Successful Investing Is a Process

1. Active Management is a Negative-Sum Game for Most Investors

Active management is at best a zero-sum game. It means that, collectively, we cannot beat the market, since the collectivity of all investors is the market.

Collective reality. The fundamental truth of active management is that for every investor who outperforms the market, another must underperform. Before accounting for costs, this is a zero-sum game. However, once fees, trading costs, and administrative expenses are factored in, it transforms into a negative-sum game for the aggregate investor base. This means the collective wealth of investors is diminished by the pursuit of outperformance.

Fee drag. The financial industry extracts a substantial portion of investor returns. For instance, estimates suggest that in 2004, the U.S. financial industry transferred $350 billion from investors, representing nearly 3% of GDP. High fees significantly reduce the probability of outperforming a low-cost index alternative. A manager charging 1.0% annually needs to outperform a 0.2% index by 0.8% just to break even, a feat that becomes increasingly difficult to sustain over longer horizons due to compounding.

Underperformance statistics. Empirical evidence consistently shows that a majority of active managers fail to beat their benchmarks after fees. Studies across various markets (U.S., Canada, Australia) and timeframes reveal that:

• Approximately two-thirds of active managers underperform their market.
• For investors paying 1.0% in annual fees, the probability of outperforming the market is less than one in three.
  This stark reality underscores the challenge of consistently identifying managers who can overcome the inherent cost disadvantage.

2. Successful Investing is a Disciplined Process, Not About Forecasting or Star Managers

When I look at asset managers, I no longer think in terms of their expertise and experience, or their so-called forecasting abilities, but in terms of whether or not the investment process offers the necessary underlying structural qualities that can lead to outperformance.

Process over personality. The book argues that true investment success stems from a robust, disciplined process rather than the perceived genius or short-term forecasting ability of "star" managers. Markets are often irrational and unpredictable in the short term, making consistent outperformance through individual stock-picking or market timing extremely difficult. The focus should shift to identifying and implementing structural qualities within a portfolio that reliably enhance performance over the long run.

Cycles and chance. Financial markets are characterized by long performance cycles across asset classes, sectors, and styles. These cycles, often unpredictable, can reward or penalize managers for several consecutive years, making it hard to distinguish skill from luck. For example:

• A manager outperforming for three years might simply be benefiting from a favorable market cycle for their specific style.
• Studies show that a significant percentage of top-performing managers over a decade spent at least three consecutive years in the bottom half of their peer group.
  This volatility in relative performance highlights the futility of chasing past winners.

Replicable qualities. Many successful managers may not even fully understand the true source of their outperformance, attributing it to skill when it's actually due to systematic biases or structural properties inherent in their investment approach. These replicable qualities, such as value or small-cap biases, can be captured at a lower cost through systematic investment protocols. The goal is to "let the market underperform" by exploiting its inefficiencies through a consistent, process-driven strategy.

3. Traditional Capitalization-Weighted Benchmarks Are Inherently Flawed

Our objective is not so much to outperform the market, but to let the market underperform—a subtle but relevant nuance.

Passive is still active. Even choosing a passive investment strategy, such as indexing, involves an active decision: selecting the benchmark. The common assumption that market capitalization-weighted (cap-weighted) indices are objective and efficient is challenged. These indices are not neutral; they are products of specific construction rules and, in some cases, committee decisions that can introduce biases.

Growth bias and instability. Cap-weighted indices inherently overweight overvalued stocks and underweight undervalued ones, effectively participating in market bubbles. Their structure is highly unstable, reflecting market sentiment rather than fundamental economic representation. For example:

• The weight of technology and telecom in the S&P 500 surged from 15% in 1990 to 37.1% in 1999, only to collapse later.
• Canada's S&P/TSX Composite saw Nortel account for over 35% of the index before its collapse, demonstrating extreme concentration risk.
  This "growth bias" means cap-weighted indices are not built for the long-term race, as they amplify market excesses.

Price noise amplification. Cap-weighted indices exhibit a near 100% correlation between the relative mispricing of securities and their weighting within the index. This means they amplify "price noise" – the difference between a security's observed price and its true fundamental value. This inherent flaw makes them inefficient. By contrast, alternative weighting schemes can effectively smooth out this price noise, leading to more stable and potentially higher long-term returns.

