How are investments like apple pie?

Think back to the last slice of apple pie you have had. My last slice, eaten with my wife and two daughters, was delicious. It was out of this world. For me, it was the best apple pie. What makes it special? The recipe (passed down from my mother in law to my wife, Emily) is simple:

First question: why are we using four pie crusts for one pie?!? Read on, and you’ll find out. Second question: how much cinnamon and nutmeg? Some. A pinch, perhaps. You’ll have to figure out how much you like cinnamon and nutmeg, in the context of apple pies, and adjust. It’s not an exact science.

What did we end up with? Several things: two apple pies, an improved knowledge of baking, and a platform for you to invent better apple pies. If you want the juice in the pies to be thicker, you can add corn starch (not well received by our family, but everyone’s different). You could instead add sugar, or pectin. If you want the crust to be more browned, wait longer before reducing the temperature.

Goals shared between apple pies and investments

This apple pie recipe rocks for several reasons:

• You want it. The pies it produces taste very very good.
• You can duplicate it. Want to see how the pie tastes? You can make one.
• You can tweak it. If you use 5 granny smith apples, it still works. If you use more sugar, it will be sweeter, but still delicious.
• You can do it. Five ingredients, none of them exotic, and a few easy steps make a good recipe. It is not a souffle. It does not require you to make that cute pie grid pattern you see in stores.
• You can mess up.  Notice I carefully made you have too many apples, and yet, you still end up with a pie (OK, two pies, but you get the idea).
• You can adapt it. This recipe has been made in a toaster oven, a gas oven, an electric oven, and an GE Advantium oven. It can also use pink lady apples.
• You know what’s going on. There’s no funny business behind the scenes. Even the frozen pie crust can be made by hand. It’s not worth the effort, but it can be done.

What’s odd is that good investment strategies have the same hallmarks, while bad ones fail some, or all of these metrics.

Following the Index

For instance, lets test index investing.

1. Do you want it? Yes, it beats most active managers.
2. Can you duplicate it? Yes, the indexes are supposed to be public information. In practice, this public information can be hard to come by, but in theory you can get it.
3. Can you tweak it? No. You can buy multiple index funds, which is like having a “pie” composed of several different slices from other pies.
4. Can you do it? Not really, but you can buy ETF’s that (in theory) index well. That’s not totally satisfying – more like buying pies from the grocery store rather than being able to make them, but at least there’s a (partial) list of ingredients.
5. Can you mess up? Depends on the index, but given that they are hard to duplicate, messing up is guaranteed. Since all the indexes are correlated, messing up is not likely a problem.
6. Can you adapt it? Sure. Before index investing was “invented” a money manager’s wife got very good performance by investing in all companies that had “American” in the name, and just holding. This had remarkably indexlike performance, which crushed most of the mangers.
7. Do you know what’s going on? If you buy one of the index funds, not really. You kinda know what’s going on, but at least it’s not being actively managed.

As an apple pie recipe, index investing doesn’t work. However there are times you don’t want to make an apple pie. You just need to eat one, and quality is less of an issue. Index investing is perfect for that situation. You don’t get the satisfaction of making the apple pie, and you don’t know (exactly) what’s in there. But you do get to eat the apple pie, and if you follow one of the huge ETF’s (SPY, QQQ, IWM, etc) you get to have cheap apple pie. If you don’t have a good apple pie recipe, this is exactly what you want.

Mutual Funds

How about mutual funds? Mutual funds are a lot like the index ETF’s except that they are:

1. More expensive. Many charge more than 1% management fees annually, not to mention entry or exit fees. Or entry AND exit fees….
2. More variable. Since you have active management, performance can be all over the map.
3. More likely to do badly. 80% of mutual funds underperform each year.
4. More opaque. Mutual funds don’t tell you how they do what they do. That’s their secret sauce. A lot like buying an apple pie without an ingredients list.
5. More of them. There are thousands and thousands of them. Worse, the ones that do poorly are folded into the ones that (by chance) have done well. So the choices around today aren’t a guide to what people actually experienced.

Again, none of this applies to index funds which are (or should be) dirt cheap, and mindlessly follow the index. Index funds are just another way of getting the grocery store generic apple pie. Also, if you have a good mutual fund that’s consistently beating the market, stick with it. Finding such a mutual fund is next to impossible. Personally, I don’t think the search is worth it. It’s easier to become an expert in the stock market. But, if you already have one, stick with it. If he does badly for a year, don’t worry about it, unless the management team changed, or the fund got bought out, or folded into some other fund.

Experts and Newsletters

Next up, following the expert (a.k.a. the newsletter).

