SMSF

SMSF: Investment Strategy

For those that are SMSF trustees or thinking of starting their own SMSF, the superannuation laws demand that a trustee of a self-managed-super-fund, formulate and implement an investment strategy, and consider any investment in light of the fund’s investment strategy.

Additionally the investment strategy must be reviewed regularly.

SMSF


The Australian Tax Office stipulate the following:

The investment strategy sets out your fund’s investment objectives and specifies the types of investments your fund can make.

Your investment strategy should be in writing and must:

  • be reviewed regularly to ensure it continues to reflect the purpose and circumstances of your fund and its members (your review and any decisions made should be documented)
  • Consider whether to hold insurance cover (such as life insurance) for each member of your SMSF.

When preparing and reviewing your investment strategy, take into account the personal circumstances of all the fund members, including their age and risk tolerance. You need to consider:

  • diversification (investing in a range of assets and asset classes)
  • the liquidity of the fund’s assets (how easily they can be converted to cash to meet fund expenses)
  • the fund’s ability to pay benefits (when members retire) and other costs it incurs
  • The members’ needs and circumstances (for example, their age and retirement needs).

Read more at the ATO website here.


To develop an investment strategy that serves your purposes, we need to begin by defining investment and strategy.


A quick overview.

  • Strategy: Study and understand the rules of the game, before formulating your strategy. Investing involves determining what is within or outside of your influence, for instance, limiting the effects of bias your investment process, and we don’t influence price changes in market stock prices.
  • Investment:  Graham & Dodd formulated investment as an investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.
  • Bringing it together: “Stocks are simply the conduit through which we own a company’s assets. When we invest our capital into a company’s stock, we enter into its particular business. [Hence] analysing a stock involves an analysis of the business. A strategy of buying securities only when their market prices are significantly below the calculated intrinsic value will produce superior returns in the long run.” Ben Graham

You Can Watch Instead of Reading

Strategy

The word strategy came from the Greek word strategos, meaning literally “ the leader of the army.” Strategy in this sense was the art of generalship, of commanding the entire war effort, deciding what formations to deploy, on what terrain to fight on, what maneuvers to use to gain an edge. And as this knowledge progressed, military leaders discovered that the more they thought and planned ahead, the more possibilities they had for success.

Novel strategies could allow them to defeat much larger armies, as Alexander the Great did in victories over thePerisnas. In facing savvy opponents who are also using strategy, there developed an upward pressure: to gain an advantage, a general had to be even more strategic, more indirect and clever, than the other side. Over time the arts of generalship became steadily more sophisticated, as more strategies were invented.

 “Well, then, my boy, develop your strategy. So that prizes in games won’t escape your grasp. Strategy makes a better woodcutter than strength. Strategy keeps a pilot’s ship on course. When the crosswinds blow it over the wine-blue sea. And strategy wins races for charioteers. One type of driver trusts his horses and car. And swerves mindlessly this way and that. All over the course, without reigning his horses. But a win with lessor horses. Keeps his eye on the post and cuts the turn close, and from the start keeps tension on the reins. With a firm hand as the watches the leader.” The Iliad, Homer

Look at things as they are, not as your emotions colour them, for the most effective strategies is born out of the present observable circumstances.

Robert Greene, author of The 33 Strategies of War, identified that;

“The greatest generals, the most creative strategist, stand out not because they have more knowledge but because they are able, when necessary, to drop their preconceived notions and focus intensively on the present moment. This is how creatively is sparked, and opportunities are seized. The better we can adapt our thoughts to changing circumstances, the more realistic our responses to them will be.”

Benjamin Graham and David Dodd, back in the 1930’s, observed these two essential characteristics of the share market:

  • The market prices of financial assets have underlying economic values that are stable and which can be measur ed with reasonable accuracy by a diligent and disciplined investor.
    • The quoted stock price represents a share in the equity of the business.
  • The price of financial securities are subject to significant and unpredictable movements, which occur outside of our control.
  • Bruce Greenwald wrote; Mr Market was the personification of the impersonal forces that determine the price of securities at any moment, shows up every day to buy or sell any financial asset. He is a strange fellow. Subject to all sorts of unpredictable mood swings that affect the price at which he is willing to do business.
    • Asset prices have a tendency to eventually, over time, revert back to their mean.

Investing is a Loser’s Game.

Charles Ellis, published anarticle in the 1970s, describing how institutional investors are playing a losers game.

Here is an excerpt.

Expert tennis is what I call a Winner’s Game because the ultimate outcome is determined by the actions of the winner. Victory is due to winning more points than the opponent wins-not, as well see in a moment, simply to getting a higher score than the opponent, but getting that score by winning points.

Amateur tennis, [Dr] Ramo found, is almost entirely different. Brilliant shots, long and exciting rallies, and seemingly miraculous recoveries are few and far in between, On the other hand, the ball is fairly often hit into the net or out of bounds, and double faults at service are not uncommon. The amateur seldom beats an opponent, but he beats himself all the time. The victor in this game of tennis gets a higher score than the opponent, but he gets that higher score because his opponent is losing even more points.

