The Stock Market Declined, Now What?

“Don’t let short-run fluctuations, market psychology, false hope, fear, and greed get in the way of good investment judgment.” – John Bogle.

Last week I was contacted by Sarah Morgan, a writer for SmartMoney.com, who had some questions about the recent volatility and decline in the stock market.  Normally, I don’t respond to the press, but her initial question struck me to my core.  Ms. Morgan wanted to know if clients were panicking.  My clients?  Panicking?  She obviously did not know me or my investment philosophy.  My email response to her was this, “I would take it as a tremendous failure of education and preparation if my clients were panicking now.”  

I went on to say that in trying to time the market (which, as I’ve said before, is patently impossible) investors are more likely to hurt themselves by not being invested when the rebound comes.  And, as historical data prove, there is always a rebound, because the long-term trend is up.

I admit that I took pride in being able to tell Ms. Morgan that clients of Key Financial Solutions do not panic.  Rather, they sit and hold tight and ride out the roller coaster.  They’re prepared for short-term fluctuations and declines, simply because they have a long term plan.

Their Investment Policy Statement specifies a well-balanced portfolio that includes a combination of stock mutual funds and bonds (in ratios that we have decided upon, based upon time horizon, risk tolerance, etc.).  So, even a 10% decline in the stock market has little effect on my clients.  And should a market decline be steep enough to affect a portfolio, rebalancing – selling some (appreciated) bonds and buying some (now, underweight) equities – is appropriate to reestablish the portfolio’s target mix.     

That information was enough to spur a half-hour long phone conversation and a follow-up email. 

It was gratifying to read the article, After Market Slide, What’s Your Next Move?, and not just because I was quoted.  No, I was happy to see that Ms. Morgan got it right. She quoted a number of people who said that long-term investing is the key to success.

Having a well thought out Investment Policy Statement is the best chance I know of to stick with a long-term plan.  When markets experience extreme volatility, it sure helps to have a strategy that is based on more than a prediction of what today’s news means to your investment portfolio.

And what are the rewards of long-term investing versus the risk of getting out of the market?  Christopher Davis of Davis Advisors gave a presentation at the NAPFA (National Association of Personal Financial Advisors) National Conference.  Here is what he reported.

Average Annual Returns for 1995 – 2009 for investing in the S&P 500

8.0%		for Staying the Course
3.2%		if you missed the 10 best days
-2.6%		if you missed the 30 best days
-9.2%		if you missed the 60 best days

 

For a fifteen year period, if you missed the 30 best days, you could have managed to lose 2.6% per year, versus earning 8.0% per year.  Thirty days in 15 years!

So let me turn the original question on its head, “Why would anyone risk being out of the stock market?”

Keeping Your Investment Balance, Part 2

In my last post on the subject, I introduced the idea of monitoring and maintaining a portfolio’s asset allocation. 

Determining when and how to effectively rebalance your portfolio requires careful monitoring of not only portfolio performance, but awareness of your tax status, cash flow, financial goals, and tolerance for risk.  The act of portfolio rebalancing results in transaction fees and has the potential to incur capital gains in taxable accounts. Thus, while there may be good reasons to rebalance, the benefits must outweigh the costs.

Given these challenges, a practical approach to rebalancing takes into consideration the occurrence of “triggering” points, yet provides enough flexibility that costs are effectively managed and minimized.

When to Rebalance

Defining triggering points helps us decide when to rebalance. Most experts recommend rebalancing when asset group weightings move outside a specified range of their target allocations.  This may be widely defined according to either a stock-bond mix or to a percentage drift away from target weightings for categories like small cap stocks, international stocks, and the like.

How to Rebalance

While rebalancing costs are unavoidable, several strategies can help minimize the impact:

• Rebalance with new cash. Rather than selling over-weighted assets that have appreciated, use new cash to buy more under-weighted assets; this reduces transaction costs and the tax consequences of selling assets.
• Whenever possible, rebalance in the tax-deferred or tax-exempt accounts where capital gains are not realized.
• Incorporate tax management within taxable accounts, such as strategic loss harvesting, dividend management, and gain/loss matching.
• Implement an integrated portfolio strategy. In other words, rather than maintaining rigid barriers between component asset classes and accounts, manage the portfolio as a whole.