4. Volatility Significantly Impacts Long-Term Compounded Returns

Fully understanding the implication of this relationship between ARI mean and GEO mean is extremely important to many aspects of the allocation process.

Volatility's hidden cost. While arithmetic mean (ARI mean) represents the average yearly return, investors' actual wealth accumulation is determined by the geometric mean (GEO mean). Volatility creates a "performance drain," causing the GEO mean to be lower than the ARI mean. The greater the volatility, the larger this drain, directly impacting final wealth. For instance, a 20% annual volatility can reduce the GEO mean by 2% compared to the ARI mean.

Diversification bonus. Efficient diversification, coupled with regular rebalancing, can significantly reduce portfolio volatility without necessarily lowering the ARI mean. This reduction in volatility translates into a "diversification bonus" – an increase in the GEO mean. The diversification bonus is maximized when:

• Portfolio weights are balanced (e.g., 50/50 for two assets).
• Assets have similar volatilities.
• Correlations between assets are as low as possible.
  This highlights that diversification is not just about spreading risk, but actively enhancing compounded returns.

Leverage pitfalls. While diversification can mitigate volatility, applying leverage to volatile assets can dramatically amplify the performance drain. Doubling leverage on an asset with 20% volatility can quadruple the performance drain from 2% to 8%, potentially leading to a lower GEO mean than an unleveraged investment. This mathematical certainty makes high leverage on volatile assets a dangerous long-term strategy, explaining why many leveraged ETFs are unsuitable for sustained investment.

5. Diversification Must Extend Beyond Asset Classes to Risk Premiums

The objective of asset allocation is to appropriately diversify risk premiums in order to create a portfolio that is return/risk efficient and that meets the liability stream of the investor and his or her constraints.

Beyond traditional asset classes. Traditional portfolio allocations, such as a 60/40 mix of equity and fixed income, often concentrate risk in a few dominant risk premiums, primarily equity. This limits true diversification. For example, in a 50/50 equity-bond portfolio, equity can account for over 80% of the total risk due to its higher volatility. Effective diversification requires identifying and balancing exposure to a broader range of risk premiums.

Types of risk premiums. Risk premiums can be categorized into:

• Asset Class: Equity, nominal bonds, inflation-linked bonds, real estate.
• Style: Value vs. growth, small-cap vs. large-cap, momentum, credit.
• Strategy: Currency carry trade, merger arbitrage.
  Studies show that portfolios diversified across style and strategy risk premiums can achieve higher Sharpe ratios and lower drawdowns than traditional asset class portfolios, often with lower correlations among them.

Balancing risk contributions. The goal is to create a portfolio where no single risk premium overwhelmingly dominates the total risk. This can be achieved by:

• Modifying asset risk profiles: Using lower-volatility equity components and higher-duration/credit-risk fixed income.
• Expanding risk premium exposure: Incorporating more distinct and lowly correlated risk premiums (e.g., small-cap vs. large-cap, value vs. growth, momentum).
• Leveraging efficient portfolios: Strategically leveraging less volatile, more diversified portfolios to achieve desired return targets, rather than simply increasing allocation to inherently riskier assets.
  This approach moves beyond simply allocating dollars to balancing the underlying sources of risk.

6. Non-Market-Cap Investment Protocols Offer Superior Portfolio Efficiency

All of the protocols that the authors tested outperformed a standard cap-weight index.

Beyond market cap. Given the inherent flaws of capitalization-weighted indices, non-market-cap investment protocols offer a statistically more efficient way to construct portfolios. These protocols aim to smooth out "price noise" and exploit persistent market anomalies, leading to superior long-term performance. They achieve this by detaching portfolio weights from market capitalization.

