Investors don’t all have the same goals, don’t face the same risks and aren’t subject to the same constraints. There are, indeed, all sorts of dimensions of difference between investors. The importance of these differences is often underestimated.
These differences mean, for example, that a market price is not really determined by an asset’s attractiveness to the average investor, but rather by its attractiveness to investors in aggregate. That’s not the same thing at all.
The better you can understand your own goals, risks and constraints, the better you are likely to perform. And these differences can be a win-win: something that is special about this approach is that it’s not a zero-sum game. This is a way to improve your investment program that does not demand being smarter than a whole bunch of other investors who are trying to do exactly the same thing you are doing. This is not about market inefficiency. It’s not about the mispricing of assets. It just needs you to know what you are looking for.
For example, the interest on many municipal bonds is exempt from federal tax¹, and that can make them particularly attractive to taxable investors. That in turn means that their pricing tends to run high from a before-tax perspective; this can make them unattractive to tax-exempt investors. So they should be a relatively larger part of the portfolio of a taxable investor than of an otherwise-identical tax-exempt investor.
Thus, your tax status affects how you want to invest: no surprise there. But this example begins to illustrate the importance of each investor’s circumstances.
Now—tax apart—return is return. How you perceive return looks a lot like how the guy next to you perceives return. Investors by and large don’t really differ all that much on the return side. But when we start to think about risk, we find a much richer source of variation between investors. Risk looks different to different people. So you want to build a portfolio that is focused on your version of risk, not some generic version.
The most obvious example of this is probably LDI (liability-driven investing.) LDI is based on the recognition that pension plans differ from most investors because, for them, rising interest rates are good news: any loss in the value of their fixed income assets is more than offset by a fall in the value of their liabilities. LDI only exists because a whole bunch of corporate plans have said “we’re looking for something different from our investments than other investors are looking for. We’re going to define and measure risk differently than they do.”
But LDI is not the only example. Different perceptions of the relative importance of tracking error versus portfolio volatility will also affect how you choose to invest. Different sensitivities to inflation, different domiciles.
Everybody is looking for something different from their investments. Understanding your objectives, especially if they are unfashionable or ignored by other investors, can make a real difference in your ability to achieve those objectives.
This blog is based on Bob’s speech to the Russell Institutional Summit in Savannah, Ga., in May. The full speech can be seen – with client login – on ClientLINK.