Conclusion

While there are good reasons to adjust portfolio risk by rebalancing, it does incur real costs that can detract from returns. A good strategy includes determining which investment components can acceptably drift, and adopting tax-saving and cost-saving strategies during rebalancing. In helping our clients rebalance, we strive to develop a structured plan that remains flexible to each individual’s unique blend of goals, risk tolerances, cash flow, and tax status.

No one knows where the capital markets will go—and that’s the point. In an uncertain world, investors should have a well-defined, globally diversified strategy and manage their portfolio to implement it over time. Rebalancing is a crucial tool in this effort.

Moreover, if and when your overall financial goals or risk tolerance change, you have a foundation for making adjustments. In the absence of a plan, adjustments are a matter of guesswork.

Keeping Your Investment Balance, Part 1

When meeting with new clients, I always discuss risk and return before helping them design a portfolio that will meet their needs.  We live in an uncertain world, so there are no guarantees, and generally, risk and reward go hand in hand. I help my clients arrive at a portfolio that is well diversified and, most importantly, has an acceptable (for them) risk profile.  It allows my clients to “stay the course,” even when market declines occur, as they inevitably will.

While global diversification gives investors a valuable tool for managing risk and volatility in a portfolio, it requires maintenance.  Over time, asset classes have different returns. This is inevitable and, in fact, desirable. A portfolio that holds assets that perform dissimilarly will experience less overall volatility, and that results in a smoother ride over time.

However, dissimilar performance can also change the integrity of your asset mix or allocation – a condition known as “asset drift.” As some assets appreciate in value and others lose relative value, your portfolio’s allocation changes, which affects its risk and return qualities. If you let the allocation drift far enough away from your original target, you end up with a very different portfolio.

If you do nothing, “asset drift” will cause your portfolio to deviate from your long range plan and risk tolerance.  As I said, even a well diversified portfolio requires maintenance.

Rebalancing is the remedy. To rebalance, you sell some assets that have risen in value and buy more of assets that have dropped in value. The purpose of rebalancing is to move a portfolio back to its original target allocation. This restores strategic structure in the portfolio and puts you back on track to pursue long-term goals.

Why rebalance?

At first glance, rebalancing seems counter-intuitive. Why sell a portion of outperforming asset groups and acquire a larger share of underperforming ones? A common reaction is to want to buy what has gone up, because you think it will continue to outperform.  This logic is flawed, however, because past performance may not continue in the future.  In reality, there’s no reliable way to predict future returns.  The old stock broker mantra (slightly modified, simply because you can’t predict the future) holds true, “Buy lower, sell higher.”

Equally important, remember that you chose your original asset allocation to reflect your risk and return preferences. Rebalancing realigns your portfolio to these priorities by using structure, not recent performance, to drive investment decisions. Periodic rebalancing also encourages dispassionate decision making – an essential quality during times of market volatility.

Conclusion

In the real world, portfolio allocations can be complex, incorporating not only fixed income and stocks, but also the multiple asset groups within equity investing. And, of course, tax considerations are very important.

In summary, to ensure that a portfolio’s risk and return characteristics remain consistent over time, a portfolio must be rebalanced.  Rebalancing is a tool to control risk and also an antidote to becoming too optimistic or too pessimistic.  You are, in effect, buying low and selling high, whether you want to or not.

Determining when and how to effectively rebalance is the subject of Part 2.

Learning from Investment Mistakes, Part 2

“Individual investors tend to invest in a small number [of stocks] and they don’t know how to construct a portfolio. Professional portfolio managers control risk.” Jim Peterson, vice president at the Schwab Center for Financial Research.

My last post discussed the basic stock-bond allocation decision. This is a technique that many investment advisers use, but it is not the way most people approach investing. Most people are looking for an idea, a story or concept that they can build upon to make a winning investment, something that captures their imagination. They want to be a part of the next big thing, discovery or cure.

From time to time, a friend or acquaintance will tell me his or her investment philosophy. Years ago, one such friend offered the advice that you should “buy what you know.” That, of course, assumes that familiarity translates to good investment analysis. Unfortunately, there is no evidence that this is always the case.

