What’s Your Investment Philosophy?

“The important thing about an investment philosophy is that you have one.” - David Booth

Regardless of whether or not you are a fan of Capital One credit cards, you have to admit “What’s in your wallet?” is pretty catchy. Maybe that’s because it gets to the heart of the matter so quickly. At the heart of solid investing is a similar key question: “What’s your investment philosophy?” Let’s explore why that’s so important.

Step One: You Think, Therefore You Are

First, at the very least, you should have one.  As recommended by Dimensional Fund Advisors chairman and co-CEO David Booth, having any sort of investment philosophy is a critical first step in grounding you, and directing your decision-making toward your desired ends.

You’d think that would be a given, but many investors would be sorely put to articulate an overarching plan behind their individual trades.  In the absence of an “all-weather” philosophy to guide your way, you’ll struggle to make sense of the economic news you hear. You’ll react emotionally to short-term market fluctuations and the crises du jour proclaimed by the media.  You’ll spend too much money on unnecessary trades or lack the confidence to act boldly when it’s in your best interests.

Step Two: Make It a Good One

Even better than having any old investment philosophy is to have a good one. It should fit well with your personal goals and risk tolerances.  It also should be based on the wealth of academic evidence on how markets are expected to reward patient investors.

Read our evidence-based Investment Philosophy and see if it makes sense to you.   Contrast it with questions I hear from those who have not yet crafted their best-laid investment philosophy: (1) Is the stock market being manipulated to benefit one political party? (2) If Governor Romney is elected president, will the stock market go up? (3) When will Facebook’s stock go back up to its issue price?

Our answers are, in order, probably not, maybe (maybe not), and who knows? These brilliantly non-committal answers reflect that they are the wrong questions to begin with.

If long-term market growth trends upward — and all evidence to date indicates that it does — why not focus on that instead? Wall Street often profits on flimflam, pretending that you need guru prognosticators to predict impending individual winners and losers, but the evidence indicates that you’re best off ignoring these theatrics and adopting a sound investment philosophy to carry you through.

We elaborate on this theme in our Key Insights quarterly newsletters

For example our April Key Insights newsletter recommended focusing on what you can actually control:

• Forget about trying to forecast near-term moves in the market.
• Form a sensible investment plan that aligns your personal goals with the market’s long-term risks and expected rewards.
• Implement a well-structured portfolio to reflect your plan.
• Stick with it.

If you’ve ever read the book or seen the movie Moneyball, you know that one of the practices of Oakland Athletics’ general manager Billy Beane is to avoid watching his team’s baseball games live.  Why would a manager do that?  Because he knows he might succumb to irrational decisions based on the heat of the moment.  Instead, he stays focused on his evidence-based philosophy on how the game is best played.

Similarly, you can fret about your investments play by play, or you can follow a sensible long-term approach based on the evidence of what will bring you the most “wins” for the least cost.  The choice is yours. 

 

 

Become a Better Investor

It is challenging to find the right investment manager.  At a minimum, you want someone who is knowledgeable, ethical and takes the time to understand your goals and present situation.  Last week’s post on Greg Smith’s resignation from Goldman Sachs outlined some of the pitfalls you may experience with the wrong firm. 

While there is more to life than money, having enough of it when you need it most is extremely important.

The end goal of finding the right investment manager isn’t (or at least shouldn’t be) merely to amass piles of money.  It’s to form and adhere to a plan that offers you the best chance for achieving what you most want out of your life, while avoiding too many painful setbacks along the way.  If you look at investing through this lens, it clarifies how you and your advisor can view your wealth management in the same, best light:

Begin at the beginning: create a plan

Are you and your advisor guided first and foremost by a mutually formed plan that defines your unique financial goals and describes a sensible process for achieving them?  If not, what else can you rely on besides blind luck to find your way (and how reliable is that)?

Ensure that your goals drive the process

I recommend that your plan be in the form of a written Investment Policy Statement that you and your advisor have signed, and that you revisit together periodically to ensure that it continues to reflect your evolving circumstances.  By sticking with this approach, you’re investing according to your own goals, rather than the whims of an ever-fickle market.

Find a fiduciary

Financial intermediaries such as brokers expose you to potential and real conflicts of interest.  While some transactions are “perfectly legal,” by definition, they may benefit the broker and not you.  In contrast, a Registered Investment Advisor (RIA) is legally obligated to form a fiduciary relationship with you, which means that the RIA must act in your highest financial interests in managing your wealth.

If someone is determined to break the law, a written agreement isn’t going to stop them.  But, it is beyond me why anyone would open themselves up to the prospect of being legally ripped off (in the form of unnecessarily higher costs or less-appropriate investments), when it is so readily prevented by ensuring your advisor is a fiduciary.

