This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.
Almost a year ago, I read a book called "Quantitative Value" by Dr. Wesley Gray and Tobias Carlisle. It remains one of the best statistically oriented investing books I've read to this date. So when Dr. Gray released a new book and offered to give the first copies away for free, I jumped at the chance. In this article, I will review the new book, titled "DIY Financial Advisor - A Simple Solution to Build and Protect Your Wealth", written by Gray, Vogel and Foulke.
Broad Impressions
Let me start by saying what the book is not about. When I first heard the title, I thought that the book was going to contain a practical step by step guide that would help people invest their own savings. However, that's not the case.
There are two parts to the book, and the first part is titled, "Why You Can Beat the Experts". This part consists of four chapters in which the authors try to dissuade you from trusting expert financial advisors. While I think the authors did a good job of making the case against relying on experts, I couldn't shake the feeling that they were probably preaching to the choir. Those who pick up this book will probably only do so after having decided not to rely on experts. For these readers, the four chapters in the first part will reinforce their decision, but they won't provide any practical advice on how to invest their savings better.
The second part of the book, titled "How You Can Beat the Experts", does give some concrete ideas on how an investor could better manage her own money. However, being "concrete" doesn't mean that the ideas are easily actionable.
For example, the authors recommend investing a portion of your money in momentum stocks. While the authors specify the formulas for calculating a stock's momentum, and while such formulas are simple to those who are comfortable with math, I nevertheless know from my own experience that many people will feel intimidated by having to perform such calculations. Furthermore, it will take the average person considerable time to perform such calculations on dozens of stocks.
This last point touches on another impression I felt throughout my reading of this book. While I think the book was written for non-investment professionals, I believe it will take someone with an investment education to fully appreciate its content. For example, this book assumes that the reader knows what Sortino ratios and out of sample tests are, among other jargon.
Although I believe the authors intended audience might have trouble getting full value out of the book, I believe the book offers a wealth of information for another set of audiences - namely, those with some investment education. These sets of audiences may include business school grads, and ironically, qualified financial advisors.
Let me briefly go through each chapter of the book and summarize what I've learned, and add some of my reflections on them.
Chapter by Chapter Review
Chapter 1 - "Are Experts Trying Too Hard?" - begins with a cautionary tale of a fund manager named Victor Niederhoffer who twice "blew up" (i.e. lost most of the clients' monies) his fund. The authors also cite other examples where brainy fund managers and analysts, whom they group together as "experts", turned out to be wrong in their analysis and lost money as a result. The authors make the point that we should never completely rely on expert opinion, as many so-called experts are often wrong.
On the one hand, I agree with the authors' basic premise. I too am very skeptical of most purported "experts" who show their faces on TV, and I feel that this is an important point to relay to would-be investors. However, I believe the notion that we shouldn't trust anybody is a step too far. After all, the authors themselves are experts who are trying to influence our opinion. If we took the authors' words at face value, we should throw away the authors' book as well.
Chapter 2 - "Simple Models Typically Beat the Experts" - continues on the same vein as Chapter 1 with another anecdote of a high profile expert who blew up his fund. This time, however, the authors main point is that simple investment models often beat both more complex models employed by experts, and also intuitive "gut" decisions made by experts as well.
While I again found myself agreeing with the authors' point that simple investment models are best, I wondered how they expected investors to distinguish between simple and complex models. The authors state that an investment model should be as simple as possible, but no simpler. I agree with that. But how do you judge whether a model is too simple or too complex? Unfortunately, I think it takes an expert to determine an answer to that question.
Chapter 3 - "Experts are Biased and Overconfident" - tells us why experts are often so fallible - basically because they're human beings, just like the rest of us. As human beings, experts suffer from a variety of emotional and other psychological biases that often cloud their views. Of course, we non-experts also suffer from the same biases, so I believe this chapter is well worth reading, not only to increase awareness of experts biases, but also to appreciate the biases that may affect our own judgement.
Chapter 4 - "Experts Tell Us Stories, Not Facts" tell us of instances where supposed experts gave plausible sounding explanations and remedies to people's problems, which in hindsight were wrong.
Again in general, I agree with the authors' assessment that many of the stories that experts tell have little value. However, for me, the fact that experts tell stories to convey their message tells us more about the audience that the experts speak to, rather than the experts themselves.
Psychologists have long known that human beings remember stories better than we do facts. Experts who know this therefore tend to use stories on purpose to convey their message, though they could also explain the same message using facts. Furthermore, the media tends to give more airtime to those who tell good stories, because that's what their audience wants.
Finally, I felt that the authors' criticism of Buffett was a little harsh. In the chapter, the authors stated that the strategy followed by Benjamin Graham, who is Buffett's mentor, actually performed better than Buffett's own strategy. The problem I found with this analysis is that what the authors claim as Buffett's strategy isn't really Buffett's strategy at all.
