Swensen was among the most influential investors of his generation and was the pioneer of the ‘endowment model’.
He was also the Chief Investment Officer at the multi-billion dollar fund, Yale, where he delivered top performance over multiple decades.
Over three decades, Swensen took the Yale Endowment from $1.3 billion to over $30 billion, averaging over 12% annual returns along the way.
He showed that less-than-efficient markets offered opportunities for smart investors. He died at the age of 67 after a long battle with cancer.
Swensen’s investment principles were based on the power of diversification to minimise risk. His approach revolutionized the way institutions invested, forcing them to change their narrow focus on marketable securities to adopting a diversified approach across a variety of unusual assets, including natural resource funds, private equity, venture capital and absolute return strategies.
Super-investors vs ordinary ones
Swensen was of the view that some investors achieved superior returns than others because they were able to make high quality active management decisions.
“Few institutions, and even fewer individuals, exhibit the ability and commit the resources to produce risk-adjusted excess returns,” he said in his book
Unconventional Success: A Fundamental Approach to Personal Investment.
He said poor asset allocation, ill-considered active management and wrong market timing were some of the common mistakes individual investors regularly made.
Also, he was of the view that a good understanding of human psychology, a reasonable appreciation of financial theory, a deep awareness of history, and a broad exposure to current events all contributed to the development of well-informed portfolio strategies.
Swensen’s investment tips and philosophy are useful for both institutional and individual investors even today. Let’s look at some of them:-
1. Asset allocation must for superior returns
There are three primary factors that can affect long-run investment performance: A) asset allocation, b). security selection c) market timing
Swensen was of the view that more than 90% of the variation in investment returns for institutional portfolios was due to the asset allocation decision.
“Given the difficulties in timing markets and the challenges of security selection, good asset allocation provides a rational foundation for investment management. By avoiding extreme allocation shifts and holding diversified portfolios, investors cause asset allocation to account for the largest share of portfolio returns,” he said.
Swensen felt security selection and market timing were negative sum games, as some investors win when they select better stocks or time the market correctly, but others lose doing the same thing.
“Finance theory teaches that active management of marketable securities constitutes a negative-sum game, as the aggregate of active security-selection efforts must fall short of the passive alternative by the amount of the fees, commissions and market impact that it costs to play the game. So when investors take into account the fees/commissions charged for doing so, the result is a negative sum game,” he said.
So, Swensen felt that the primary driver of long-term performance has to be asset allocation.
“What assets you own (and in what proportions) are going to be the primary determinant of your investment results, all else equal,” he said.
a) What assets should you own
Swensen said the most sensible approach for investing is to come up with specific asset allocation targets that can be implemented with low-cost, passively-managed index funds and rebalanced regularly.
b) Increase your equity exposure
He said that though future asset returns can’t be predicted, investors can certainly assume that equities would outperform bonds, commodities and cash in the long run. Swensen recommended an increased exposure to equities for those with longer-time horizons.
c) Keep a long-term focus
Swensen believed that investors should look to invest in asset classes that could be expected to generate higher rates of return over the long term, even if they have to give up some degree of short- and intermediate-term liquidity.
“Market participants willing to accept illiquidity achieve a significant edge in seeking high risk-adjusted returns. Because market players routinely overpay for liquidity, serious investors benefit by avoiding overpriced liquid securities and by embracing less liquid alternatives,” he said.
d) Diversify judiciously
Swensen was of the view that investors should diversify a portfolio judiciously. They should divide it into approximately five or six parts and invest roughly equal amounts in each.
e) Keep your discipline
It is vitally necessary to devote sufficient time and resources to the formulation of investment philosophy, strategy and tactics. Swensen said it was important for investors to keep their discipline and not deviate from well-thought-out plans in response to the market chatter, fluctuating economic events and financial market conditions.
f) Conduct an in-depth research
Swensen said before making an investment decision, and even after having made an investment, it is essential to conduct a great deal of quantitative, qualitative, and multi-point investment research.
He felt this should be done to gain and maintain true insight into a proposed investment’s dynamics, degree of uncertainty, competitive position, time horizon, upside potential, exit strategy, and possible worst-case outcomes.
g) Take advantage of short term mis-pricing
Swensen felt investors should develop the ability, willingness and the resources to take advantage of opportunities created by short-lived price changes that are 2-3 standard deviations or more away from normal. “Supremely rational investors take the further step of acting against consensus, rebalancing to long-term portfolio targets by buying the out-of-favor and selling the in-vogue,” he said.
h) Select investment managers carefully
Swensen said it was very important to select a good investment manager to manage a portfolio. He felt investors should devote extraordinary resources to check, cross-reference, and re-check facts, knowledge, and opinions about investment managers.
i) Understand the investment climate
He believed investors should make sure to understand the economic, financial, social, political, and geopolitical environment before making an investment decision.
“Environmental influences almost invariably point investors down the path to investment failure. Advertisements flog stocks at equity market peaks, with nary a mention of diversifying fixed-income assets. After stocks suffer bear-market losses, the media tout the beneficial effects of owning bonds as an important part of a well-balanced portfolio. The overwhelming bulk of messages to investors suggest owning yesterday’s darling and avoiding yesterday’s goat,” he said.
j) Always share knowledge to guide others
Swensen believed successful investors should make it a point to educate the next generation and share their tips and lessons that they have learnt from the market to make the investment journey easier for others. “People think working for something other than the most money you could get is an odd concept, but it seems a perfectly natural concept to me,” he said.
The secret to investment success
Swensen believed to achieve success in investment, it requires sticking with trading positions made uncomfortable by their variance with popular opinion. He said only with the confidence created by a strong decision-making process can one sell mania-induced excess and buy despair-driven value.
“Unless investors truly believe in the efficacy and validity of an unconventional approach to asset management, the end result almost certainly fails to withstand the wear and tear of market forces. Thoughtless,” he said.
Hence, he believed inefficiently priced asset classes with compelling active management opportunities can increase the odds of investment success.
(Disclaimer: This article is based on the book Unconventional Success: A Fundamental Approach to Personal Investment
by David Swensen)