Writers spend a lot of time in their head. I spend so much time in my head I often take for granted the investing journey I have been through and the many things I have learned along the way that have contributed towards me arriving at a very simple investing strategy.

I follow what some people call it the 90/10 rule. Essentially what it means is that I invest 90% of my assets in index funds of stocks and bonds and another 10% to “go crazy” in exotic or fad-like investments. I have my own fads just like anyone else. Personally, I don’t jump into popular tech stocks like Netflix or Tesla. Those can be fun but they get a lot of attention. Attention can be good when it comes to things like options liquidity but it also means big institutional money as well. That type of money can blow a position out of the water. Even if you are right in the long run, in the short term a big investor moving into a stock or exiting a stock can produce severe short term fluctuations that can wreak havoc with small investor positions. Of course, some people trade on those big investor flows as well and that’s great for them. My fad for the moment is in emerging market stocks, I think they have been neglected for some time and are overdue for an upswing. Despite my personal views on fads though, I can offer a few reasons why following the index path can be more rewarding.

First it’s worth acknowledging, this advice will be boring. There is no get rich quick scheme in investing in index funds and playing with a small portion of your portfolio, but that is the point. I had to take big risks, get big payoffs but also get burned, to realize that sometimes the most boring advice is the best advice. At some point I realized grandpa was on to something.

My Journey to Investing Like Grandpa

I was reminded of my journey to this investment style when I was invited to a group chat a few weeks ago by a collection of young, avid investors who are very active.

It brought me back to my early days of investing before the crisis. I remember older people advising me to just put my money in index funds or even to advise on specific sectors of the markets like REITs. I heard their advice and to some extent, I listened to it. When I finally graduated from school with a bunch of degrees, I took the conservative route when it came to my retirement funds. I dollar cost averaged and set the contributions on automatic. The other thing I did was set all investments to a target date retirement fund and then vowed to never touch it under any circumstances.

My after tax savings were a different story though. Much like these young intrepid investors, I had glory on my mind. I spent hundreds of hours scouring the market for those neglected gem stocks. I had no coherent strategy, I followed small cap, micro-cap, mid-cap, large cap, emerging market, developed market etc. I invested in media companies, chip manufacturers, banks, retail stores, anything I thought would blow up and beat the market, proving that I too could make it rich through investing.

Then came the crisis. Unlike the people who took their money and ran, I had such a long term vision that I knew that this may be the opportunity of a lifetime. I waited patiently as the market wobbled in 2008, then Lehman happened and the market fell off of a cliff. In essence, in my first two years of serious investing, the S&P 500 looked like this:

Source: Yahoo Finance

However I was, and still am, a serial optimist. I had faith the market would rebound and I took the time to invest in what the market hated. Banks, real estate stocks and high yield bonds. I made some fantastic returns. Investments in companies like Lowes (LOW), Bank of America (BAC), US Bank (USB), Wells Fargo (WFC) and Markel Corporation (MKL) paid off and I still hold many of these 10 years later.

Other high yield bond funds roared back with double digit returns while I collected fat monthly dividends. I didn’t always know exactly what to invest in when the world was imploding but I had heard people like Warren Buffett de investing in the common stocks of some of these companies and I knew he liked to go against the grain so I thought it was good enough for me.

Being Brutally Honest With Your Results

When you have great returns though, it begs the question: what next? In the following years, this is where I started to stumble. I didn’t have the easy win of the crisis to just pick up low priced blue chip stocks. It went back to being foggy and nuanced. The US was downgraded, the recovery was anemic, it was tough to see where things were going and what the next home run was.

The likely answer at that time (around 2011 to 2013) was the big tech stocks. The subsequent rally in the FAANG stocks was totally missed out by me. Just take a look at how the Nasdaq ETF (QQQ) performed against the S&P 500 (SPY) from 2012 to 2018.

Source: Yahoo Finance

If I had been at the forefront a few years ago, I was left in the dust by the tech returns. Even my crisis era investments started to look dull and tarnished compared to the returns of Amazon, Netflix and Apple. I had a lot of soul searching to do, should I realign my portfolio? Jump in to tech or do something else?

Rather than chase returns of investing past, I decided to sit down and do an honest assessment of my after tax portfolio. Luckily, I had an easy benchmark to compare it to. The whole time I had been researching and chasing home runs, I made singles every two weeks when I contributed to my 401k. I was able to fund a Roth IRA as well which I discussed in my post The Best Investment I Ever Made. I was able to compare what my return would have looked like if I had just invested in a boring old mix of stocks and bonds in one fund all those years.

The results surprised me. Despite all my great 200% returns over time, I had still underperformed the market by a few percentage points. Bad bets in energy and telecoms had dragged down the awesome returns of those bank and real estate picks. My boring portfolio had returned about 10% annually while my after tax portfolio was about 7-8%

The only thing I did have that either matched or beat the market overall were my real estate investments. However those were not due to asset returns but rather leverage. The real estate I owned returned 3-4% annually. I discuss how this return is sent into the double digits with leverage in my post Why Real Estate Makes You Rich (In America).

So after all my years of work, I came to the same conclusion as grandpa: just put it in the index fund.

A Few Exceptions and Things to Note

It’s not all just boring indexing out there, there are a few caveats I want to point out:

1. Research is Still Worth It – This is by no means to say research is not worth it. In fact, some studies have shown that those micro cap stocks which are not covered by institutional analysts, do hold Alpha and have upside (or downside for shorting) for those willing to do the analysis. The link above found the annual return from a micro cap value strategy to be 20% annually.

2. The Small Portion Keeps Your Investing Mind Active – There is a reason I still play with that 10%: it keeps me sharp and keeps me abreast of market developments. It’s also fun, I enjoy doing it, I just want to limit my risk of lagging the overall market too much.

3.The Taxes Are Much Better – indexing usually means you don’t sell funds for many years, this reduces taxes substantially due to the lower rate of long term capital gains. Profits from puts, options and shorting are all short term profits that are taxed like income and you need to include that in your analysis of your past returns, especially if comparing them to the long term index returns.

4. Try Focussing On Leverage – Want to know one secret that many super wealthy use to beat the market? They hold the market portfolio but they just use a little leverage. Yes, there is more volatility but if you are very wealthy and understand long term reversion to the mean return, you likely aren’t phased. I discuss this in my post The Kelly Criterion and Optimal Leverage. If the market returns 10% annually, 30% leverage before interest could boost those returns to 14.3%. Not bad.

Conclusion

Learning from your past mistakes is key and will give you the confidence to be sure of your overall strategy going forward. My initial strategy of being conservative with my retirement funds has paid off handsomely, despite all that has happened in the world since I started saving. It’s annoying to say grandpa or your parents had a point, but don’t forget that they have been there too.

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