Diversification

Can investing be stress-free? (Part 2)

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Requirement 2: An understanding of your portfolio.

The vast majority of investors have little to no understanding of what they own in their portfolio, and even fewer have an understanding about why they own what they own. When you don’t know how or why you’re invested the way you are, the result is a murky, nervous, disposition towards investing. The only thing we know how to measure is the percentage marks, and any downward movement is going to be super stressful.

So an understanding of your portfolio, how and why it’s constructed as it is, could alleviate some of the stress. Unfortunately, it could also magnify the stress if you find out the portfolio is an actively managed, non-diversified disaster.

Stress-free investing involves an understanding of your own portfolio, but also an understanding of how a portfolio should look.

  • An actively managed portfolio cannot reduce stress. When the bad years come, and they will come, you will necessarily feel stressed that either your money manager or yourself is not living up to the task. Not only will the bad years cause stress, but they’ll also be more frequent because actively managed portfolios routinely underperform the market over time.
  • A non-diversified portfolio will cause stress because of the large increase in volatility and the possibility of random outcomes (especially if you only own a few different stocks, or worse, options). I mentioned in part 1 that over long periods of time (10+ years) the market is always up, but it’s important to remember that individual sectors of the market (like the S&P 500) could have droughts even longer than that. From 2000 to 2009 the S&P 500 averaged about -1% per year, for 10 years! And individual stocks can do a lot worse.

These two components, passive management and global diversification, work wonders to reduce the stress of investing. We understand the market has its ups and downs, but we can rest assured that the passive, globally diversified portfolio will trend up and perform best over time. Don’t be afraid to look under the hood of your portfolio.

The Investor Behavior Question

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So we looked at the problems with stock picking, market timing and track-record investing. The evidence strongly suggests we should avoid these investing pitfalls. So why do people still engage with them? Many people aren’t familiar with the research, which is an indictment on the investing industry, but the problem goes deeper than that. Even people who understand the research, even people who understand and assent to the research, still don’t consistently comply. Why is this? The industry calls it investor behavior, and it’s big business. I hear a lot about bad investor behavior, but I don’t hear much about why investor behavior is bad, or how to think helpfully about it. Here are a few reasons why I think it’s tough to be a good investor today:

1) The practice of buying low and selling high is ingrained in us. We’re deal shoppers. We see a good deal, something that’s worth more than its sale price, and we can feel great about the purchase. We’ve got TV shows that show us how to buy cheap houses and storage units in order to flip them for a profit. The booming fantasy football business teaches us to perform hours of research before drafting players (no? only me?) in order to find the underpriced guys who will overperform. We’ve got side hustles flipping cars, furniture, clothes, electronics, you name it. We’ve got sale adds spilling out of our mailboxes. That’s just how our world works, we shop for deals, things that are underpriced. Another way to say it, we’re always on the lookout for inefficiencies. But the stock market in not inefficient (see Are you stock picking?). It’s the one place we shop where there are no sales or discounts. It makes sense that we would apply our standard buying principles to investing, but unfortunately, our instincts aren’t helpful here.

2) Active investing feels right. Trading in a portfolio is exciting, especially if you think you’re good at it. A big win in the stock market makes for a really nice adrenaline hit. It’s similar to gambling. You can do it from your favorite chair in your living room, or a bustling coffee shop; it feels meaningful; it provides a perfect excuse to be constantly checking the news; you get to use your favorite tech gadgets (that’s what gets me). And even if you’re not the one making the trades, it just seems responsible to watch the news and track your returns every day. It seems right to talk predictively about the market, to decide on an investing strategy for the upcoming year. We’re not lazy people, we do our due diligence; unfortunately, with investing, we diligently do the wrong things.

3) We’re inundated with encouragement to engage in active investing. Financial news networks and websites were not created to educate their viewership, they exist to drive traffic. Since patience, diversification, minimal trading, (aka the staples of a good investment strategy) are really boring, news outlets lean heavily towards the predictive and active trading slant. Specific stock recommendations and bold market predictions fuel our instinct to do something with our investments. Again, it feels right to try to figure out where the market is going and how to profit from it. The news only tickles that itch.

Investing is counterintuitive and human behavior is often the trickiest part in investing. Sometimes we simply lack the knowledge required to be a good investor, but more often it feels like we should be doing more. When something needs fixing, we put our heads down and figure out how to fix it. Before we decide to buy something we do our research. But the way we make buying decisions in our every-day lives doesn’t work in the stock market. While we constantly look for inefficiencies, sales, discounts, deals, etc., the stock market is efficiently moving along on its unpredictable upwards trend. Instead of working to beat it, let’s ride it.

Are you stock picking?

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Stock picking is the art of choosing stocks that you believe will outperform (in which case you’d buy) or underperform (in which case you’d sell) the rest of the market, at least for a period of time. Whether you decide based on some special analytics or just follow your gut, it doesn’t really matter, you buy stocks you think will do well or dump stocks you think won’t. To put it another way, you’re looking for inefficiencies in the stock market. You believe that the stocks you plan to buy are underpriced; if everyone else knew or believed what you do the stock price would already be higher. Or you plan to sell stocks you believe are overpriced; again, if everyone knew or believed what you do, the stock price would already be lower. Naturally, once you’ve made your move, you expect the rest market to catch up and the stock prices to move accordingly.