Diverse approaches. Various non-market-cap protocols exist, each with distinct characteristics:

• Equal Weight (1/N): Simplest, highly effective at smoothing price noise and diversifying idiosyncratic risk, often outperforming cap-weighted indices.
• Minimum Variance (MinVar): Focuses on minimizing portfolio volatility using the covariance matrix, often biased towards lower-volatility stocks/sectors.
• Maximum Diversification (MaxDiv): Maximizes the ratio of weighted average volatility to portfolio volatility, efficiently exploiting the covariance matrix.
• Fundamental Indexing (RAFI): Weights securities based on fundamental metrics (sales, cash flow, book value, dividends) to represent economic footprint, effectively smoothing price noise.
  These methods consistently demonstrate better risk-adjusted returns than cap-weighted benchmarks.

Empirical validation. Extensive research across global markets confirms the outperformance of these protocols. For example:

• Equal-weight S&P 500 significantly outperformed its cap-weighted counterpart over decades.
• Fundamental indexing (RAFI) consistently beat cap-weighted indices across 23 countries.
• MinVar and MaxDiv protocols show lower volatility and higher Sharpe ratios.
  This evidence suggests that the benefits are not due to chance but to structural advantages that exploit market inefficiencies and behavioral biases, offering a reliable path to outperformance.

7. Dynamic Rebalancing and Volatility Management Enhance Portfolio Performance

Managing the overall portfolio risk (for example, maintaining a constant 5% or 8% portfolio volatility, or managing the entire return distribution) may be more efficient than managing fixed investment weights (such as 40/60 or 60/40 allocations).

Beyond static allocations. Traditional rebalancing, which periodically restores fixed asset weights (e.g., 60/40), is an improvement over drifting portfolios but fails to account for dynamic market conditions. Since volatilities and correlations are time-varying, a fixed-weight portfolio's risk profile constantly fluctuates. A more efficient approach involves dynamic rebalancing strategies that adapt to changing market environments.

Managed volatility strategies. These strategies aim to maintain a constant portfolio volatility or manage tail risk (e.g., using Conditional Value at Risk - CVaR). By adjusting asset allocations in response to changes in market volatility and correlations, these approaches:

• Improve the geometric mean by stabilizing the portfolio's risk exposure.
• Reduce drawdowns during turbulent periods, as exposure to risky assets is reduced when volatility spikes.
• Capitalize on the persistence of volatility and correlation, which are more predictable than returns.
  Empirical studies show that managed volatility portfolios can significantly outperform static allocations, especially in terms of risk-adjusted returns and downside protection.

Rebalancing for enhanced returns. Beyond risk control, rebalancing can also capture "momentum/mean reversion" effects in asset classes. Less frequent rebalancing (e.g., quarterly or annually) can be more profitable than monthly rebalancing, as it allows portfolios to ride favorable relative momentum for longer. However, the optimal frequency depends on market conditions and asset characteristics. Combining efficient investment protocols with dynamic, risk-based rebalancing creates a powerful synergy, leading to superior long-term performance and more stable risk profiles.

8. Tax Efficiency and Asset Location are Critical for Individual Investors

The asset allocation decision (i.e., the allocation among asset classes) cannot be dissociated from the asset location decision (the portfolio in which these assets classes are located), since it may be more efficient overall to locate specific assets in specific portfolios.

Taxation's dual impact. For individual investors, taxation affects not only returns but also risk. Different investment income sources (interest, dividends, capital gains) are taxed differently, and tax-exempt or tax-deferred accounts offer unique advantages. This complexity necessitates an integrated approach to asset allocation and asset location to maximize after-tax wealth.

Strategic asset location. Optimizing where assets are held can significantly boost after-tax returns. Key principles include:

• Tax-inefficient assets in tax-advantaged accounts: High-yield bonds (interest taxed at ordinary rates) and high-dividend foreign stocks are best placed in tax-deferred (e.g., 401(k), IRA) or tax-exempt (e.g., Roth IRA, TFSA) accounts.
• Tax-efficient assets in taxable accounts: Low-dividend growth stocks or municipal bonds (tax-exempt interest) are more suitable for taxable accounts.
  This strategy leverages the compounding power of tax-free growth within sheltered accounts.

