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August 17, 2014
Welcome to the next installment in our series of Key Investment Insights: The Benefits of Diversification.
In our last post, “The Myth of the Financial Guru,” we concluded with our explanation of the formidable odds you would face if you tried to outsmart the market’s lightning-fast price-setting efficiencies. Today, we turn our attention to the many ways you can harness these and other efficiencies to work for, rather than against, you.
Among your most important financial friends is diversification, arguably your “best” friend. After all, there is no other single action that you can take which would alleviate your exposure to a number of investment risks, while simultaneously potentially improving your overall expected returns. Is your new BFF too good to be true? Hardly; while they may seem almost magical, the benefits of diversification have been well-documented and widely explained by some 60 years of academic inquiry. The “powers” of diversification are both evidence-based and robust.
Global Diversification: Quantity AND Quality
What is diversification? In a very general sense, it’s about spreading your risks around. In investing, however, diversification is more than just ensuring that you have many holdings; it’s ensuring that you have many different kinds of holdings. If we relate this definition to the old adage about not putting all your eggs in one basket, an apt comparison would be to ensure that your multiple baskets contain not just eggs but also a bounty of fruits, vegetables, grains, meats and cheese!
This may make sense intuitively, but the fact is that many investors believe that they are well-diversified when, in reality, they are not. Yes, they may own a large number of stocks or stock funds across numerous accounts, but upon closer inspection we often find that the bulk of an investor’s holdings are concentrated in large-company U.S. stocks.
In future installments of our series, we’ll explore what we mean by different kinds of investments. For now, though, think of a concentrated portfolio as the non-diversified equivalent of many baskets filled with only plain, white eggs. If your diet consisted only of plain, white eggs, that would not only be unappetizing but perhaps dangerous to your well-being. It’s the same thing with investing; over-exposure to a single “ingredient” can be detrimental to your financial health. The lack of diversification within your portfolio can:
- Increase your vulnerability to specific yet otherwise avoidable risks;
- Create a bumpier, less reliable overall investment experience; and
- Have you second-guessing your investment decisions.
Individually or collectively, these three “strikes” can generate unnecessary costs, lowered expected returns and, perhaps most important of all, increased anxiety. Ultimately, you’re back to trying to beat, instead of play along with, a powerful market.
A World of Opportunities
Instead, consider that there is now a wide world of investment opportunities available from tightly-managed mutual funds, designed specifically to facilitate meaningful diversification. These investment opportunities offer efficient, low-cost exposure to the globe’s capital markets.
To best capture the full range of benefits that global diversification has to offer, we recommend turning to the sorts of fund managers who focus their energies – and your investment dollars – on efficiently capturing diversified dimensions of global returns.
In our last piece, we described why brokers or fund managers who are fixated on trying to beat the market are likely wasting their time (and your money) on fruitless activities. While you may be able to achieve diversification, your experience with these “gurus” would be hampered by unnecessary efforts and extraneous costs which could, ultimately, act only as a distraction to your resolve as a long-term investor. And really, who needs the hassle when diversification alone offers so many benefits?
In our next post, we’ll explain in more detail why diversification is sometimes referred to as one of the only “free lunches” in investing.
August 11, 2014
Welcome to the next installment in our series of Key Investment Insights: The Myth of the Financial Guru.
In our last post, “News and Market Prices,” we explored how price-setting occurs in capital markets, and why investors should avoid reacting to breaking news. It’s clear that the cost and competition hurdles are simply just too high. Today, we will explain why you’d be ill-advised to seek out a pinch-hitting expert, the so-called “financial guru,” to compete for you. As Morningstar strategist Samuel Lee has said, managers who have persistently outperformed their benchmarks are “rarer than rare.”
Group Intelligence Wins Again
As we discussed in “Market Prices,” independently thinking groups (like participants in capital markets) are better at arriving at an accurate answer than even the smartest individuals within the group. In part, that’s because their collective wisdom is already bundled into prices, which we already learned adjust with fierce speed and relative accuracy to any new, unanticipated news.
Thus, even the experts, those who specialize in analyzing business, economic, geopolitical or any other market-related information, face the same challenges you would, if they attempt to beat the market by predicting an outcome to unexpected news. For them, too, particularly after costs, group intelligence remains a prohibitively high hurdle to overcome.
The Proof is in the Pudding
Let’s say a friend of a friend’s cousin’s uncle has told you of a financial guru — an extraordinary stock broker, fund manager or TV personality who strikes you, perhaps, as being among the elite few who can successfully make the leap over that high hurdle. Maybe this guru has a stellar track record, impeccable credentials or brand-name recognition. Should you, then, rely on this guru for the latest market tips, instead of settling for “average” returns?
Setting aside market theory for just a moment, let’s consider what actually works. Bottom line; if investors were able to depend on these so-called gurus who claim that they have consistently outperformed the market, shouldn’t we be seeing credible evidence of that?