Dr Ramo, a scientist and statistician, gathered data to test his hypothesis. He found that in expert tennis, about 80 per cent of the points are won. In amateur tennis, about 80 per cent of points are lost.

There are other Loser Games (war, gambling, and campaigning for office) that were Winner Games, like the Money Game in the mid-1920s, when John J. Raskob, a prominent business executive, could write with encouraging title “Everybody Can Be Rich.” The article gave a cookbook recipe to riches beyond the dreams of avarice. The Great Crash abruptly reversed the situation and made investing a Loser’s Game for nearly two decades.

It was during these decades of the thirties and forties that preservation of capital, emphasis on the safety of bonds, and sobersided conventional wisdom came to dominance the foundation was laid for the renaissance of the Winner’s Game. The trouble with Winner’s Games is that they tend to self-destruct because they attract too much attention and too many players-all of whom want to win. But in the short run, the rushing in of more and more players seeking to win expands the apparent reward.

Investing is one of the most fiercely challenging games you can play, with low entry costs, and riches to be won, it attracts a vast number of very intelligent participants, you’re effectively competing in a gold medal match in the Olympics. And considering the fact trading stocks is a zero-sum game – for every winner there is a loser –  by making mistakes you are making someone else rich.

“When luck plays a part in determining the consequences of your actions, you don’t want to study success to learn what strategy was used but rather study strategy to see whether it consistently led to success.”                            ― Michael J. Mauboussin

Two Prominent Human Bias.

Cognitive Dissonance:

Cognitive dissonance refers to a situation involving conflicting attitudes, beliefs or behaviours. This produces a feeling of discomfort leading to an alteration in one of the attitudes, beliefs or behaviours to reduce the discomfort and restore balance, etc.

Cognitive dissonance is the enemy of every investor. We will form a thesis based upon our analysis of a stock, to justify selling or buying, or holding, and then comes along information that shoots a hole through the thesis, telling us we were originally wrong.

For most people it can be emotionally painful to hear accurate information as to why our thesis was wrong. The correct thing to do is check that the information is correct and update our thesis.

Take the example of Bill Ackman, who had invested billions of dollars into Valeant Pharmaceuticals in February 2015. He thought he had identified a CEO with talents matching those identified in the book by William Thorndike; The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success.

And for a period of time, Valeant’s stock price rose from about $161 per share to peak at close to $260 per share, validating his opinion of the stock. But slowly, as new information about Philidor, a Valeant subsidiary, and its possible criminal activities, Bill refused to believe what was happening even after several short sellers informed him.

News of Philidor and a possible Government crackdown on big pharma pricing sent Valeant’s stock price falling, but Bill doubled down and brought more stock. Finally even after after conceding defeat, Bill Ackman had lost about US $4 billion of his clients money.

Availability bias:

The availability heuristic is a shortcut we use to assess the cause or probability of an event on the basis of how readily similar examples come to mind—that is, how “available” they are to us. One consequence is that we tend to over-estimate the importance of information that we’ve encountered recently, that is frequently repeated, or that is top of mind for other reasons.

Investors tend to make decisions based upon the most recent earnings call announcement, without putting new information into business’s context.

First Level Thinking:

“It’s not supposed to be easy. Anyone who finds it easy is stupid.”

Charlie Munger

Howard Marks, co-founder of Oak Tree Capital, wrote about the difference between first level and second level thinking in terms of investing.

“First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first level thinker needs is an opinion about the future, as in, “The outlook for the company is favourable, meaning the stock will go up.”

“Second level thinking is deep complex and convoluted. The second-level thinker takes many things into account:

  • What is the range of future outcomes?
  • Which outcome do I think will occur?
  • What’s the probability I’m right?
  • What does the consensus think?
  • How does my expectation differ from the consensus?
  • How does the current price for the asset comport with the consensus view of the future, and with mine?
  • Is the consensus psychology that’s incorporated in the price too bullish or bearish?
  • What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

“The bottom line is that first-level thinkers see what’s on the surface, react to it simplistically, and buy or sell on the basis of their reactions. They don’t understand their settings as a marketplace where asset prices reflect and depend on the expectations of the participants. They ignore the part that others play in how prices change. And they fail to understand the implications of all this for the route to success.”

Psychologists have known about this tendency for simplistic thinking since Dr Daniel Kahneman, winner of the Noble Prize for economics, published researched explaining how people have two general thinking systems.

System one acts fast and is intuitive, but system two is slow and deliberate, requiring concentration in solving a problem.

System one is susceptible to bias, like our mentioned availability and cognitive dissonance bias’s. Because system two requires a large amount of energy to concentrate, we seldom use it, preferring to use system one, which uses heuristics (shortcuts) to allow us to navigate the world around us.

