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Key Investment Insights: Managing the Market’s Risk

August 25, 2014

Welcome to the next installment in our series of Key Investment Insights.

In our last post, “The Benefits of Diversification,” we described how effective diversification means more than just holding a large number of accounts or securities. It also calls for efficient, low-cost exposure to a variety of capital markets from around the globe. Today, we’ll expand on the benefits of diversification, beginning with its ability to help you better manage investment risks.

There’s Risk, and Then There’s Risk

Before we even have words to describe it, most of us learn about life’s general risks when we tumble into the coffee table or reach for that pretty cat’s tail. Investment risks aren’t as straightforward. Here, it’s important to know that there are two, broadly different kinds of risks: avoidable, concentrated risks and unavoidable market risks.

Avoidable Concentrated Risks

Concentrated risks are the ones that wreak targeted havoc on particular stocks, bonds or sectors. Even in a bull market, one company can experience an industrial accident, causing its stock to plummet. A municipality can default on a bond, even when the wider economy is healthy.  natural disaster can strike an industry or region, while the rest of the world thrives.

In the science of investing, concentrated risks are considered avoidable. Bad luck still happens, but you can dramatically minimize its impact on your investments by diversifying your holdings widely and globally, as we described in our last post. When you are well diversified, if some of your holdings are affected by a concentrated risk, you are much better positioned to offset the damage done with plenty of other, unaffected holdings.

Unavoidable Market Risks

If concentrated risks are like bolts of lightning, market risks are encompassing downpours in which everyone gets wet. They are the persistent risks that apply to large swaths of the market. At their highest level, market risks are those you face by investing in capital markets in any way, shape or form. If you stuff your cash in a safety deposit box, it will still be there the next time you visit it. (It may be worth less due to inflation, but that’s a different risk, for discussion on a different day.) Invest in the market and, presto, you’re exposed to market risk.

Risks and Expected Rewards

Hearkening back to our past conversations on group intelligence, the market as a whole knows the differences between avoidable and unavoidable investment risks. Heeding this wisdom guides us in how to manage our own investing with a sensible, evidence-based approach.

Managing Concentrated Risks

If you try to beat the market by chasing particular stocks or sectors, you are exposing yourself to higher concentrated risks that could have been avoided with diversification. As such, you cannot expect to be consistently rewarded with premium returns for taking on concentrated risks.

Managing Market Risks

Every investor faces market risks that cannot be “diversified away.” Those who stay invested when market risks are on the rise can expect to eventually be compensated for their steely resolve with higher returns. But they also face higher odds that results may deviate from expectations, especially in the near-term. That’s why you want to take on as much, but no more market risk than is personally necessary. Diversification becomes a “dial” for reflecting the right volume of market-risk exposure for your individual goals.

Your Takeaway

Whether we’re talking about concentrated or market risks, diversification plays a key role. Diversification is vital for avoiding concentrated risks. In managing market risks, it helps you adjust your desired risk exposure to reflect your own purposes. It also helps minimize the total risk you must accept, as you seek to maximize expected returns.

This sets us up for our next piece, in which we address another powerful benefit of diversification: smoothing out the ride along the way. 

Key Investment Insights: The Benefits of Diversification

August 17, 2014

Welcome to the next installment in our series of Key Investment Insights.

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:

  1. Increase your vulnerability to specific yet otherwise avoidable risks;
  2. Create a bumpier, less reliable overall investment experience; and
  3. 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.

Your Takeaway

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. 

Key Investment Insights: The Myth of the Financial Guru

August 11, 2014

Welcome to the next installment in our series of Key Investment Insights.

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).

Your Takeaway

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.