Talk the talk

Have an investment strategy.  A plan is a great start, but, ultimately, it’s only as good as your ability to stick with it.  An advisor’s key role is not only to help you design your plan, but to serve as your constant ally in adhering to it under all market conditions.   He or she should consistently encourage sensible investment activities and remind you what you’re about if you are tempted to stray (such as panic-selling when the markets turn bearish, or chasing hot streaks when the market’s on a tear).

Walk the walk

Last but certainly not least, your advisor should establish his or her business and service offerings to complement rather than conflict with all of the above. Some of the characteristics to look for include: 

• Transparent, fee-only arrangements.  Greg Smith’s Goldman Sachs op-ed piece illustrated all too clearly the conflicts of interest that can arise when your “advisor” is operating in an environment in which portions of his income are in the form of often undisclosed commissions and similar incentives coming from outside sources.
• Arm’s length custody.  Your assets should be held by a separate custodian, who sends regular, independent reports directly to you, so you can substantiate your advisor’s activities on your behalf.  Ideally you should have online access to your account.
• Passive management.  Easily a topic for another post, but the recommended investment solutions within your portfolio should be optimized to help you achieve your personal goals. Briefly, this translates to funds that are “passively” managed to capture available, long-term market risk factor premiums as effectively and efficiently as possible.  A passive strategy helps you avoid the costs and inconsistencies found in attempting to outfox the market through “active” predictions.  The market as a collective, highly informed entity is pretty tough (and expensive) to attempt to beat.
• Go over your results at least once a year.  Find someone you can trust and also verify the results.  You can’t expect to do well every year, but you should at least know your returns.

Conclusion

There is a lot we cannot control: the business cycle, changes in tax policy, political instability and even acts of terrorism.  But we can concentrate on the things we can control.  The proper relationship with a fee-only advisor is your best chance for a positive result.

 

Can You Trust Wall Street?

For anyone who is a movie buff, this bombshell can be compared to the classic scenes in Tom Cruise’s Jerry Maguire and his career-killing “mission statement.”  Except this time, it’s not fiction, it’s for real. When executive Greg Smith quit his job on March 14th, he declared, “The environment (at Goldman Sachs) now is as toxic and destructive as I have ever seen it.” 

And this was no internal memo in which he aired his grievances.  As most are now aware, he went public (very public) in his now-viral New York Times op-ed, Why I Am Leaving Goldman Sachs.

Time will tell whether Greg Smith ends up honored as a game-changing hero, cast aside as a “whiner,” or largely forgotten, like that JetBlue steward who departed his career via the emergency exit.   But Smith’s observations are spot on. “If clients don’t trust you, they will eventually stop doing business with you. … People who care only about making money will not sustain this firm — or the trust of its clients — for very much longer.”

He may not enjoy lasting personal fame, but I fervently hope that the message he delivered ends up spurring a much-needed cultural shift within the financial industry.  Smith’s condemnation of the leadership changes he saw during his decade at Goldman Sachs struck most of us as illustrative of a global epidemic rather than a problem at only one Wall Street firm. 

It really shouldn’t be that complicated.  As Susan John of the National Association of Personal Financial Advisors (NAPFA) commented in InvestmentNews, “I think clients want to know that whoever is working with them has their interests at heart, and that there’s more loyalty to the client than to the firm.”

It seems to me that this sort of dedication to investors’ best interests should be a no-brainer — regardless of a firm’s business model, fee structure or service offerings.  It seems equally clear that, at least among Wall Street’s behemoths and likely far more widespread than that, it’s all too frequently not.  (This blog contains a series of posts on the “dark side” of Wall Street.)

How do we make meaningful progress toward eliminating financial service environments in which, as Smith alleged, his former colleagues “push the envelope and pitch lucrative and complicated products to clients even if they are not the simplest investments or the ones most directly aligned with the client’s goals”?

Legislation can help, up to a point. But one need only look to Bernie Madoff to know that laws will only get us so far when someone is determined to break them. What’s required is an attack on all fronts.  As individuals — financial professionals and investors alike — we must share a common passion for championing continued cultural, legal, procedural and educational improvements in all that we do with our investment activities.

My first recommendation is that you insist that your financial advisor promise in writing that your highest interests will come first.  In legal terms, this is known as a fiduciary relationship between you and your advisor.

If your advisor won’t agree to this legally enforceable relationship with you, I would suggest you respond with a quote from another movie character, Howard Beal, excellently portrayed by Peter Finch in Network: “I’m as mad as hell, and I’m not going to take this anymore.”

30 Kidney Transplants, a Reason for Hope

Despite plenty of disheartening news in the world, one masterful act can restore my faith that there are always reasons to be hopeful, even optimistic. A recent case in point: The New York Times article, 60 Lives, 30 Kidneys, All Linked, relates a chain of anonymous kidney transplants among 30 donors and recipients. Why would I, a financial planner, write about this?  Besides being a magnificent example of the human spirit, I see intriguing connections between the process, and the way our markets frequently overcome challenges the way they do.