1. Do you want it? Maybe. Depends on what the expert does. His fees probably won’t taste very good, though.
2. Can you duplicate it? Not really, as you don’t know why the expert bought what he did. You also won’t buy when he did, and that’s important. Also, most experts don’t share their entire portfolio regularly, so you don’t know how the expert diverifies or handles risk.
3. Can you tweak it? No. You will have no idea whether you are improving on the expert or destroying the fundamental idea.
4. Can you do it? You should be able to, depending on how often the expert trades, and what they trade in. It might be difficult, and it will be boring. Also, when it fails, sticking with it will be really really hard.
5. Can you mess up? You have no idea how robust the expert’s trading is. No idea at all.
6. Can you adapt it? If you are as good as the expert is, you should be able to. If not, good luck!
7. Do you know what’s going on? Unlikely. The expert is not going to share, for fear that you would copy his secret sauce and put him out of business. You’ll learn just enough to convince you the tips are correct. It is all about the sales ability of the expert.

To me, the expert becomes less appealing when judged that way. I’ve heard that from others I’ve talked to. Sticking with an expert is hard, and finding a good one is close to impossible. If you have a good one, then that’s a different situation, though. Like the mutual fund, if you are in the (very) unlikely situation of having beat the market while following a financial advisor or newsletter, stick with it!

Gold and other shiny stuff

Fine. Let’s try something simple. Gold.

1. Do you want it? No. The performance over any reasonable span has been terrible, and highly volatile.
2. Can you duplicate it? Sure. Easily. Buy bars of gold.
3. Can you tweak it? Sure. Silver works as well, as does copper. Not that “as well” is anything to write home about, but that’s not the point.
4. Can you do it. Absolutely. It’s really simple. You just need a good safe.
5. Can you mess it up? How? It’s gold. Although, if you buried it, and forgot where, that could hurt returns….
6. Can you adapt it? Sure. If you have no safe, you could buy a gold ETF. Or if you are really worried about security, you could hire armed guards.
7. Do you know what’s going on? Yes. It’s gold. It sits there.

Notice that the lack of desirability kills gold (at least for me). As an end of the world hedge, maybe, but not as an investment vehicle.

Following your own strategy

Let‘s find out. Let’s test the sample simple value strategy (see the strategy here). This strategy fairly simple (like our apple pie recipe).

1. Do you want it? It certainly beat the index!
2. Can you duplicate it? Certainly! It’s easier with Equities Lab, but we use Morningstar data, and all of our formulas are public. So yes, you can. The results will vary (slightly), based on the data provider chosen, and the process you use to handle the data, but the general idea will be the same.
3. Can you tweak it? Sure! Change whatever you like, and you can test the results, and see how it holds up. It does pretty well for many sorts of changes. Over time these tweaks will represent you evolving it into your apple pie, which will be better than
4. Can you do it? Yes. It trades quarterly, and takes minutes to execute, especially with our trade integration. Yep, that’s minutes per three month period.
5. Can you mess up? Yep. It’s robust on different rebalance periods, subsets of stocks and more. Your mistakes won’t make too much difference.
6. Can you adapt it? Absolutely. Again, you can and should test it after you put in your adaptations. Want only large cap? Want no energy stocks. You can see how much impact those decisions have.
7. Do you know what’s going on. We show you what happened every step of the way. You can see what you bought, and why. Tweaking it will tell you more, and help you make it truly yours.

The tasty conclusion

There are two sorts of investors in the world.

Those who should buy store bought pies

If you have no interest in cooking (investing), you shouldn’t be making apple pies (investment strategies). If you’ve tried it and gotten frustrated because nothing you do works, then keep eating store bought pies until you find a recipe that actually works. Your only job is to make sure that you’re really paying attention to what you’re getting: it’s easy to accept bad results because of intertia or not knowing there’s something better.

Those who should make their own pies

If you like cooking, don’t buy apple pies! Make them instead. You’ll get both the better pie, and the joy of having made it. Similarly, you will get joy out of investing your way, if you have a system that works. If you catch yourself doing any of the following, you should think about baking your own pies:

1. Checking the stock market on Google finance, or similar. Are you going to trade based on the market going up or down? If so, you’d better have a system, or a lot of money you don’t need. Or preferably both. If you won’t trade based on this news, then that indicates you like looking at the market. Maybe you should figure out how to put that liking to work.
2. Checking individual stock quotes. Same story as the market, but more so. People sometimes do this because the individual stock has them worried. Either they have too much invested in it, or they have options on the stock. Using the time you spend checking quotes to learn how to invest is a good investment (pun intended).
3. Reading financial news. Are you really interested in Intel’s future transition to 10nm processes, or are you trying to scope out Intel as an investment? If it’s the latter, then you clearly like investing.
4. You have read investing books recently. I’m always reading investing books. You probably are too. Might as well put all that knowledge to work.
5. Talking about stocks.