Take, for example, people in Rochester, N.Y., who over-weighted their portfolios with Eastman Kodak and Xerox – more’s the pity for their retirement accounts. I submit that where you live (or where you grew up or where you work) should not be the guiding factor to which stocks you buy. Suppose you had lived in Houston and bought a ton of Enron stock or lived in Charlotte and invested heavily in Wachovia Bank stock?

Another past story line I’ve heard was “buy dominant technology companies with market power” as in Cisco, Microsoft, and other highflying tech stocks. That bit of advice was proffered in 2000, incidentally, just before all those “dominant technology companies” tanked.

More recently, a friend said that he liked GE, simply because Warren Buffett had invested in it. (And Buffett must know what he is doing, after all.) Fine, but Mr. Buffett’s company bought preferred shares with powerful guarantees and plenty of sweeteners; a much better deal than you or I or any “ordinary” investor will ever get buying GE common stock on the open market.

Some people follow trends, buying what “is going up” (which really means buying what has already gone up; granted, a small difference in interpretation, but a big difference in results). A good example of this is gold, which I have been asked about recently. (I’ll write more about gold in a future post.)

And, naturally, I’m also approached by the pessimists, who talk only of deficits, higher taxes in 2011 or 2012, third world debt, possible terrorism, etc., etc.

What is to be made from all these divergent concerns and predictions? In my opinion, not much. Hot tips and stocks with a good “story” or narrative are not necessarily going to reward you as an investor, because you cannot get the past performance that you have already witnessed.

Conclusion

My approach has always been and will continue to be this: If you are an investor, then you should invest. You should not allow yourself to be influenced by the news – good or bad – or by what your friends are doing or not doing. Investing is about cost control, having a globally diversified portfolio (preferably one holding thousands of securities), and taking the amount of risk that is right for you.

It is simple, but it is not easy.

To be continued…

Learning from Investment Mistakes

What, if anything, have we learned from the recent steep stock market decline?  One lesson, I hope, is that planning and designing a portfolio that is appropriate for you and that you can live with is very important.  Read on to learn about an approach that may help you decide on the right portfolio design for you.

The Stock-Bond Decision

When meeting with clients, I emphasize that choosing a basic stock-bond mix is a very important first step in effective and productive portfolio design. Unfortunately, I sometimes encounter people who have allocated their portfolio at either extreme – 100% in stocks or 100% in money market accounts/bonds.  Very few advisors would ever recommend either approach.

Although the stock-bond decision may appear simple, it can have a profound impact on your wealth.  Studies have proven that nearly 90% of a portfolio’s long-term results are directly linked to asset allocation, and the right stock-versus-bond mix should be your first deliberate and strategic decision.

The Rationale

Because neither I nor anyone I know can predict the future, I believe in having a diversified portfolio that includes both stocks and bonds.  I “dial down” total risk by adding fixed income to the stock market mix.  Quite simply, the greater the bond allocation relative to stocks, the less risky the portfolio, but the lower the total expected return.  On the other hand, the greater the stock allocation relative to bonds, the higher the portfolio’s expected return, and the higher the associated risk.

So, how do you confidently allocate between stocks and bonds?  One method is to use model portfolios to illustrate the risk-return spectrum over time. For simplicity and clarity, the highest risk portfolio holds 100% in a stock index, while the least volatile portfolio holds 100% in high quality bonds. Between these extremes lie other stock-bond allocations, such as 80/20, 60/40, 50/50, 40/60, and 20/80.  Comparing past results side by side is illuminating and quite helpful in the decision making process.

Certainly, relying on historical performance is not foolproof, because past results are not a guarantee of future performance.   But if you compare the average annualized return and volatility (standard deviation) of each model portfolio since 1970 (for example), you have an idea of what relative risk you can expect and whether or not you can accept the potential loss.

Lately, I have found that showing how portfolios did in 2008 is very helpful in illustrating the risk-reward tradeoffs.  Analyzing just that specific year shows that diversification neither assures a profit nor guarantees against loss in a declining market, at least in the short term.

For example, a portfolio with a stock allocation of 80% declined 30% in 2008, while a portfolio of 60% stocks “only” declined by 21%.  Many people can live with a 21% decline, knowing that markets do rebound and the long term outlook is positive.  On the other hand, suffering a 30% loss (or more) could have tipped some investors into panicking and getting out of the stock market entirely, much to their chagrin today.