Stock picking is a normal practice throughout the investing industry, even the prevailing practice. Professionals have been engaging with it since the inception of the stock market, and, with the advances in technology, more non-professionals than ever also have access through convenient investing apps and websites. Stocking picking is everywhere. In fact, most people think stock picking is investing, that they’re one and the same. The above definition of stock picking sounds like investing, doesn’t it? Here are a few reasons why that’s a problem:

1) Stock picking is built on the premise that the market is not efficient, that smart people can find deals and make money buying and selling the right stocks at the right time. The problem is that’s a false premise, the stock market is actually efficient. An efficient market means that stocks are never overpriced or underpriced, there are no deals, there is no right or wrong time to buy. Stock prices move based on future news and information (no one knows the future) and they react to the new news and information very quickly. If you purchase a stock based on an intuition about the future, that’s just guessing. If you purchase a stock because you believe it’s poised for growth based on a new report you read, the stock price has already adjusted to the report’s information, the price has already moved. With improving technology and additional regulation the market is more efficient now than ever before. News is disseminated immediately and trades can be placed instantaneously. There are differing beliefs as to the level or scale to which the market is efficient, but research continually supports the Efficient Market Hypothesis. Since the market is efficient, stock picking doesn’t work by definition.

2) Research into the results of stock picking has been impressively depressing. Study after study shows that no one, not even professionals, has consistent success picking stocks over time. People will outperform the broader market occasionally, maybe even for a few years in a row, but because of the number of people trying that’s a statistical probability, it’s not based on any skill. Professor Russ Wermers stated in a 2008 mutual fund study, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, that “the number of funds that have beaten the market over their entire histories is so small that the False Discovery Rate test can’t eliminate the possibility that the few that did were merely false positives.” He’s basically saying that there are so few active stock pickers who have outperformed the market that they were more likely a product of luck than skill. And that’s the professionals. Stock picking doesn’t work because it’s built on a false premise and the research agrees.

3) Research into the costs associated with stock picking is also grim. William Harding, an analyst with Morningstar, said that the average turnover ratio for managed domestic stock funds is 130% (Apr 23, 2018). That’s a terrifying number. It means that through the course of a year the fund will replace all of the stocks it owns, and then re-replace another 30%. It means that the average stock is held for only 281 days. There is a lot of trading going on here. One of the reasons stock picking fails is because of the additional expenses it incurs for all of these trades. Active funds charge an expense ratio, which is normal (although active funds typically charge higher expense ratios than passive funds because of the additional work it takes to actively trade), but they also incur significant trading costs, which is unique to active funds. The expense ratios are published but the trading costs often aren’t. A 2013 study, Shedding Light on ‘Invisible’ Costs: Trading Costs and Mutual Fund Performance, discovered that the average trading costs of mutual funds amounts to 1.44%, that’s in addition to the already higher expense ratio. Even worse, funds owning higher performing long term asset classes (see Three Factor Model) have even higher trading costs, 3.17% on average for small cap funds. These additional trading fees are debilitating to fund returns.

So stock picking is built on a false premise, it doesn’t work by definition, and it charges a premium for its lackluster results. On top of all of that, there’s a massive cost of lost opportunity when your portfolio is stuck stock picking. While your funds are engaged in the losing strategy the rest of the market is consistently earning great returns over time, returns that can be captured simply with diversification, rebalancing, and discipline. Unfortunately, large swaths of the investing industry still promote the active stock picking strategy, in fact, you’ve more than likely got stock picking funds in your 401k portfolio. There’s a better way to invest.

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!

Pay attention to asset classes, not returns

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When people think about deciding between investment advisors, or mutual funds, or even stocks, the temptation is to look at past performance. That’s the default. And it seems basic, you’re looking for returns, what else would you look at? What else could you even look at?

The problem is the past performance we see is short term. You’ll see three to five year histories on your account statements, Morningstar defaults at a ten year history (if the fund has been around that long), and the news rarely talks about anything further back than the last year. Those are relatively short periods of time, especially when we’re talking about market returns. Instead of comparing past performance in advisors and mutual funds over the past ten years, we should be looking at long-term historical returns of asset classes.

An asset class is a group of similar securities that tend to move together. The main general asset classes are equities (stocks), fixed income (bonds), and cash. Each of these, but especially the equities group, can be broken down further. In equities, we see large vs small, value vs growth, U.S. vs international. For an example, a very popular asset class is U.S. Large Growth, which is basically the S&P 500. We have returns data on these asset classes all the way back to the early 20th century. That information can tell us much more than the past ten years. We can see which asset classes tend to outperform others, we can see how the different asset classes correlate to each other, and we can know what returns and risk a fund or portfolio can expect over long periods of time. A ten-year history of returns is almost irrelevant. Over ten years any asset class could outperform any other, but we don’t know when or which. So to look backward at the performance of a fund is not only unhelpful, it’s more often hurtful. A good ten-year history on a fund, or even an asset class, deceives us into thinking the performance will continue in the future. The short-term history the only information we know to use, and besides that, it seems to make sense. But that’s the opposite of a good investing strategy. Instead, let’s analyze the asset class data going back as far as it goes, understand where returns come from, and diversify our portfolio’s in a way that’s consistent with the data. Then we let the market perform and deliver results. Our balanced diversified portfolio won’t always be the big winner year by year, but over the long haul, it will outperform anyone trying to predict market movements based on ten-year histories, or any other material information.