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.

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.

Index issues (part 2)

 

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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.

Financial Advisors aren’t evil (mostly)​

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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.

Human capital

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What’s human capital?
To start, we need a definition. Here’s what Wikipedia has to say: “Human capital is the stock of habits, knowledge, social and personality attributes (including creativity) embodied in the ability to perform labour so as to produce economic value.” A little tricky, but basically human capital is the economic value of a person based on their skills and ability in the workplace.

So who gets paid for human capital?
In a free-market economy, everyone gets paid based on their own human capital. We each own our own skills and abilities and we collect income based on our ability and value when we work. Regardless of whether we work for a company or ourselves, we’re compensated for the value we’re able to provide.

So far so good. Now let’s tie this into investing. Without some understanding of the market, people tend to believe that they can beat the market by picking the right stocks. Consistent success (beating the market) in stock picking is actually impossible, but let’s pretend for a moment that’s not. If the market was beatable, there would naturally be people who were especially endowed with the skills and/or training to beat it. Those people would often become money managers and they would be highly sought after by the general public looking for great returns in their portfolios. But who would collect the premiums for additional returns achieved above-market returns? Stock picking would be a human capitalist skill! The brilliantly skilled money manager would collect some serious fees for his valuable ability, fees almost exactly in line with the amount of return he was able to achieve above the market. The additional return of the portfolio wouldn’t end up in the pockets of investors, it would go to the brilliant manager with the impressive human capital skills.

So here’s the point: the stock market is efficient and so it’s not consistently beatable, but even if it was, investors would not be the beneficiaries. The super-skilled money managers would rightly collect large fees, highly correlated to the additional value they were able to provide based on their human capital skills.