Asset Class

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.

Fishing and diversification

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I love salmon fishing. I love all sorts of fishing, but salmon fishing is special. Instead of the romantic image of fly fishing in a river, or the flashy idea of big-time bass fishing, or even the nostalgic memory of fishing off a rowboat with your grandpa, salmon fishing is more like a battle. Forget everything you know about traditional casting and reeling, salmon fishing involves rigging up multiple fishing rods, attaching them to downriggers and various mechanisms for getting the lures down deep, and a slow troll on open water. The key to catching fish has nothing to do with technique or sport, it’s about setting a broad array of bait covering many different depths. We call it a ‘spread.’ If you only had one or two rods you’d be poorly served, it’s simply not a sufficient level of depth diversification. Ideally, you want 8 to 12, or even 15 to 18 in the case of professional charter boats. Here’s a quick visual:

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Notice how the lines are prudently spread across varying depths? Investing is the same way! Stick with me here; the water is the stock market, the lines/rods are investment dollars, and the different depths are asset classes. We don’t know which depth, or depths, will produce fish, we just know the fish swim all over the place and that if we’ve got a good spread (lines at different depths) we’re bound to catch something. Same with asset classes! We know that they all perform over time, but we don’t know which one is going to hit next year or which one will be best over the next 5 years. So we own all of them. Imagine how dumb it would be to have one line out in the water trolling for salmon, it makes no sense. Even if that one line is set at the depth that has produced the most fish over the last few weeks, it still doesn’t make sense. Fish move around all the time, why would you not want to cover the whole water column/stock market? Just like downriggers and multiple lines ‘enable the whole water column to be covered when trolling,’ diversification allows you to own the whole market when investing! No guesswork, no hoping, no predicting, no gut feelings, no casting lots, no anxiety, just well balanced, widely diversified investments. I’m not saying it’s easy, salmon fishing is a lot of work, but when you’re eating your salmon dinner at the end of it, you’ll be glad you diversified.

Are you market timing?

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Market timing is the practice of moving money in and out of the market, or in and out of specific sectors of the market, based on a belief that the market, or specific sectors of the market, will do well (in which case you’d be in) or poorly (in which case you’d pull out) in the future. If you’ve read about stock picking, market timing might sound familiar. Market timing is similar because it’s also built on a false premise that the market is inefficient, but it’s also a little bit different. Market timing is more subtle than stock picking. Instead of a belief that you can buy underpriced stocks and sell overpriced stocks, market timing is a larger bet on the future of entire market sectors. It gives the allusion that you can simultaneously be well-diversified and engage in market timing since you might always own a few different asset classes. It’s sort of like stock picking in disguise (it’s often called ‘tactical asset allocation’ which sounds super smart) because it’s essentially picking market sectors (asset classes) instead of stocks. Market timing can seem more legitimate than stock picking, but it’s still essentially gambling.

Market timing is unfortunately just as pervasive in the investing world as stock picking. It is often incited by panic, people move their money around or out when the market seems especially scary and move it back again (or not) when the market feels more safe. The timing tends to be exactly opposite of what should be done, people end up selling low and buying high and sacrificing millions of dollars in returns. But damage is done apart from panic too. Dalbar (an investor research company) reports that the average equity (stock) fund investor stays invested in their funds for only 4 years before jumping to a different set of funds, perhaps unintentionally market timing. Money managers routinely shift strategies within popular mutual funds (referred to style drift), shifting focus between market sectors. Pundits constantly discuss market trends which include market timing suggestions. Similar to stock picking, we’re so immune to market timing that it just sounds like normal investing at this point. That’s bad, here are a few reasons why:

1) People are bad at market timing. A study by William Sharpe conducted in 1975 (Likely Gains from Market Timing) concluded that in order for a market timer to beat a passive fund they would have to guess right about 74% of the time. An update to the study by SEI Corporation in 1992 concluded that the market timer would have to guess right at least 69% of the time, and sometimes as high as 91% of the time in order to beat a similarly invested passive fund. So the important question is: does anyone guess right with that frequency? Maybe you’ve made your own guess by this point, the answer is a resounding no. CXO Advisory did a fascinating study on the success ratios of market timers between 2005 and 2012. They looked at 68 ‘experts’ who made a total of 6,582 predictions during that period. The average accuracy of all predictions? 46.9%, well short of the minimum 69% threshold. These predictions sell news subscriptions and online adds, but they’re detrimental to investor returns.

2) Market timers miss out on returns. Trends are a big topic in the world of investing. Market timers analyze previous trends, they track current trends, and they look for the next trend, it’s incessant. Nejat Seyhun in a 1994 study entitled “Stock Market Extremes and Portfolio Performance” analyzed the period between 1963 and 1993 (a total of 7,802 trading days) and found that only 90 of the days were responsible for 95% of the positive returns. That’s about 3 days per year on average where 95% of returns came from. In all the misguided ‘trends’ talk and the popular practice of moving money in and out and all around, market timers routinely miss the most rewarding days in the market. Instead of focusing on market trends, investors would do much better to focus on the whole market and ride the general stint of the market upwards.