We should, but not only are such data lacking, the body of evidence to the contrary is overwhelming. Star performers – “active managers” – often fail to survive, let alone persistently beat comparable market returns. A 2013 Vanguard Group analysis found that only about half of some 1,500 actively managed funds which were available in 1998 still existed by the end of 2012, and only 18% of those had outperformed their benchmarks. Dimensional Fund Advisors found similar results in its independent analysis of 10-year mutual fund performance through year-end 2013. In a nutshell, across the decades and around the world, a multitude of academic studies have scrutinized active manager performance and consistently found it lacking.
- Among the earliest of these studies is Michael Jensen’s groundbreaking 1967 paper, “The Performance of Mutual Funds in the Period 1945–1964.” Jensen, who was my professor at the University of Rochester, concluded that there was “very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance.”
- In 2009, Eugene Fama, a Nobel Prize winning economist, and Kenneth French conducted what is now widely considered a landmark study, “Luck Versus Skill in the Cross Section of Mutual Fund Returns.” They demonstrated that “the high costs of active management show up intact as lower returns to investors.”
- In the decades between 1967 and 2009, there have been as many as 100 similar studies published by a “who’s who” list of academic luminaries, all echoing Jensen, Fama and French. In 2011, the Netherlands Authority for the Financial Markets (AFM) scrutinized this body of research and concluded: “Selecting active funds in advance that will achieve outperformance after deduction of costs is therefore exceptionally difficult.”
Lest you think hedge fund managers and similar experts can fare better in their more rarefied environments, the evidence dispels that notion as well. For example, a March 2014 Barron’s column took a look at hedge fund survivorship. The author reported that nearly 10% of hedge funds existing at the beginning of 2013 had closed by year’s end, and nearly half of the hedge funds which had been available only five years prior were no longer available (presumably due to poor performance).
So far, we’ve assessed some of the investment obstacles you either have or may face. The good news is that there is a way to invest which enables you to nimbly sidestep those obstacles rather than face them head on, and which simply allows the market to do what it does best, on your behalf. In our next installment of Key Investment Insights, we will begin to introduce you to the strategies involved, and your many financial friends. First up, an exploration of what some have called the closest thing you’ll find to an investment free lunch: Diversification.
August 5, 2014
Welcome to the second installment in our series of Key Investment Insights: News and Market Prices.
In our last post, “Market Prices,” we explored how group intelligence can govern relatively efficient markets in an imperfect world. Today, let’s look at how prices are set moving forward. This, too, helps us understand how to play with rather than against the wisdom of the market, as you seek to improve your investment results.
What causes market prices to change? It begins with the fundamentals, or what is considered the never-ending stream of news and data which informs us of the good, bad and ugly events that are or will shortly be taking place. Let’s say, for example, that the U.S. Department of Agriculture issues a report that a fungus is attacking Florida’s citrus crop; as a result, orange juice futures may soar, as the market’s collective wisdom predicts that there is going to be less supply than demand.
But what does this mean to you and your investment portfolio? Should you buy, sell or just hold tight? Before the news tempts you to jump into or flee from a breaking trend, it’s critical to be aware of the evidence that tells us the most important thing of all: You cannot expect to consistently improve your outcomes by reacting to breaking news.
How the market adjusts its pricing is why there’s not much you can do in reaction to breaking news. There are two principles to bear in mind here.
First, it’s not the news itself; it’s whether or not you saw it coming. When a security’s price changes, it’s not because something good or bad has happened. It’s generally because the next piece of news, good, bad or even neutral, is better or worse than expected. If, in the aforementioned example, it’s reported that the citrus fruit disease is continuing to spread, changes in pricing may be minimal because everyone had already been expecting doom and gloom. On the other hand, if news of an ingenious new fungicide is released, prices may change dramatically in reaction to the unexpected and possibly swift resolution.
Thus, it’s not just news, but unexpected news which alters pricing. By definition, the unexpected is impossible to predict; moreover, how the market responds (or fails to respond) to it is another uncertainty.
The Barn Door Principle
The second reason to consider breaking news as irrelevant to your investing strategy is “The Barn Door Principle.” By the time you hear this so-called “breaking” news, the market has already priced it in, well ahead of your ability to do anything about it. Thus, those proverbial horses have long since galloped past your open trading door.
This is especially true in today’s micro-second electronic trading world. In his article, “The impact of news events on market prices,” CBS MoneyWatch columnist Larry Swedroe explored how fast global markets respond to breaking news. Pointing to evidence from numerous studies among several developed markets, the universal response was nearly instantaneous price-setting during the first few post-announcement trades. As Swedroe concluded, “since current market prices already incorporate all that is knowable, the next piece of news is random in terms of whether it is better or worse than the market expects, and the market adjusts almost instantly to that news.”
Unless you happen to be among the very first to respond to breaking news (and mind you, you will be competing against automated traders who generally can and do respond in fractions of milliseconds), you will likely be too late to take advantage of any breaking news.
Rather than try to play a potentially very expensive game based on ever-changing and uncontrollable information, the preferred way to position your life savings is according to a number of market factors that you can better expect to manage in your favor. In future Key Investment Insights, we’ll introduce these factors to you.
But first, you may be asking yourself this question: Although you might not be up to the challenge of competing against the market, what’s to stop you from having a pinch-hitting expert compete for you? In our next Key Investment Insight, we’ll explore how well that tactic has worked in the past.
Click here to read it.