constitution, is the basis of a very healthy diet.
Originally printed in Citywire in November 2021. Nothing here should be taken as specific investment advice.