The authors assume that Buffett's strategy involves investing in companies with high scores in a metric called EBIT/Capital. This metric is similar to the ROE metric I blogged about some time ago. However, Buffett doesn't actually invest in companies based on EBIT/Capital. Instead, he chooses to invest in companies with wide "economic moats". Such companies have almost insurmountable competitive advantages that prevent their competitors from taking business away from them.
While companies with wide economic moats tend to have high EBIT/Capital scores, that's not necessarily the case. One famous example of this is Blackberry. At the height of its popularity in late 2000s, Blackberry had very high EBIT/Capital scores as a result of their booming smartphone business. However, Buffett didn't, and would never have invested in Blackberry because the company didn't have a large economic moat.
Chapter 5 - "A Framework for Investment Decisions" - lays out the aspects of investment approach that we should concentrate on, such as minimizing taxes and fees. The chapter also introduces the readers to value and momentum strategies. I felt that this was a good, solid chapter on thoughtful investment approach.
Chapter 6 - "A Simple Asset Allocation Model That Works" - highlights the failings of complex asset allocation models. Here, the authors are referring to asset allocation models based on Modern Portfolio Theory and its successor theories, which you can read about in my previous article. The authors showed that portfolios produced by such theories didn't perform as well as portfolios that used a simple allocation model that divided money in equal parts across different types of investments.
Reading this chapter, I couldn't help but wonder what assumptions they used to create portfolios using complex asset allocation models. Such models are heavily dependent on assumptions, which means that "complex" portfolios created using certain assumptions would have outperformed the simple "divide money equally" portfolios.
Nevertheless, I do agree with the authors that we shouldn't just assume that a complex portfolio is better than a simple portfolio. I believe understanding why a portfolio is constructed the way it is is very important.
Chapter 7 - "A Simple Risk Management Model That Works" - shows how momentum based strategies can be used to minimize a portfolio's risk. The authors here define risk as the degree to which the portfolio's value fluctuates, which is technically termed 'volatility'. The greater the volatility, the higher the risk. The authors show that investments whose prices keep falling tend to exhibit greater volatility, so an investor can minimize the portfolio's volatility by avoiding such stocks.
Now, I should mention that Buffett disagrees with equating volatility with risk, and I personally agree with Buffett. However, I also see the value in minimizing volatility for most investors, as higher volatility can induce a sense of fear. So for most people, employing momentum strategies to minimize risk would probably make sense.
Chapter 8 - "Simple Security Selection Models That Work" - focuses on how investors can generate higher returns on their investments using both value and momentum strategies.
I've written a separate article on momentum strategies in the past, in which I expressed my reservations regarding such strategies. However, I can't deny that employing a momentum strategy would have generated higher returns in the past. I'm still unsure whether momentum strategies can survive the test of time, so I personally will refrain from using them. Still, the authors do a good job of presenting evidence of favour of using the strategy.
The authors also explain a basic rules-based value investing strategy. Although I don't think value investing can be completely reduced to a formula, I do see that using a formulaic approach could be better than not using a value investing method at all. Again, I think the authors do a good job of presenting a case for using value investing.
Chapter 9 - The Do-It-Yourself (DIY) Solution - lays out the exact strategy, based on previous chapters, that the authors recommend using in order to invest your money. I appreciated that the authors were very specific with their ideas, showing what the returns would have been had an investor followed this approach in the past.
Chapter 10 - Some Practical Advice - both encourages the reader to consider investing her own money on one hand, but also cautions the reader on the pitfalls of managing her own money on the other.
I found myself divided reading this final chapter. On one hand, I believe the authors give valuable advice thats backed by psychological research. On the other, I just couldnt help but feel that the reader would come away confused as to whether she really should invest her own money, given the pitfalls.
Whom Id Recommend The Book To
In summary, I found the DIY Financial Advisor to be a conflicted book. On the one hand, it gives a wealth of wisdom on how we should approach our investments and which strategies may hold promise. On the other hand, I dont believe it truly accomplishes the goal of persuading its readers to manage their own money.
Ironically, I believe the investment approach outlined in this book is better followed through a financial advisor. In other words, investors who are convinced that the authors approach is correct may feel tempted to hand the book over to their advisors and tell them to follow the strategies outlined. In fact, thats exactly where the authors are headed next.
In a recent conversation, Dr. Gray mentioned that his firm is in the process of constructing a robo-advisor that follows the strategy outlined in this book. If youre a U.S. investor interested in this service, I believe you should read this book to understand what would happen with your money.
However, that option is not available for Canadians, and so I recommend this book, but only to those who already have an investment background who will be able to appreciate the deeper lessons from it.
Rating: 3 stars.
Disclosure:Neither the author nor MoneyGeek receives any compensation for promoting this book
This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.