Refining the Stock Allocation

After establishing the basic stock-bond mix, I turn my attention to refining the stock allocation.  Depending on an investor’s individual profile, I may overweight or “tilt” the allocation toward riskier asset classes that have a history of offering average returns above the market.

Research published by Eugene Fama and Kenneth French reveals that small cap stocks have had higher average returns than large cap stocks, and “value stocks” have had higher average returns than growth stocks.  By holding a larger portion of small cap and value stocks in a portfolio, an investor increases the potential to earn higher returns for the additional risk taken.

The final step in refining the stock component is to diversify globally.  By holding an array of equity asset classes across domestic and international markets, you can reduce the impact of underperformance in a single market or region of the world.  And lest you worry about the global recession, last year developed and emerging markets grew at a rate higher than domestic markets, by 27.7% and 74.1%, respectively.

Conclusion

Over short periods of time, returns on stocks are quite variable; in other words, in any year we don’t know whether stocks will produce good results or not.  But, over a longer period of time – and this has been historically proven – stocks provide higher average returns than low-yielding bonds.  That’s why I generally recommend that investors with a long investment life ahead of them focus on achieving the higher long-term returns through investment in stocks.  As your time horizon or risk tolerance changes, you can reallocate your portfolio’s risk more in favor of bonds.

Summary

The stock-bond decision drives a large part of a portfolio’s long-term performance. During discussions with clients, I have found that examining different stock-bond combinations can help them visualize the risk-return tradeoff as they consider the range of potential outcomes over time. Once a mix is determined, it can guide more detailed choices of asset classes to hold in the portfolio. And, as one’s appetite for risk shifts over time, the allocation decision can and should be revisited.

Inspiration from Warren Buffett

There are many reasons why people listen to Warren Buffett.  Besides being the second richest American (right after Bill Gates of Microsoft), Buffett is widely considered the most respected (i.e. best) investor there has ever been.

But there are other compelling reasons for listening to him; simply put, he speaks in a way that anyone can understand.  It’s a Midwestern common sense, seasoned with well-earned and certainly, much deserved, confidence. He’s cheerful, loves what he does, and apparently cares very little about consumption.  He is extremely grateful for the opportunity he has had in the United States and the life that he has lived.  He has already given away billions and plans to give away still more to charitable foundations.

Buffett was a guest on the November 13th episode of the Charlie Rose TV show.  Unfortunately, only excerpts of that show are available for online viewing. Go to the Charlie Rose website and search for Warren Buffett. What you’ll find are his ideas on financial regulation, his reasons why he bought the Burlington Northern Santa Fe Railroad, and his assessment of the global economy. There is also a “Web Exclusive” interview.

A full written transcript is available here.

I’d like to focus on his basic optimism about the future of the United States, because in my opinion, you need three things to be a successful long-term investor.

• Faith in the future.
• Patience.
• Discipline.

Here are some relevant quotes from the November 13th program.

(Regarding consumer demand)  Well, it will come back eventually. … Our system will still work. … We talked last year about the patient, you know, being on the floor with a cardiac arrest … and we’re not out of the hospital yet.   But we will come out of the hospital.  This — the things that made America what it is have not disappeared, and they will — they will assert themselves with time.

The American economy will come back.  It won’t be tomorrow, and, you know, it won’t be exactly the same.  But in the end, we have not — we’ve not changed the American people in their capacity to innovate or their excitement about — about becoming more prosperous, and coming up with new ideas.  Businesses will be formed.  Businesses will expand.  But not much tomorrow.

If you look back a couple of hundred years, we’ve gotten where we are not because we’ve gotten smarter or not because we work harder.  We’ve got it because we found ways to unleash more of the human potential.   And what does that?  Well, a rule of law helps.  A market system helps.   Equality of opportunity helps.  All of these things that are still a fundamental part of the American system. As a matter of fact, the American system is now better than it was a couple of hundred years ago, because until the 19th Amendment, you know, we’ve had half the talent in the United States that wasn’t entitled to do much. So we’ve got a great system.  (Emphasis added.)

