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.

Affirmation is not the path to growth

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We live in an age of affirmation. It’s on church signs, it’s enforced in the court of public opinion (Twitter), it’s even taught to children in school. Everyone is great just the way they are (unless they’re not affirming). That’s obviously not all bad, but if affirmation is the highest good we’re missing something.

We tend to think of affirmation as a virtue on a spectrum. Affirmation occupies one side of the hypothetical spectrum and pure evil hatred exists on the other. If that’s true then anything less than affirmation is bad, or at least tainted. But that’s not a real spectrum. Affirmation and hate are not opposites, love and hate are opposites. And love and affirmation are two very different things. We tend to think that the loving thing to do for people is to affirm them, but that’s not true either. Love seeks what’s best for people.

Affirmation can be crippling if we begin to believe that we’re just right the way we are. If we’re affirmed as we are, why make an effort to change? Why take responsibility if it’s not your fault? Why take some initiative if you have no control over what happens to you? Instead of affirmation, you may benefit from a loving nudge towards something better.

Growth happens when we’re challenged, pushed, when we realize that we might not be great just the way we are, when we see a new world of potential. It doesn’t happen by affirmation but by relationships, by tough conversations and experiences, by a new way of seeing or understanding, by coaching.

We all want affirmation, but most of us would benefit from some growth.

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.

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.

2018 Book Recommendations

I would say that reading, specifically reading books, is the single most important method of self-improvement that a person can engage in. A few years ago, in a desire to improve myself and my circumstances, I decided to read more books, and the payoff has been overwhelmingly positive. Probably the main benefit reading has imparted to me these last few years is to change the way I think. My goals and ideas and aspirations are bigger, my concept of what’s possible has grown. This change in thinking has also affected my behavior, my actions have been more consistent and more ambitious, I even waste (a little) less time with TV and on my phone. Basically, reading books can have a transformational effect. So, I want to share some of the best books I read last year (2018) in the hope you can reap some similar benefits from them. The list is broad, ranging from self-help and productivity to history to fiction and anything in between. Dig in!

The Three Laws of Performance is top shelf coaching material. Steve Zaffron delves into what actually causes transformation in people’s lives and organizations, how to really induce change. It’s not the typical rah-rah motivational material, this is real, strategic, transformative coaching. It’s also filled with real-life examples and stories, which makes it very accessible.

What’s Best Next is an incredible guide to greater personal productivity. Matt Perman is a confessed productivity junky who has gathered and distilled some of the best productivity literature available, conducted interviews with accomplished subjects, and drawn from his own experience to build his best strategies for increased effectiveness. It’s organized, well-researched, very practical, I even found it inspiring. The structure of my entire week is based on things I gleaned from What’s Best Next.

The Marks of a Spiritual Leader is not simply for pasters and Bible-study leaders. This little book is packed with practical and helpful advice for anyone in any type of leadership role. It’s clear, concise, practical, and at less than an hour total read time, it is well worth the investment.

The One Thing may be the best book on setting and achieving goals that I’ve come across. The title is a giveaway, but Keller stresses the need to determine your most important one thing and focus on that one thing tenaciously. It’s full of practical, actionable advise presented in a fun and engaging way.

Tim Keller is a leading Christian apologetic. Making Sense of God builds upon his previous popular work The Reason For God. Whether or not you’re a Christian, this inquisition into foundations and defenses of Christianity is remarkably insightful.

Reset is a type of self-help book, but instead of pushing readers to do and be more and more, David Murray encourages us to understand our limits and work within the bounds. Humans tend towards arrogance, limitations are seen as an inconvenience, but our unwillingness to acknowledge them leads to burnout. Through his concept of ‘Repair Bays,’ Murray encourages us to slow down and live consistently with reality.

I started reading Earnie Pyle during my WW2 phase in high-school. I still remember the day I finished Pyle’s Brave Menit was the most visceral, funny, and affecting account of war I had, and probably still have encountered. Ernie Pyle in England is his first collection of essays during WW2 (Brave Men is his third collection). Before the U.S. had joined the effort Pyle spent several months in England observing and reporting for an American newspaper.

In the Garden of Beasts is a look at the rise of Hitler’s regime through the eyes of the American ambassador’s family in the 1930s. It’s fascinating. Larson is a historian, but In the Garden of Beasts is not like the college history textbooks that may have put you to sleep, it reads almost like a novel, very accessible.

The Last Kingdom is the first installment of a multi-book series called The Last Kingdom Series (Cornwell just published the 11th book of the series in 2018). The genre is historical fiction, the setting is 9th and 10th century Britain, the story features protagonist Uthred of Bebbanburg fighting the Danish invasion. Cornwell is simply a great story-teller. I’ve gladly resolved to read the entire series after finishing The Last Kingdom.

I picked up The Richest Man in Babylon on a whim a few months ago. The book is a series of parables, all taking place in the context of ancient Babylon, and all dealing with a point of wisdom surrounding life and work. It’s surprisingly compelling. Clason weaves the stories around wisdom in such a unique and interesting way, and it sticks.

The Call of the Wild is an old classic that my sister encouraged me to revisit last year. Jack London’s brilliant use of language and word pictures are on full display. It’s short and profound, well worth the read.

You Need a Budget is another little gem. Jesse Mecham is the founder and CEO of YNAB, the best personal online budgeting tool out there. But the book is not a sales pitch, he digs into the nuts and bolts of building and operating a successful, zero-sum budget. This look book is packed with valuable guidance for your personal finances.

Sometimes you need to kick back and read something for the pure enjoyment of it. Ready Player One was that for me, I could hardly set it down. It’s certainly not perfect, but it’s interesting, it moves quickly, and it’s thoroughly entertaining.