The article is so breathtaking that it takes time to appreciate its impact and implications. While I recommend that you read the entire piece, here is how the Times summarizes the two-page story: “A record chain of kidney transplants resulted from (a) mix of medical need, pay-it-forward selflessness and lockstep coordination among 17 hospitals over four months.” The article also mentions Garet Hil, who was inspired by his own daughter’s kidney transplant experience to found the National Kidney Registry, which was behind the successful chain of events.

In financial planning, we do not know what medical expenses might be. This story merely hints at how complicated that can be. In addition, bad things happen to good people, and as much as we can plan for the future, there will always be unhappy surprises and setbacks. That’s why we buy all kinds of insurance: car, life, umbrella, and long-term care. It’s also why we should have wills and other estate planning documents.

Ever since I studied economics in college and graduate school, I have been curious about when markets work beautifully and when they don’t. Milton Friedman (and other free-market economists) argued that central planning doesn’t work very well compared to the decisions of millions of people acting in their own interests. (See the Power of the Market – The Pencil) 

But by law there cannot be a market in body organs; you cannot legally pay someone for his or her kidney.  (I’ll leave it to the bioethicists to argue why that should be.)

Is it stretching the point too much to suggest that Garet Hil created a “market” by forming the National Kidney Registry?  It may not depend on buyers and sellers using prices to allocate scarce resources, but the ability to coordinate 60 (or more) anonymous donor/recipients toward a common cause is a comparable, if not greater challenge.  Certainly Mr. Hil’s computer programming prowess was complemented by his ability to convince hospitals to accept his better way for finding matches for kidney transplants.  People (mostly) responded to understandable incentives although a totally selfless donation started the whole process this time.

As an ex-Marine and M.B.A. from the Wharton School, Mr. Hil is worthy of a book or article by Michael Lewis. Brad Pitt, are you free to make a movie in 2014 ?

And personally I am always amazed and inspired when someone experiences adversity or loss and then resolves to change the world so someone else does not have to suffer the same fate.  (It’s worth noting that Hil’s daughter did find a donor, but not without some touch-and-go moments that Hil felt should have been avoidable.)

So what did it take to accomplish this particular “miracle”? (1) someone had the idea of transplant exchanges and wrote a journal article in 1986; (2) someone else witnessed suffering first hand and had the motivation, financial resources and expertise to do something about it; (3) there have been amazing changes that computers and information technology make possible; (4) doctors and hospitals had to get over the “not invented here” syndrome; (5) altruistic individuals wanted to make a difference and were willing to undergo surgery and some suffering to accomplish that; (6) trust was needed that people would honor their commitments; (7) coordination, logistics and persistence all played their part; (8) and finally old-fashioned chance and luck contributed to the final result.

If you take a moment to view Friedman’s short pencil-example video, you’ll find it succinct and persuasive, but isn’t the “60 Lives, 30 Kidneys” story so much more powerful?  It is, especially if you happen to know someone who needs a kidney transplant.

What Investors Should Learn From 2011

The year 2011 will go down as one of the most volatile ever.  We witnessed political upheaval and wide swings in market prices.  Everything seemed to conspire to undermine investors’ composure.

Yet, the major U.S. stock market indices avoided a downturn in 2011 after two strong recovery years.  Those who bailed out after any one of the market  tumbles would have missed the year’s many improbable, unpredictable recoveries. 

So, what lessons can we learn from such a volatile year? 

1.  Be humble about making predictions. Even the experts can get it wrong – just ask Pimco’s Bill Gross.

2.  Don’t even try to time the market. That’s difficult even in the best of times and these aren’t those. 

3.  Stay diversified and disciplined; that’s always the best course, regardless of volatility.

4.  Don’t buy into the crisis du jour mentality of the media.  Shock and awe sells; judicious analysis does not.

Weston Wellington, Vice President of Dimensional Fund Advisors, does an excellent job of summarizing the year’s events and the lessons we can learn from 2011.

 

Year-End Review

Equity investors around the world had a disappointing year in 2011 as thirty-seven out of forty-five markets tracked by MSCI posted negative returns. The US did well on a relative basis and was the only major market to achieve a positive total return, although the margin of victory was slim. Total return for the S&P 500 Index was 2.11%, and the positive result was a function of reinvested dividends—the index itself finished the year slightly below where it started.