Capital gains management. The timing of capital gains realization is crucial. While deferring gains is generally beneficial, it must be balanced against portfolio efficiency. Strategies include:

• Low-turnover protocols: Minimize realized capital gains, especially short-term gains (highly taxed in the U.S.).
• Tax-loss harvesting: Proactively selling assets at a loss to offset realized gains, effectively providing an interest-free loan from the government. This is most effective in volatile markets with high dispersion in returns.
• Avoiding concentrated positions: Diversifying highly concentrated, low-tax-basis portfolios, even if it triggers immediate taxes, can significantly improve long-term risk-adjusted returns by reducing idiosyncratic risk and enhancing the geometric mean.
  The decision to realize gains should also consider potential future tax rate increases and estate tax implications (e.g., step-up in basis at death in the U.S.).

9. Liability-Driven Investing (LDI) Requires a Dynamic, Integrated Approach

LDI should be perceived as a mandate, not to be managed simply by imposing constraints on the portfolio management process (such as maximum equity weight and cash flow matching), but rather by integrating it into the fabric of our portfolio management process.

Beyond simple matching. LDI is a holistic portfolio process aimed at meeting an investor's objectives and liabilities, not merely a product or strategy. For pension funds, this means managing assets to stabilize funding status and contributions. A static approach, simply matching asset and liability durations, is often insufficient and potentially detrimental, especially in low-interest-rate environments or when liabilities are significantly underfunded.

Dynamic duration management. Liabilities have various durations (inflation, real rate, credit). Efficient LDI requires dynamically managing asset durations to align with these liabilities. For instance:

• Nominal liabilities (fixed cash flows) have both real rate and inflation durations.
• Indexed liabilities (inflation-adjusted cash flows) primarily have real rate duration.
  While nominal and inflation-linked bonds can hedge these, their low expected returns necessitate a more dynamic approach. Equity duration, though empirically short-term, can be conceptually high, but its volatility makes it an unreliable direct hedge.

Integrated asset-liability management. A robust LDPMP (Liability-Driven Portfolio Management Process) integrates:

• Efficient asset components: Utilizing non-market-cap protocols for equities and commodities to enhance returns and manage risk.
• Dynamic allocation: Adjusting asset weights based on time-varying volatilities, correlations, and liability characteristics, rather than fixed targets.
• Risk management: Employing strategies like managed volatility to control overall portfolio risk and protect against adverse market conditions.
  This integrated approach aims to create a portfolio that is not only return/risk efficient but also inherently aligned with the evolving nature of liabilities, moving beyond simple asset-liability matching to a more adaptive and resilient framework.

10. Be Skeptical of High Fees and the Illusion of Alpha in Complex Products

The first principle of investing is do not overpay for expertise that is unsubstantiated, for processes that are disguised as expertise, for similar or identical exposure that can be achieved substantially less expensively through other product channels and for guarantees that are unnecessary and expensive.

Fees erode wealth. The financial industry often creates complex, expensive products that promise "Alpha" (excess returns beyond market risk) but frequently deliver only "Beta" (market risk) at a premium price. High fees, especially the 1-2% fixed fees and 20% performance fees common in hedge funds, make it statistically improbable for investors to achieve meaningful net outperformance. This wealth transfer from investors to the industry is a significant drag on long-term returns.

Hedge fund mirage. While some hedge funds may offer genuine Alpha, the industry as a whole, particularly after its massive growth, largely provides a repackaging of standard Beta risks. Replication studies show that a significant portion of hedge fund performance can be explained by exposure to common risk factors (equity, credit, interest rates, etc.) and dynamic asset allocation, rather than unique manager skill. Investors often pay high fees for:

• A more balanced mix of existing risk premiums.
• Volatility management strategies they could implement themselves.
  This suggests that the perceived value of many complex products is an illusion, masking high costs for accessible strategies.

Prioritize efficiency and cost. Before venturing into complex or illiquid alternative investments, investors should maximize the efficiency of their core public market portfolio. This involves:

• Utilizing low-cost, efficient investment protocols (e.g., non-market-cap equity strategies).
• Implementing dynamic asset allocation and risk management.
• Being highly critical of fees, especially for products with questionable Alpha generation or illiquidity.
  Illiquid assets, like private equity, often lack transparent benchmarks and reliable data, making their true risk-adjusted returns difficult to ascertain and potentially overstated. The focus should always be on verifiable structural advantages and cost-effectiveness.

Last updated: September 5, 2025