Well, I have everything I want in life, so there’s nothing to spend it on.  I mean, I could have 10 houses instead of one, would I be happier?  No way.  I could have 10 cars instead of, you know, two in the house.   I wouldn’t be happier.  You know, it would drive me crazy.  I could have a 400-foot boat, you know, and then I’ve got to have a crew of 50 or 60, and some of them (inaudible), sleeping together — I mean, who knows what would be going on. So I don’t — if I wanted to be a ship’s captain, you know, I’d have gone into a different profession.  I have everything in life I want.

I love working — I love working with the people I work with.   I love just viewing the human scene, but I mean, I have an ideal life.  I get to do what I want to do every day.  So, you know, and money can’t — can’t buy any more than that.

As I said earlier, you need three things to be a successful investor:

Faith in the future. Optimism is the only realistic attitude; you cannot be fearful and succeed as an investor.

Patience. Moving in and out of the market or among various investments does not accomplish anything.

Discipline. Do not be driven by headlines or events.  Ask not, “What’s working now?”  Ask, “What always works?”

I believe Warren Buffett to be instructive and inspirational on all three counts.

More About Ric Edelman

When in my last post, I criticized some of Ric Edelman’s practices and fees, I felt a bit queasy.  Was I being unfair?

I reached my conclusions by reading the handout material and by what he said in a seminar.  I also studied his web site, which disclosed his fees.  But I did not have direct access to a client’s portfolio, so I felt somewhat tentative in my judgments.  But today’s post by Allan Roth An Interview with Ric Edelman – Is High Cost Indexing an Oxymoron? confirmed my suspicions.

Roth analyzed an Edeleman client’s portfolio, and he also spoke to Edeleman. Roth reached the same conclusions I had about the high fees, and he also questioned Edelman’s recommendation of not paying off a mortgage.  Finally he confirmed my belief that Edelman was not paying attention to asset location, since he found the same allocations in the IRA accounts as in the client’s taxable accounts.

But enough criticism.  The rest of this post is about Edelman’s book The Lies About Money, which I can recommend.  In the first two chapters he persuasively lays out the case for diversification and for not trying to time the market.  This is a very important message which many investors still do not get.  Then he explains the advantages of mutual funds.

But it in his fourth chapter, The Demise of the Retail Mutual Fund Industry, that he shines.  He essentially demolishes (active) retail mutual funds.  For starters, he discusses the frequent manager changes, the costs of active management, and the dangers of style drift.  And this is just the beginning; he discusses 25 reasons why you should not use a typical (active) retail mutual fund.

Not satisfied with that, Edelman actually put together A Mutual Fund Scandal Timeline outlining the abuses that have been alleged or proven from 2003 to 2007.  It takes him a “mere” 40 pages to summarize the questionnable practices and allegations of abuse.  If that is not enough to make you question whether your mutual fund or stockbroker is actually your friend, then nothing will.  So buy the book or get it out of the library simply for Chapter 4.

Conclusion

The financial services business is fraught with conflicts of interest, high fees, misleading ads, and general confusion for the typical investor.  Sorting through this mess is not easy.  As William Bernstein says, “Both mutual fund companies and brokerage houses know more ways than you can count of fleecing you without your knowing it.”

To be continued.

Edelman Financial: Bigger Isn’t Necessarily Better

Because Edelman Financial Services is opening six offices in the New York/ New Jersey area, I accepted an invitation to attend a seminar by Ric Edelman, the well-known author, radio host and investment manager.  The talk was held at the luxurious Hilton Hotel in nearby Short Hills last week.

Here is my review.  As a public speaker, I gave him an A+.  He was entertaining and informative, and offered a very clear piece of advice: Buy-and-hold a diversified portfolio of low-cost institutional mutual funds. Certainly, I would recommend his firm over a broker from Ameriprise, Smith Barney, Merrill Lynch, etc.

Still, I would only give him a B to a B+ as an investment manager.  I realize that it takes a certain amount of chutzpah (nerve) for a solo practitioner like me to judge someone whose firm manages approximately $4 billion and has thousands of clients – my goodness, Barron’s rated him the No. 1 independent financial advisor in 2009 – but I believe it is my responsibility to give you my opinion.  Read on, and see if you agree with my assessment.