3) Market timers misunderstand the market. The most culpable cause of market timing is panic. People do crazy things when they’re scared and their money is on the line. Don’t get me wrong, the stock market can seem pretty scary, and it definitely involves money, but just because it seems scary doesn’t mean you should be scared. The average market crash of 10% or more lasts just under 8 months, 4 months until it hits the bottom, and just under 4 months to return to the pre-crash high. That’s not so scary. Over the last 93 years (going back as far as we have super-reliable data) 68 years were positive by an average of 21%, 25 years were negative by an average of 13%. Also not so scary. There are 45 countries in the world with free markets and the ability to buy and sell stocks and over 17,000 companies to invest in. What would it take for a well diversified portfolio to lose everything? Only some type of global apocalyptical event, at which point you probably wouldn’t be concerned with the amount of money in your portfolio. That is scary but not because of the market, it’s actually pretty reassuring as far as your portfolio is concerned. Instead of panicking, investors would do much better to rebalance during turbulent markets and capture returns on the way back up.

So market timing is a losing game. It can’t provide any consistent value to a portfolio, it actually causes a drag on returns, and it’s often driven by an inaccurate understanding of the market. Unfortunately it’s prevalent, and many portfolios engage in market timing while investors remain unaware. So take a look, have an advisor do an analysis for you. It pays to understand how you’re invested and to avoid market timing in your portfolio.

Sources:

https://www.ifa.com/12steps/step4/#footnote_3

https://money.usnews.com/investing/buy-and-hold-strategy/articles/2018-06-19/no-right-time-for-market-timing

3 Questions to Ask your Financial Advisor

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Your investment advisor is a very important person. You rely on this person to help you navigate your lifelong financial journey, and hopefully guide you to a successful outcome. There are obvious characteristics we want in an advisor: integrity, honesty, diligence, etc., all good things. But there are other, almost equally important things most of take for granted in an advisor: What’s their investment strategy? What’s their view on the market? How do they expect to help you capture returns? These are questions we don’t tend to ask, after all, they’re the professionals, but the answers to these questions will have a profound impact on your future.

  1. Do you think the market is efficient or not?

This is a simple question with massive implications. Basically, you’re asking whether or not your advisor thinks he/she can consistently get you better returns than the market by actively buying and selling stocks (stock picking), moving in and out of different market sectors (market timing), and using funds with the best recent return history (track-record investing). If the market is not efficient then these are valid exercises. An inefficient market means that stock prices could be underpriced or overpriced and assumes that smart advisors should be able to figure out which stocks are which and pick the ones that will outperform all of the others. Unfortunately, advisors don’t consistently beat the market, they can’t consistently pick the winners. The results of choosing stocks and timing the market have been overwhelmingly negative and research has resoundingly supported the assertion that the market is actually efficient (Efficient Market Hypothesis). An efficient market means a stock is never overpriced or underpriced, its current price is always the best indication of its current value. If the market is efficient, that means it’s impossible for anyone to consistently predict or beat it, in fact, attempts to do so are more like gambling than investing. Instead of trying to outperform the market, the goal should be to own the whole of it as efficiently as possible. This brings us to the next question.

2. What Asset Classes Do I Own?

In order to efficiently own the market, you need broad diversification. That means you want to own many companies, but more importantly, you want to own many companies in many different asset classes (large companies, small companies, value companies, international companies, etc.). When you ask, most advisors are going to tell you that the large majority of your money is in Large US Growth companies (S&P 500), which is unfortunate because the Large US Growth company asset class is one of the lowest returning asset classes in history. That’s not to say the asset class is a bad investment, it’s great for diversification, but it’s certainly not where you want most of your money. Small and Value asset classes return better over time, so you want to ensure you’re broadly and significantly invested in those asset classes.

3. How will you help me capture returns?

There are three important components to successfully capturing returns: 1) diversify, 2) rebalance, 3) remain disciplined. Diversification (1) means you’ll have ownership in companies of all different shapes and sizes all over the world. Good diversification does two things for an investor: it reduces risk/volatility and increases return. Since we don’t know which sectors or stocks will do best this year, we own all of them, and then we rebalance, which brings us to point 2. The goal in rebalancing (2) is to keep an ideal percentage of each of the different asset classes in your portfolio. Since stocks and asset classes don’t all move the same way every year when one asset class is up and another is down your portfolio percentages get out of whack. That’s where rebalancing comes in. In order to rebalance your portfolio, your advisor will sell some of the asset class that went up and buy some of the asset class that went down, bringing the percentages back into alignment. This must happen systematically, for example, it could be every quarter, in order for it to be effective. The end result is that you’re automatically selling high and buying low. There’s no gut instinct, no guessing, no market timing, it’s committed disciplined rebalancing, which brings us to point 3. Discipline (3) isn’t something that comes naturally to most of us, but it’s extremely important in capturing returns and planning for your future. There’s a behavior element that all of this hinges on, if an investor doesn’t have the discipline to ride out the ups and downs in the market they can’t be a successful investor. The average investor switches advisors and funds and strategies every 3.5 years, that’s a losing game. So how will your investor help you stay disciplined and on track to capture those returns and achieve your goals?

Since I’m writing this and I’m an advisor, you probably assume I’ve got answers to these questions, your assumption is correct. But this isn’t just a sales pitch, good answers to these questions are critical for successful investing, and far too many people simply have no idea what their advisor is doing for them, whether good or bad. So ask a few questions!