Damodaran’s Viral Market Update VIII and the Layman Investor

Professor Damodaran raised poignant insights in his 8th viral market update relating to how the crisis has exacerbated or exposed certain fundamental beliefs. On a more personal note, Damodaran has been an enriching source of learning and I constantly find myself attempting to apply his teachings to my frameworks. The following piece focuses mainly on the discussed topics of (1) value vs growth investing and (2) active vs passive investing.

Growth investing triumphant?

As mentioned by Damodaran, value investing has seemingly lost its appeal and recent data highlights how value funds have lagged growth funds.

The COVID-19 situation did not do value investors the expected justice of punishing firms trading at high multiples of earnings and book values. Instead, data has shown that following old-time value investing rules and selecting stocks with low P/E ratio and high dividends, would have caused investors to lose more than if they have favoured a growth approach.

I definitely do not think that value investing has lost its place in the investing world. But my time spent reading timeless value driven classics including The Intelligent Investor and Security Analysis, have given me the impression that value frameworks can get rather rigid in nature – think predefined P/E and other financial ratios. There can be at times too much focus on assets possessed by the company as opposed to taking a holistic high-level view of the market and exercising forward thinking.

The Passive Onlooker vs The Active Searcher

Sometimes active investing gets placed on a pedestal and glorified – after all, common logic states that those who spend more time perusing the markets for outperformers should consequently receive better yields for their effort right?

Data says no, unfortunately.

Then came COVID-19, a situation where active investors should presumably have excelled in compared to their passive peers (given how active investors could either hold short positions or select outperforming sectors). Surprisingly, there has been no clear cut advantage as distilled by Damodaran’s datasets with active investors generally underperforming based on a range of equity mutual funds.

So what does this mean for the layman?

Active investing is commonly characterised with timing the market and stock picking – at a risk of repeating myself, activities which imply market beating holdings.

Retail investors would do well to follow what the data tells us. Active investing is a gruelling task, offering little respite when placed against institutional investors pumping big money into the market. It is a difficult game to play, putting it lightly.

The best way forward in my opinion is to hold a diversified passive portfolio, spreading your wealth across different industries, asset classes or geographies. As Ray Dalio succinctly puts it: the total amount of wealth in the world does not change very much year on year – the distribution merely changes.

What do you mean by diversification?

Diversifying your portfolio at its core, is a manner of hedging against potential downsides caused by market movement. In finance terms, diversification removes unsystematic risk – business and financial risk.

Let us say you bought stocks in the upstream oil industry and the ecommerce industry. If it is announced that oil is facing a supply glut and oil price tanks, the share price of your holdings will inevitably drop. Your e-commerce holdings will likely mitigate the impact on your portfolio since your portfolio value is split between these two industries. In fact, the lowered oil prices could reduce transportation costs for order fulfilment, potentially benefiting your e-commerce holdings.

Taking it one step further, if you had held stocks which might have a strong negative correlation with the oil industry (e.g. green tech and renewables), there could even be a greater extent of loss offsetting.

Index ETFs like the SPDR S&P 500 ETF Trust, do a remarkable job of diversifying since it tracks the stock performance of the 500 largest companies publicly listed in the US, without an explicit preference for any industry. Holding an index ETF provides diversification in industries for equities.

For diversification in asset classes, one would do well to take a look at other investment vehicles such as fixed income instruments. A popular fixed income instrument are government or commercial bonds, which promise a fixed coupon payment at the end of every period while repaying a face value amount at the end of the bond tenure.

Bonds are generally less risky to hold which implies returns lower than stocks, assuming you do not pick junk bonds. There are a few ways one can employ bonds in your portfolio:

(1) Government bonds – T-bills / SSB / SGS bonds (latter 2 only for Singaporeans)

(2) Commercial bonds – though they usually require a minimum amount of capital which can be in the 5 digits for Singaporeans

(3) Bond ETFs – Nikko AM SGD Investment Grd Corp Bd ETF (MBH.SI)and ABF SG Bond ETF (A35) are two examples

Do note that the bond ETFs are still listed in the market, therefore your holdings will still face some modicum of volatility and will incur transaction costs

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Another way to diversify is to employ some gold in your portfolio. Gold has always been widely viewed as an inflation hedge and with the weakening of the US dollar, gold could potentially see some major plays in the mid to long term. Generally speaking, gold has historically had a negative correlation to equities and investors would combine gold with stocks and bonds in a portfolio to reduce the overall volatility and risk. Gold is a standalone topic for another day but it is very worth considering in a properly diversified portfolio.

The following article makes references to Damodaran’s post which can be viewed at: http://aswathdamodaran.blogspot.com/2020/05/a-viral-market-update-viii-crisis-test.html

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