Points of Agreement

First of all, let me state the areas of agreement.  I think his basic message is absolutely correct.  Most individual investors have so many misconceptions and make so many mistakes that their results are generally terrible.  Edelman provides a useful service in summarizing the theory, evidence, and his personal experience to educate the public on what really works.  He correctly points out that investing in safe instruments such as CDs is just about guaranteed to cause penury in retirement, because the “safe” investments don’t keep up with inflation, especially after taxes are considered.

He convincingly explains in great detail the necessity for wide diversification, proper asset allocation and rebalancing.  He also shows that listening to the media is bad for your investment results.  Good for him!

Like so many good investment managers, Edelman recommends having a long-term strategy and the importance of being invested at all times.  He was quite convincing in explaining how past performance is no guarantee of future results.  His down-to-earth “toaster” comparison was so good that I plan to use it myself when the occasion arrives.

He also explained in detail why retail mutual funds are just way too expensive.  These are not just opinions, but are based on facts.

He graphically illustrated the high cost of being “out of the market” for even a short time.  According to the data, provided by Standard & Poor’s, the average yearly return of the S&P 500 from 1994 to 2008 was 6.5% per year, if you were invested all 3,827 days.  If you missed the 10 best days, that’s right only 10 days, your return was actually 0%.  What a convincing comparison for a buy-and-hold all-the-time strategy.

So in general, I applaud Ric Edelman for being on the right track.

Where we disagree

My first criticism is that, although Edelman emphasized the long term cost that inflation inflicts on client portfolios, pointing out that over the long term inflation has been 3.2%, he says that it is “too early” to be concerned about inflation. He is “monitoring the situation” and will change his strategy when he thinks it is appropriate. In my opinion, this is a very strange approach for someone who believes that you cannot forecast the future.

Since markets react very quickly to new information, I worry that Edelman will not be able to change his strategy at just the right time. Why try to “time the market” by saying that inflation is not a concern now? To paraphrase an old Wall Street saying, “No one rings a bell to let you know when you should be worried about inflation.”

The question and answer portion of the seminar revealed a position that I take exception to.  Edelman suggests that paying off a mortgage quickly is a mistake, because clients can invest the money for a higher return.  While this is a controversial area, I believe that it is comparing apples to oranges, because mortgage debt is a certain obligation, while investment gains are variable.  As with many personal financial issues, the right answer is “it depends.”  There are too many variables in one individual’s life to hand out one-size-fits-all investment advice.  For some people, paying off a mortgage is the right thing to do, depending on their tax situation and their risk tolerance.  The peace of mind a debt-free retirement provides is valuable to some people who are no longer trying to maximize returns.

And, frankly, I am concerned that he is recommending something that will give him more assets to manage and therefore increase his fees, without mentioning the conflict of interest.

When I decided to look up Ric Edelman’s previous books, including The Truth About Money and The Lies About Money, I was surprised to see reviewers on Amazon.com chastising him for his previous rejection of index funds.  While Edelman now (appropriately) denounces actively managed retail mutual funds (because they are a rip off to investors with their high fees and hidden expenses), it’s unconscionable that it took him such a long time to realize that. 

It appears that Edelman had been attacking the notion of index funds for years.  Interestingly, he now follows a correct passive approach to investing, which is very similar to index investing.  He just isn’t willing to admit his conversion (or his past mistakes, for that matter).

In addition, I have read that Edelman doesn’t require that his advisors be Certified Financial Planners.  If true, this is a very serious shortcoming. Real financial planners address more than just investments, and while the CFP certification is not a panacea, it does indicate the seriousness to master your craft. More than passing a 10-hour test, the continuing education requirements are invaluable.

Fees and Value

Edelman Financial Services uses low-cost institutional mutual funds and ETFs, as do I.  The firm charges annual management fees of 2% on the first $150,000, 1.65% on the next $250,000, 1.25% on the next $350,000, 1% on the next $250,000, etc.  There is no additional cost for buying and selling mutual funds, which is a plus.  Another good thing is that they are willing to take on clients with modest amounts to invest, as low as $50,000.

However, while all-in costs are less than you might pay a typical stockbroker, I believe that for individuals with as little as $250,000 or $300,000 to invest, his fees are higher than those of a typical independent fee-only financial planner.

