Should Your Portfolio Be More Exotic?

As Managing Director and Head of Global Financial Strategies at Credit Suisse, Michael Mauboussin advises clients on valuation and portfolio positioning, capital markets theory, and competitive strategy analysis. He has also authored three books -- Think Twice, The Success Equation, and More Than You Know -- and is an adjunct professor of finance at the Columbia Business School, and chairman of the Board of Trustees at the Santa Fe Institute.

No longer content with just win, place, or show, gamblers are placing more exotic bets than ever before. Should investors be looking at exotics as well? It's hard enough to do well just sticking to the fundamentals, Mauboussin says, so most investors are probably better off keeping it simple.

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A transcript follows the video.

Matt Koppenheffer: Now I've got to ask this, since you brought up horse racing. I've done a little bit of that. I lived in Las Vegas -- you have to!

One of the things that I've read is that, because of the way the betting happens on the horse tracks, going into the exotics, where there's more uncertainty, there's more potential for money to be made, versus just betting a straight win bet, or a show bet, or something like that.

Taking that over to investing, is there reason for investors to go beyond just buying a stock -- going into options, going into stuff that's more exotic -- to look for better opportunities?

Michael Mauboussin: Super interesting question. By the way, I was looking at this not too long ago and, in the 1970s, like 75% of all bets were win, place, show bets. They were just plain vanilla bets, and that's really changed quite radically in the last 20 or 30 years. Now, most bets are exotic bets.

But there's an interesting feature about exotic bets that's important to underscore. It's that, even when you make those successfully, you lose a high percentage of the time. But when you win, you win a lot. It's this very different payoff scheme, which is you lose, lose, lose, lose, and then you make a lot.

Psychologically, that's very difficult for people to deal with. I think for the average person, it's very difficult. I think the sharp handicappers can make a living betting the exotics, but it's very difficult for the average handicapper.

Moving over to the world of investments, look. My attitude is, for most investors, keeping it simple makes the most sense -- which is having a diversified portfolio that's relatively low cost, and rebalancing. Those are the things that actually probably make the most sense for most people.

Now, if you have time and attention, and some proclivity to do this, you might be able to use some sort of strategies that are options strategies and so forth, but for me, wandering too far away from that core ... I guess it depends what you want to do, but wandering too far away from that, the payoffs don't seem to me to be too exciting. I would probably ...

Koppenheffer: Stick to the ... it's hard enough, within just ...

Mauboussin: It's hard enough. Again, even following basic principles, it's hard enough.

One of the things I will say -- and I call it the most depressing statistic in investing -- is that you look at the market over, let's say, the last 20 years for the S&P, it's up about 9% or so. And the average mutual fund is up 7.5% or so; the difference being, primarily, fees. But the average investor has only earned about 6%.

It doesn't seem to make sense at first blush -- 6% when they're investing in mutual funds -- but the answer is, it's because of bad timing. They're putting money in at the top, and they're pulling money out at the bottom.

Say 6 over 9, so their earning ... call it 60-80% of the market returns. You compound that over a generation or two ...

Koppenheffer: It's huge.

Mauboussin: It becomes very substantial. To me, if you say, "Where are my opportunities?" rather than saying "I'm going to get fancy with exotics," it's saying, "I'm going to try to get rid of that behavioral mistake, and that 150 basis/2 percentage points of performance," and by staying the course get much closer to the market's rate of returns, and let that compound.

That's going to be a much more fruitful, and I think much more powerful way to get to your financial objectives.


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