Take the example of this simple question.

A bat and ball cost $1.10 in total. The bat costs $1.00 more than the ball. How much does the ball cost?

If you immediately thought the ball costs 10 cents, then most likely you came to that conclusion using system one. But the correct answer is 5 cents, as $1.05 is one dollar more than 5 cents.

“So why do so many people answer incorrectly? The answer is that people often substitute difficult problems with simpler ones in order to quickly solve them. In this case, people seem to unconsciously substitute the “more than” statement in the problem (the bat costs $1.00 more than the ball)  with an absolute statement (the bat costs $1.00). This makes the math easier to work with; if a ball and bat together cost $1.10 and the bat costs $1.00, then the ball must cost 10 cents.” (Source –Association for Psychological Science)

The Cure

Creating your own investment checklist will help you avoid bias operating at the subconscious level, as well as helping you avoid missing crucial points during the investment process.

Atul Grande book “The Checklist Manifesto” is a must read. 

Investment

“[W]e think the very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value — in the hope that it can soon be sold for a still-higher price — should be labeled speculation (which is neither illegal, immoral nor — in our view — financially fattening).” Warren Buffett

Benjamin Graham and David Dodd proposed a clear definition of investment in their seminal book; Security Analysis:

An investment operation is one which, upon thorough analysispromises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

The critical parts of this definition are “thorough analysis” and “safety of principal, and a satisfactory return.” Nothing about these requirements has changed since 1934.

 “By thorough analysis we mean, of course, the study of the facts in the light of established standards of safety and value.”

Bruce Greenwald, (RobertHeilbrunn Director for Graham & Dodd Investing – Columbia Business School), observed that the advantage of the value investors approach – first valuing assets, calculating earnings power value, and finally and rarely calculating the value of potential growth – is that it gives the most authority to the element of valuation that are creditable. Asset values depend on tangible aspects of a company’s situation today. Earning power valuation uses the value of current earnings.

It’s much easier to establish with confidence the current market price of land or current profitability of a division than predict the size of the market, one company’s share of that market, its profit margin, and cost of capital 20 years, or even five years, into the future. Ultimately the future does matter, but it’s important to separate what we reliably know today form less secure conjectures about tomorrow.

“The safety sought in investment is not absolute or complete; the word means, rather, protection against loss under all normal or reasonably likely conditions or variations.”

A safe stock is one which holds every prospect of being worth the price paid except under quite unlikely possibilities. Where study and experience indicate that a considerable chance of loss can occur, and it is recognised and allowed for, we then have a speculative situation.

A satisfactory return is a wider expression than adequate income, since it allows for capital appreciation or profit as well as current interest or dividend yield.“Satisfactory” is a subjective term; it covers any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence.” 

What will you measure your returns against?

The ASX 200? A simple Australian Index fund investment? Against a popular fund management firm? A 10– 30 year Australian Government bond rate? Or the Inflation rate (CPI)?

Would you be disappointed if your  SMSF earned 12 per cent return for the financial year if the ASX 200 averaged 14 per cent? (Assuming you sold all stocks at financial years’ end).

What about if you earned 15 per cent against the ASX 200’s 30 per cent?

Or, would you feel better earning minus 8 percent compared to the ASX 200’s return of minus 12 percent?

In the first two cases, your SMSF has increased in value (9 per cent & 12 per cent respectively).

In the last case, you may have beaten the ASX 200, but in absolute terms, you have lost 11 per cent (assuming inflation averaged 3 per cent plus the 8 per cent negative return).

The first couple of suggestions are not recommended as a foundation to base your returns against. Long-term government bonds rates and the inflation rate are the two important ones.

Why?

Measuring returns on anabsolute basis, in real terms, keeps the investor’s feet planted firmly in reality.

Inflation erodes our purchasing power, a dollar today is worth more than a dollar next year, and hence we want to earn rates of return above the rates of inflation.

And,  long-term government bonds are perceived to be risk-free (unless yielding below the rate of inflation), so if we cannot earn rates of returns above the rates of return on long-term government bonds, we should just park our money in long-term government bonds.

The goal is to earn above average rates of return (as compared to inflation and the risk-free rate of return) to one; to firstly not lose money, secondly; achieve our future desired dollar amount to fund our retirement lifestyle.

In retirement, having achieved your objectives, would you look back look back in regret if your SMSF underperformed the ASX 200, 6 out 10 times?

In Summary

Benjamin Graham and David Dodd wrote back in 1934 (Security Analysis):

“Stocks are simply the conduit through which we own a company’s assets. When we invest our capital into a company’s stock, we enter into its particular business. [Hence] analysing a stock involves an analysis of the business. A strategy of buying securities only when their market prices are significantly below the calculated intrinsic value will produce superior returns in the long run.”

Yours in investing,

Article by Adam Parris, Searching For Value


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