Advisor

Year-end investor review

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We made it, another year is in the books and everyone has an opinion on where the market is going. My line of work involves me adamantly advising people not to try to predict markets, but even I have an opinion about what might happen in the future. Thankfully, there’s a difference between having an opinion and making a poor investing decision.

So where are we now? We’re coming off of a historically great period of market returns, especially in the category of U.S. large growth companies (the S&P 500, which happens to be the category we almost exclusively hear about in the news). Since U.S. large growth companies have faired well, so have investors, because the vast majority of investors have the majority of their investments in large U.S. growth companies. That’s great news right now. But it’s also a problem.

Large growth companies are historically one of the poorest performing asset categories in the free market. This holds in performance data going back one hundred years, but it also makes sense a priori. Large growth companies are inherently less risky than small and value companies, they stay in business longer, they seldom go bankrupt (it happens, just not as often), and their prices don’t fluctuate as significantly. Small companies are often younger, less established, and more susceptible to tough markets. Value companies are often distressed and sometimes never recover. These small and value companies default more often and their prices are more volatile, they’re riskier.

You’ve heard the principle, risk equals return. That applies here. It makes sense that as entire asset classes, small companies and value companies outperform large growth companies by a significant margin over time because their additional risk brings additional return. The fact that large growth companies have performed so well over these last ten years is great, but it also means that at some point we’ll see these returns balance out. Now, I would never pretend to know which asset classes will perform better or worse next year, that’s a fool’s errand which we refer to as ‘market timing.’ But I do know that most years will favor a diversified portfolio that leans toward small and value asset classes instead of a heavy weighting towards large growth companies. Next year the most likely circumstance is that you’ll be happy to have left your large growth company portfolio to get into a more diversified situation, which, incidentally, is true at the end of every year.

So the obvious question is how to diversify with a lean towards small and value companies. I’ve covered this before, but total market index funds won’t help you here, because of cap weighting total market funds are invested almost entirely in large growth companies. Index funds have become very popular over the last 20 years and, while they’re certainly an improvement over active funds, they’re inherently flawed. To get into an ideal portfolio takes an advisor committed to the academics of investing utilizing structured funds (a solution to the index fund problem).

Take the opportunity to review your portfolio as we head into the new year. The returns may look great, but that doesn’t mean you’re in a great portfolio.

Your 401k account is probably loaded up in the wrong asset class

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401k accounts good and bad. They’re mostly good because they provide an avenue for people to save and invest money for their future, but there are some things to watch out for.

Good stuff:

  • The main benefit of a 401k is that it allows you to invest qualified money. You could just invest money on your own, but investing in your 401k accounts means that you get some significant tax advantages (no capital gains on the growth of your investments and an income tax break). The same advantages apply to IRA accounts, but 401ks include two other significant advantages.
  • Many employers offer a matching contribution. For example, if you contribute a certain small percentage of your income (say 5%), the employer may kick in an additional small percentage into your 401k account (say 4%). That’s free money, and you should definitely take it.
  • 401k contributions are capped at $19,000 per year by the employee, employer contributions can exceed that. IRA contributions are capped at $6,000 per year. Not all of us are maxing out our qualified retirement accounts, but the larger cap offered by 401k accounts is certainly an advantage.

Bad stuff:

  • 401k accounts offer a limited number of investing options, and they’re almost never great. 401k Plan sponsors (employers) are typically concerned with one thing when choosing a plan: cost. If the plan seems expensive it will be harder to explain to the board, regardless of the value or benefits of the portfolio and the advisor.
  • Your money is locked up for as long as you work at the company. You’re stuck with the options available and you can’t move the money elsewhere unless you leave or retire.
  • Investors have little to no help deciding which funds or options to use within the 401k so they end up in default options, which are usually target dated funds. You may have seen these funds that end with a future year, like 2045, which you’d be in if you were expected to retire sometime around 2045. A target dated fund is not the worst investment you could be in (which isn’t saying much) but it’s far from ideal. A target dated fund will load you up in U.S. large growth companies (essentially the S&P 500), sprinkle in some international large growth companies, and decide what percentage of your money should be in bonds based on the target year. Unfortunately, in the history of the market, large growth company asset classes are among the lowest-performing of any asset classes over time. A target dated fund is usually made up of index funds (along with their inherent problems) so at least it’s not active, but it will sacrifice large amounts of return over time because of its poor diversification.

