Year-end investor review

frank-busch-PzifgmBsxCc-unsplash.jpg

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.

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.

Index issues (part 2)

 

claudio-schwarz-purzlbaum-8j6_3iUcgec-unsplash

Alright, so we know passive investing trumps active investing, and we know that index investing, while passive, has some serious deficiencies. So what’s left?
We want to own the market passively, but that doesn’t mean we’re restricted to index funds. There is a much more responsible way to allocate money to different companies and sectors – structured funds. Structured funds deal with each of the index funds issues:

1. Instead of an arbitrary grouping of companies, a structured fund can make it’s own set of rules to decide which companies are in an asset class or fund and which are not. The S&P 500 is 500 of the largest companies in the U.S., but what if that’s not the best way to own the U.S. Large growth asset class? The same question can be asked of any index. Instead of abiding by the arbitrary index rules, a structured fund makes its own rules based on a century of market data. Just like the S&P 500 has rules to decide which companies are in and which are out (largely based on that 500 number), a structured fund has a set of rules that a company has to meet (size, profitability, book to value ratio, etc.) in order to be included in that fund. It’s still passive (in fact, often more passive than index funds), the rules are what determine which companies are in and out not an advisor’s gut feelings, but it’s a different type of investing. And it’s based on actual market research instead of arbitrary measurements.

2. We know that small companies outperform large companies over time, but indexes, by necessity (because of cap-weighting), own the least amount of the small companies. Even small company indexes like the Russell 2000 (which owns the smallest 2,000 companies in the U.S.) have much more money invested in the larger several companies than in the smaller hundreds of companies. If you’re in a target dated fund (the ones with a year at the end) in a 401k or a total U.S. market index fund, you’re missing out on the best returns the market has to offer because of cap-weighting.

3. Structured funds are not as cheap to own, and they’re much more scarce than index funds. You’ll probably have to work with an advisor to gain access to them. They rarely let investors put their finger on the trigger. Over time, these funds outperform traditional index funds because they’re designed to maximize return. An index fund would have to pay you to achieve similar returns, even after the additional costs of structured funds are considered. And because investors can only access them through an advisor, the likely-hood that investors consistently realize the returns (instead of hopping in or out or all around at the wrong time) increases significantly.

Often times index funds are the only decent option available (this is true in many 401k accounts), but when the options are open, a good advisor offering good structured funds is the best option.

Value Investor (part 1)

sean-stratton-ObpCE_X3j6U-unsplash.jpg

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)​

hunters-race-MYbhN8KaaEc-unsplash.jpg

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.