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.

There are only two ways to invest (part 3)

 

carolina-pimenta-J8oncaYH6ag-unsplashSo there are two basic strategies to invest, and your first decision as an investor is to decide which road to take. In part 2 we talked about the active option, in part 3 we’ll cover the alternative option: passive investing.

Whereas active investing feels right, passive investing is a little counter-intuitive. You actually don’t have to do anything to be a successful passive investor. You should probably have an understanding of how the market works and have a conviction about why you’re investing the way you are, but as far as activity goes you’re taking it real easy.

One of my favorite analogies for passive investing is salmon fishing. Salmon fishing is not sport fishing, it’s almost like harvesting, like work. The importance is not in casting and reeling (a staple of sport fishing), the importance is in how well you’re set up. You need to have varying types of bait at varying depth of water, you might try variations in boat speed, variations in direction, variations in water depth, etc. The important thing is to be equipped to catch a fish at any moment by diversifying your offering as much as possible. Once you’re all rigged up, you sit back and let the market do its work.

The basic question here is about whether or not you’re confident in the fact that the market is efficient. If you believe the market is efficient (which data supports) any attempt to outperform the market by actively picking stocks or timing the market is vain. Instead of spending time on all different types of analysis and market trends, the focus can be on how to design the most efficient portfolio possible, how to diversify in the best possible way. Instead of trying to bet and predict the market, you simply need to own the market as efficiently as possible. It’s an entirely different game.

Passive investing is a wonderful thing, it reduces a great deal of stress. A poor year of returns is simply a result of the market, it’s not the result of some poor guesses by you or anyone else. A recession is no longer terrifying because you’re well-diversified and you understand that the market always bounces back, that the average market downturn lasts less than a year. Your retirement is no longer a question of ‘if,’ but of ‘when.’ A passive investor is free from analyzing endless piles of company data, the uneasiness about the market sectors they’re invested in. Passive investors don’t have to worry about how the riots in Hong Kong, or Bolivia, or Lebanon, or Iraq will affect their portfolio. It’s an entirely different way of being.

So the first decision you’ve got to make as an investor is whether you’ll be active or passive. That’s certainly not the last question you’ll have to answer, but it’s a very important one and one that set the direction of your investing journey and your financial future.

There are only two ways to invest (part 2)

 

carolina-pimenta-J8oncaYH6ag-unsplashSo we’ve identified the two basic ways you can invest. That’s great, but how do you know which one to choose? Let’s talk about the active option.

Active investing feels right. We’re active people after all. We shop around for deals, we love sales and Facebook Marketplace. We check weather forecasts on the regular, we set future plans on our calendars. We do research before we buy things (some of us perhaps to a fault), we read reviews, we ask our friends. All of these things are active. So then active investing just seems like the normal way to do things, look for underpriced companies, do some stock research, make a prediction about the future, nothing too out of the ordinary, right?

There’s just one small problem, investing isn’t like normal life. We’ve got really smart people positing that the stock market is efficient, which means there aren’t actually and sales or deals on underpriced companies. Sure, stock prices will generally move upwards, but not because a company is underpriced. New news and information comes into the market and affects stock prices, new things happen that we can’t know for sure beforehand are going to happen. Research into specific stocks is great, professionals are doing it all of the time, but no one person can possibly have a complete understanding of a company, let alone how unknown events in the future will affect the company. There’s just too much data to make picking stocks a long-term viable strategy. Predictions in the stock market are not like weather predictions, we don’t have a radar watching a storm-front move in. And if people believe there is a storm front coming, it’s already priced into the stock prices because again, the market is efficient.

It’s really tough to be a good active investor. Even professionals fail to outperform the market at an extraordinary rate (over the last 15 years, 92% of active funds trading in the S&P 500 have underperformed the S&P 500), and even those who seem to be good at it tend not to repeat their performance. So maybe you’ve guessed by now, I don’t advocate active investing. If you really believe that the market is not efficient and that you or someone you know has a special ability to buy and sell the right stocks at the right time then active investing is the way to test your belief. Unfortunately, the odds are not in your favor.

In part 3, we’ll talk about the alternative option.

There are only two ways to invest (part 1)

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If you’ve faced an investing decision at any point in your history you know it can be daunting. Maybe you’ve reviewed your 401k options within the plan at your work, how in the world should you decide which funds to use? Maybe you’re feeling the pressure to start saving for your future, how do you decide who would manage your hard-earned savings well? Conduct any amount of research and instead of settling anything you’ll find innumerable different philosophies and strategies and a lot of recommendations to ‘invest in what you believe in.’ Well, I’m going to try to help you understand the first decision you have to make.

The first decision is actually pretty simple, there are only two options because there are only two ways to invest. You can invest your money actively or passively.

  1. Active means that either you yourself or someone you delegate to selects stocks and investments they believe will do well. At work in active investing is a fundamental belief that the market is not all that efficient and smart people can achieve better returns by only investing in the ‘right’ things.
  2. Passive investing means that you don’t try to choose the ‘right’ companies or even market sectors. Instead, you own the whole market and hold it passively. At work in passive investing is a belief that the market is mostly efficient, and probably better at setting prices based on supply and demand than you are.

You certainly aren’t done making investment decisions when you’ve answered this question, but it’s the first thing you need to interact with. So when you start evaluating, start with this question, will you be an active or passive investor?

We’ll dig into these options in part 2.