Throughout the year, investors seeking clues regarding the strength of business conditions or the prospects for stock prices were confronted with ample reason to rejoice or despair. Optimists could cite the strong recovery in corporate profits and dividends, the substantial levels of cash on corporate balance sheets, low interest rates and inflation, a booming domestic energy sector, continuing strength in auto sales, and record-high share prices for leading multinationals such as Apple, IBM, and McDonald’s. Pessimists could point to persistently high unemployment, slumping home prices, tepid growth in retail sales, worrisome levels of government debt at home and abroad, and political gridlock in both Congress and various state legislatures.

Although the broad market indices showed little change for the year, there were opportunities to make a bundle—or lose one. Among the thirty constituents of the Dow Jones Industrial Average, thirteen had double-digit total returns, including McDonald’s (34.0%), Pfizer (28.6%), and IBM (27.3%). But losing money was just as easy: The three worst performers in the Dow were Hewlett-Packard (–37.8%), Alcoa (–43.0%), and Bank of America (–58.0%). If nothing else, the substantial spread between these winners and losers discredits the argument we often hear that all stocks are now marching in lockstep and that diversification is ineffective.

Achieving even modest results in the US market required more discipline than many investors could muster, since investor sentiment fluctuated dramatically throughout the year and the temptation to enhance returns through judicious market timing often proved irresistible.

For fans of the “January Indicator,” the year got off to a promising start as stock prices jumped higher on the first trading day, pushing the Dow Jones Industrial Average to a twenty-eight-month high. Bank of America shares jumped 6.4% that day, the top performer among Dow constituents. With copper prices setting new records and factory activity worldwide perking up, the biggest worry for some was the potential for rising prices and higher interest rates that might choke off the recovery. “Overheating is the biggest worry,” one chief investment strategist observed. By April 30, the S&P 500 was up 8.4%, reaching a new high for the year.

Stocks wobbled through May and June but strengthened again in July. On July 19, the Dow Jones Industrial Average had its sharpest one-day increase of the year, jumping over 200 points, paced by strong performance in technology stocks. Just a few days later, however, stocks began a precipitous decline that took the S&P 500 down nearly 17% in just eleven trading sessions. The century-old Dow Theory—a sentimental favorite among market timers—flashed a “sell” signal on August 3, and on August 5, Standard & Poor’s downgraded US government debt from AAA to AA+. As investors sought to assess the implications of sovereign debt problems in both the US and Europe, stock prices fluctuated dramatically, with the S&P 500 rising or falling over 4% on five out of six consecutive trading days in early August. Rattled by the sharp day-to-day price swings, many investors sought the relative safety of US Treasury obligations in spite of the rating downgrade, pushing the yield on ten-year Treasury notes to a record low. Stock prices hit bottom for the year on October 3 as some market participants apparently lost all confidence in equity investing. A Wall Street Journal article cited a number of individual investors as well as professional advisors who had recently sold all their stocks and did not expect to repurchase them anytime soon. “I feel like a deer in the headlights,” said one.

As it turned out, the article appeared in print on the second day of a powerful rally that sent the Dow Industrial Average surging over 1,500 points during the next 19 trading days, putting it back into positive territory for the year.

What can we learn from a difficult year like 2011? As Dimensional founder David Booth is fond of saying, the most important thing about an investment philosophy is that you have one. Many investors (as well as some allegedly professional advisors) apparently decided to switch from a buy-and-hold philosophy to a market timing strategy in the midst of an unusually stressful period in the financial markets. We suspect few of those adopting the change would have been able to clearly articulate their investing beliefs and why they had shifted.

Legendary investor Benjamin Graham offered the following observation nearly forty years ago: “There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he himself is a part.”

Good advice then, good advice now.

By Weston Wellington, Vice President of Dimensional Fund Advisors

Sources

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Mark Gongloff, “Investors’ Forecast: Sunny With a Chance of Overheating,” Wall Street Journal, January 3, 2011.

Jonathan Cheng and Sara Murray, “Stock Surge Rings in Year,” Wall Street Journal, January 4, 2011.

Matt Phillips and E.S. Browning, “Tech Sends Stocks Soaring,” Wall Street Journal, July 20, 2011.

Steven Russsolillo, “‘Dow Theory’ Confirms It’s an Official Swoon,” Wall Street Journal, August 4, 2011.

Damian Paletta, “U.S. Loses Triple-A Credit Rating,” Wall Street Journal, August 6, 2011.

Tom Petruno, “Investors Stampede to Safety,” Los Angeles Times, August 19, 2011.

Kelly Greene and Joe Light, “Tired of Ups and Downs, Investors Say ‘Let Me Out’,” Wall Street Journal, October 5, 2011.

Benjamin Graham, The Intelligent Investor (New York: HarperCollins 1949).

The S&P data are provided by Standard & Poor’s Index Services Group.

MSCI data copyright MSCI 2011, all rights reserved.

Yahoo! Finance, www.yahoo.com, accessed January 3, 2012.