An investor with $500,000 will have to pay Edelman $8,375 per year as compared to a typical $5,000 fee to a smaller financial planning firm. An investor with $1,000,000 will pay Edelman $14,000 per year as compared to $10,000 for most boutique firms.  And many of the fee-only planning firms use the same low-cost institutional mutual funds and ETFs that Edelman does.

Conclusion

I have received mixed reviews from other financial planners regarding Edelman Financial Services.  Some call his portfolios cookie-cutter, which may or may not be a fair description.  Others have pointed out that there is very little attention paid to asset location, as compared to asset allocation. One financial planner told me that there was no effort to do tax loss harvesting, but another one said “it depends” on the client.  These are issues that many investors will not even be aware of, but the answers can influence after-tax returns.

Certainly Edelman’s services are better than working with a typical stockbroker, who might put you into a bunch of expensive retail mutual funds or sell you a variable annuity.

However, investors should understand that they are paying a premium for a celebrity’s name on the door.  And something a potential client should definitely ask is how much financial planning will be done, in addition to investment management.  The answer to that may also be “it depends.”

For a second opinion, and to help do a cost comparison, use “Find an Advisor” at the National Association of Personal Financial Advisors’ (NAPFA) web site and interview other financial advisors.

Evidence-based Investing, Part Two

“When you look at the results on an after-tax, after-fee basis over reasonably long periods of time, there’s almost no chance that you end up beating an index fund. The odds…are 100 to 1.” – David Swensen.

Passive investing, sometimes called index investing, is, as the name suggests, the exact opposite of active management of a portfolio.  The latter attempts to “beat the market” by various means, including selecting securities that are (hopefully) underpriced, trading holdings, and sometimes, by getting out of (and eventually back into) the market entirely.  Passive investing, on the other hand, employs a consistent strategy of buy and hold.  The $64 billion (adjusted for inflation) question is which approach is better?

The evidence proves that active fund managers actually under-perform their relevant benchmarks.  Specifically, over a 10-year period, approximately 75% to 80% of all mutual funds fail to “beat the market.” Attempting to be one of the 20% to 25% who succeed is known as “playing the loser’s game.”

And the longer the period under consideration, the worse the odds become. A study published in 2008 found that from 1975 to 2006 only one in 166 mutual funds outperformed the stock market.  That was 0.6% of the total. 99.4% failed to outperform the market.

Keep in mind that mutual funds that use active management charge more in management fees.  First of all, they have higher operating expenses, because they spend more money on research and on active trading.  And by claiming that they can outperform their peers, they can charge more, so they do.  But as an investor, you start with a handicap if the mutual fund you are using has higher expenses.

I don’t doubt that some of the active managers sincerely believe that they can deliver on their promises.  But logically, and statistics proves this out, they can’t all be above average.  So buyer beware.

Another consideration is that active management generates short-term profits, which are more highly taxed than long-term capital gains.  So, even some investment managers who think they can add value by actively managing a portfolio decline to manage a taxable account.  They believe that, after taxes, an actively managed portfolio will always underperform a passively managed portfolio.

Given the stakes in determining whether you can ever “beat the market” it’s not surprising that so much has been written on the subject.  And since we are talking about 50 years of research, it isn’t easy to summarize the evidence.  So I’ve chosen one (somewhat facetiously titled) article, How to Beat the Market in Three Easy Steps, which I think is well-written and which will give you a flavor for the logic and practical implications of passive investing.

Here are some quotes from the article by Karl N. Huish, Esq., CFP®

To be an active investor, you must say, ‘I am right, and most of you are wrong.’

One huge challenge is separating talent from luck.  Wall Street is filled (and overflowing) with bright, capable fund managers, with gold-plated MBAs and Ph.Ds in economics, mathematics, computer science and physics.  IQ tests and education resumes will not be enough to distinguish the true geniuses from the merely intelligent.  Most of these funds are advertised by top-flight marketing companies.  How do we dis­tinguish the sheep from the goats?

Can past performance help us?  This is the miscon­ception upon which many investors stumble.  It turns out that [surprise!] past performance is not indicative of future performance. A recent large study (3,700 public and corporate plans, representing $737 bil­lion invested) found that manager hiring and firing decisions made by retirement plans, endowments and foundations was a complete waste of money and time: the fund managers performed better than the market before being hired, but underperformed the market af­ter hiring.  In other words, their market-beating per­formance was luck, not skill.