Don’t be afraid to use your 401k account, especially if your employer offers a matching contribution (again, free money). But if you’ve obtained the maximum matching contribution, think about investing additional money into a better portfolio through an IRA. Unfortunately, your 401k is probably loaded up in the wrong asset class.

Index Issues (part 1)

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Passive index investing has seen significant growth over the last 30 years as an alternative to active (stock picking) investing. Studies surrounding active investing have shown that on the whole, active investors underperform the market significantly, for two main reasons: high fees and poor stock selecting. As people come to grips with the problems inherent to active investing they naturally turn towards index funds, which seems to solve both of the problems listed above. Index funds are typically very cheap to own (solves the fee problem), and instead of actively picking stocks, they simply own sections of the market (solves the poor stock picking problem). Sounds pretty good, right?
Well, it’s definitely better than an active investment strategy but index funds are not without their problems, and they’re certainly not the best way to invest your money. Here are a few issues:

  1. An index is arbitrary. The S&P 500 Index (the most popular index out there) was created more as a measurement than an investment vehicle. It’s simply a list of 500 of the largest companies in the U.S., there’s no magic to the number 500. But that’s the thing, indexes were not created to maximize investor returns or diversify into asset classes in the most strategic way, they’re just arbitrary measurements.
  2. Index funds are almost all cap-weighted. This is an important thing to note. What this means is the larger the company, the larger percent of the index it takes up. In the S&P 500, the largest 10 companies take up 20% or more of the entire index while the bottom 10 companies take up less than 0.2%. In any index, most of your money is going into the most valuable several companies instead of being evenly diversified. A total U.S. market index fund, while seemingly offering lots of diversification, is almost entirely loaded up in the largest companies because of its cap weighting.
  3. Index fund investing often puts your finger on the trigger. Many index fund investors do their investing on their own since you can own an index fund yourself for a fraction of the cost you could pay an advisor to put you in the exact same fund. I’ve made this point in the past, but when it’s as easy as the click of a button to pull money out of an investment account, people tend to make mistakes. The S&P 500 for instance, has averaged about a 10% return per year for almost 100 years, which is fine, not great, but fine. However, from 2000 to 2009, it averaged a -1% return per year. It doesn’t matter how low the fees were or how well it compared to the stock-picking accounts, precious few of us would have stuck around for those returns over 10 years if we could move the money with the click of a button. Successful investing requires good coaching. Good coaching should include a better portfolio than a bunch of cheap mutual funds.

So what’s the alternative? Stay tuned for part 2.

Value Investor (part 1)

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Value investing sounds really cool. It sounds savvy, it sounds smart, it sounds responsible, it sounds like it makes a lot of money. I mean, Warren Buffet is a value investor!

So what is a value investor? Well, a value investor is someone who invests in value companies. So what’s a value company? I’m glad you asked. Essentially, a value company is one whose stock price is about the same (could be a little higher or lower) than its intrinsic, or book, value. A lot of words there but stick with me. The intrinsic value of a company is what you get when you add up all the company’s assets, its land, warehouses, products (which can include patents), equipment, cash, etc. It might seem a little odd that a company’s stock price wouldn’t always be close to its intrinsic value, but the stock market prices of growth companies (the opposite of value companies) can actually trade multiples of 8 times higher than its intrinsic value. This happens because the market expects the growth company to continue growing. Value companies aren’t typically expected to grow much, they’re often characterized as distressed. So value investors are analyzing these value companies and deciding which ones they think are actually undervalued and which ones could bounce back. Again, it sounds great, they’re the brilliant nerdy guys reading all of the fine print and finding the deals in the stock market, the companies that are underpriced. All you have to do is hitch up to their wagon and ride those value companies up when everyone else figures out how valuable they actually are. Sounds pretty responsible, right?

A semi-famous value investor, Michael Burry, featured in the Big Short (as Christian Bale) crushed the growth stock market from 2001-2005. In the middle of 2005, he was up 242% when the U.S. large growth market (S&P500) was down 6.84%. Michael Burry is the quintessential weird genius that we love to fall in love with, and hand our money over to. He did things differently, he didn’t take normal massive fees, he was incredibly awkward with people in person, he kept to himself, he obsessively studied the interworkings of the companies he invested in, just about everything you would expect from the next market genius. He’s most famous for predicting, and attempting to short, the housing crash in 2007. And now’s he’s rich, and semi-famous, and still investing. He recently stated that passive investing is a bubble, that he’s concentrated on water (you get it), that GameStop is undervalued, and that Asia is where it’s at. While these investment tips might accord with the laws of value investing, they hardly seem prudent.

Michael Burry is definitely smarter than I am, but here’s what I know:

1) Ken French, a professor of finance at the Tuck School of Business, Dartmouth College, who has spent much of his adult life researching and publishing in the sphere of economics and investing, conducted a study of mutual-fund managers (Luck versus Skill in the Cross-Section of Mutual Fund Returns) and found that only the top 2% to 3% had enough skill to even cover their own costs. Eugene Fama, another father of economic and investing academia, who co-wrote the paper with Ken French, summarizes their findings this way: “Looking at funds over their entire lifetimes, only 3% demonstrate skill after accounting for their fees, and that’s what you would expect purely based on chance.” Of the managers who do exhibit enough skill to cover their own costs, it’s hard to determine whether an actual skill is at work or it’s simply a facet of luck; most free-market scholars lean towards luck.

2) Fama continues: “Even the active funds that have generated extraordinary returns are unlikely to do better than a low-cost passive fund in the future.” Some managers do well enough to cover their own costs and beat the market in a given year. Unfortunately, their success languishes quickly and they regress to the same plane that active managers on the whole occupy, which is underperforming the market.

So is Michael Burry, or any value investor, the weird, brilliant savant that we desperately want to attach our life-savings to, or is he one of the 3% of managers who have done well enough to cover their own fees, but who the data says is more likely to regress to market underperformance mean than to do it again? I know which side I’m playing.

Financial Advisors aren’t evil (mostly)​

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I met a stranger this morning (the beauty of Facebook marketplace). He had looked me up in advance, not to be creepy (he assured me), just to make sure he wasn’t meeting a crazy person. He saw that I’m a financial advisor and wondered if I had ever met his financial advisor, whom he trusts very much. In fact, he trusts his financial advisor so much he recently handed over full discretion, meaning the advisor no longer needs his permission to make trades and move money. It was becoming cumbersome to give the okay every time the advisor wanted to make a trade. I informed him that I had not met his financial advisor, and he assured me that his advisor is a great guy.
Here’s the thing, I’m sure he is a great guy, I’m sure his intentions are (mostly) pure. Many financial advisors are really great, and they really care. But that little discretionary bit he shared with me is alarming. When it becomes cumbersome to approve every trade your advisor wants to make, that’s a problem. According to the data, financial advisors who actively trade routinely underperform the market, even advisors who are really great guys. Don’t work with an advisor only because he or she is a great person. Find an advisor who is a great person, but who also understands how the market works, how to most efficiently capture returns, how to avoid stock picking and market time and trying to beat the market, and most importantly, how to coach you. Your future depends on more than the integrity of your advisor. He may not be evil, but he may also be submarining your retirement.