David Swensen is the manager of the Yale University Endowment, which is the highest performing endowment fund over the past 20 years.  To many he is considered the greatest current institutional investor – a modern mastermind. … He stated the fol­lowing:

‘When you look at the results on an after-tax, after-fee basis over reasonably long periods of time, there’s al­most no chance that you end up beating an index fund. The odds…are 100 to 1.’

Mr. Swensen – the best in the business – isn’t very con­fident about beating the market rate of return, as re­flected in an index fund.  How confident are you that you or your advisor can identify those active funds that will – taking all costs into consideration – outperform the passive alternatives?

What Does the Research Say?

Well, what about the data?  It turns out that David Sw­ensen is just about right.  In a 2008 published study, Professors Laurent Barras, Olivier Scaillet, and Russ Wermers used the most advanced statistical testing in science (using tests from computational biology and astronomy), to drill down into the performance of active mutual funds for a 32-year period, from 1975- 2006.  The researchers found that, on a pre-expense basis, 9.6% of mutual fund managers showed genuine market-beating ability. But after expenses were de­ducted only 0.6% of fund managers outperformed the market.”

Conclusion

My Investment Philosophy is based on the belief that a passive approach is the best way to invest my clients’ money.  I follow that same strategy for my own portfolio, as well.   I am not convinced, however, that using simple index funds is the best strategy, largely because of their trading inefficiencies.

But that’s the topic of another post.

Evidence-based Investing, Part One

Just as evidence-based medical care utilizes fact-based best practices in treating illness and disease, it is possible to use research from the academic community in making investment decisions.  Evidence-based investing is really a bridge between academic finance research and practical portfolio management. That’s a mouthful, but what it comes down to is attempting to maximize potential returns, while limiting risks and avoiding common mistakes.

It all started in 1952 when Harry Markowitz published a seminal paper called Portfolio Selection.  He wrote about risk and return and the value of diversification. It may seem commonplace now, but at the time it was groundbreaking.

Markowitz simply said that investors should be more concerned with the characteristics of their portfolio than in choosing individual investments.  He concluded that while investors cannot control the “risk” of individual stocks, they can control the variability (risk) of an entire portfolio with proper diversification.  Of course he proved his point with a lot of mathematics and statistical analysis.  But underneath it was an elegant exposition of a simple concept that your grandmother not only understood, but probably often quoted – don’t put all your eggs in one basket.

Academic research has ballooned since the 1950s.  There have been thousands of studies trying to explain how investors do (and should) behave. The old rule of “publish or perish” certainly applies to professors of Economics and Finance, yet many of the papers were published in journals that very few investors even know existed, such as the Journal of Finance, The Journal of Financial Economics, and the Journal of Portfolio Management.

Harry Markowitz earned a Nobel Prize in 1990 along with Merton Miller, and William F. Sharpe for their work in “Financial Economics.”   The body of work developed by them and others has become known as Modern Portfolio Theory (MPT).  This approach is not foolproof, and the advice is based on models, not truth written in stone.  And, of course, MPT can be misinterpreted and used incorrectly, sometimes (unfortunately) to sell questionable investment products.  Nevertheless, the practical implications of MPT – focusing on risk and return – are extremely valuable for investors.

You really don’t have to understand all of the details of terms such as the Capital Asset Pricing Model, Alpha, Beta, the Sharpe Ratio, and Portfolio Optimization; there’s no test, after all.  But you should be aware of the major conclusions and practical applications.

One major topic previously discussed in this blog is the difference between active and passive management of investments.  This dichotomy comes straight out of the research that academic economists have performed.

Similarly, you don’t have to read the research of Eugene Fama and Ken French, nor do you need to understand the Fama-French three-factor model, but it would certainly be helpful if your investment manager did.

Actually, Fama and French are quite accessible on their blog.  If you check out the Fama/French Forum, which I highly recommend, you will notice a logo that says “hosted by Dimensional.”

Dimensional Fund Advisors (DFA) is a company best known for applying academic research to portfolio management.  DFA has been referred to as “the best mutual fund company you’ve never heard of.”

To be continued.

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