Can investing be stress-free? (Part 3)

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Requirement 3: Coaching. 
Success in investing, just like success in many other things, requires the help of a coach. The stock market is the greatest passive wealth creation tool in existence, but it’s not a cakewalk to navigate. Successful investing requires knowledge of the market and an unwavering dedication to the right investing philosophy. When the market turns downward, which it has and will again, most people freak out and make serious mistakes with their investments. Investor stats from the 2008 crash are astoundingly bad. Billions of dollars fled the market at effectively the worst time to get out (at or near the bottom). It was the second crash the S&P 500 had suffered within the decade and people were understandably scared and pessimistic. This is where a coach helps. A coach will help you gain an understanding of the market (so you won’t have to stress about the downturns), but more importantly will help you maintain your investing discipline (so even when you do feel stressed, you won’t make a big mistake). When most investors are panicking, a coach will keep you on track.

A good coach is the most important facet of stress-free investing. They help by educating clients to an understanding of the market, they help by providing a great portfolio, and they help clients actually obtain the market returns and outcomes they’re looking for. A good coach will allow clients to focus on their purpose instead of stressing about how their money is doing in the market.

3 Questions to Ask your Financial Advisor

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

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.

You should know something about ETFs

First things first, if you’re unsure what an ETF (exchange-traded fund) is, let me explain broadly. An ETF is something you can invest money into, it’s an investment vehicle. Like mutual funds, ETFs provide a way for investors to own multiple companies through one fund. You might even have some money invested in ETFs through your 401k or other investment accounts.

ETFs have quickly become a very popular investment option in the US. We hear a lot about robo-advisors these days, their offerings consist almost exclusively of ETFs. In 2016, seven of the top ten traded securities in the US market were ETFs. Assets deposited and held within ETFs have grown substantially within the last 15 years:

Besides all that, ETFs are cool. They’re based on algorithms, you can buy and track them through really nice apps, they’re usually super cheap, the list goes on. They’re the perfect investment for this generation. I’ll admit, they appeal to my millennial preferences too. But, there are a few important things to understand about ETFs before making any investment decisions, and there’s a reason we don’t recommend them.

Now let’s define ETF a little more specifically. The easiest way to explain them is by a comparison with mutual funds. Mutual funds have been around for much longer, they’re a little simpler, and probably a little more familiar. We’ll look at two distinguishing characteristics between mutual funds and ETFs:

1) Ownership.

A mutual fund owns shares of different companies. So if you buy one share of a mutual fund, you’re actually investing in each of the different companies that the mutual fund owns. Different mutual funds make different decisions on which companies they own. Some are actively managed, meaning there’s a manager buying and selling different shares within the mutual fund; some are passively managed, meaning they own a group of companies that are chosen based on a set of rules and the companies don’t change too much; some are index funds (which is a type of passive fund), which means they own the same companies that an index tracks (like the S&P 500); there’s no shortage to the type of mutual fund you can own, there are lots of them, and they’ve been a very popular investment vehicle for a long time. The thing to remember is that the value of a mutual fund is the value of the stocks it owns. Mutual funds actually own stock shares.

ETFs also invests in different companies, and different ETFs have different criteria for the companies or sectors they invest in (the most popular ETFs track with the S&P 500). However, ETFs don’t actually own stock shares in those companies. Instead, they own pledged assets, which are contracts to provide shares. Essentially, ETFs own rights to shares. This brings benefits like low expense ratios within ETFs (no fees for buying and selling stocks since the only things that trade within an ETF are contracts) and occasional tax savings (if you have a taxable account).

2) Fund type.

Mutual funds are their own separate type of investment, they’re not like stocks. Mutual funds are only valued once per day, after the close of market. Then all the stocks and investments within the fund are added up and the value of the mutual fund is determined anew. Because of this, you can only buy and sell mutual funds once per day, when the value has been calculated. Mutual funds are a longer type of investment by design. That doesn’t mean the holdings within the mutual fund are long term, a mutual fund manager could be making trades inside the mutual fund at any time, but the mutual fund itself can’t be day-traded or hedged or anything you might do with stock holdings.

ETFs however, are traded on an exchange, which means they act like a stock. You can make inter-day trades, the value is moving whenever the market is open, you can hedge and short and order stops, and engage in all sorts of risky stock market things. It also means there’s a fee for each trade, which isn’t necessarily a problem, but you wouldn’t want to be executing lots of ETF trades. This extra trad-ability makes mutual funds appealing for many. The trade costs are a bit of a deterrent, but you can actually day-trade with ETFs.

So that’s what ETFs are. The rise of ETFs in one of the most significant changes in the world of investing over the last 20 years and many people are excited about the opportunity. Here are a few reasons why I’m less excited, and why we don’t recommend ETFs for our investors.

Regulation surrounding ETFs has proven insufficient. I’m usually not a big proponent for the increase of regulation, but when it comes to ETFs, the lack of regulation is a real problem. There currently isn’t even an official legal definition for ETFs so they’re regulated individually, fund by fund, under mutual fund rules. As you’ve seen above, ETFs differ from mutual funds in significant ways, and mutual fund regulations simply can’t account for the discrepancies.

Since ETFs own contracts for shares instead of actual shares, the value of an ETF is tied to the viability of its contracts to perform, its arbitrage mechanism. Theoretically, the value of an ETF should be the value of the promised shares (like mutual funds are valued based on the shares they own), and usually, it is, but not always. When the price diverges, the arbitrage mechanism has to kick in to bring it back. So there’s a whole new type of risk involved, the reliability of the arbitrage mechanism, which can also dramatically affect the price. The fact is, when the market is stressed, the arbitrage mechanism can fail, causing massive swings in the pricing of ETFs, unrelated to the underlying stock assignments. That’s not just a hypothetical, it has happened, and continues to happen. August 24, 2015, is one specifically egregious example. It’s not entirely clear how or why these things happen from a market perspective, and the differing regulations (even between funds with the same pledged assets) only cause more uncertainty. The whole system is shrouded. What we know is that the inconsistent regulation, the cloudy definitions, and the unreliable arbitrage mechanisms have created more risk for ETFs. Unfortunately, it’s impossible to quantify the additional risk in any meaningful way because there are still too many unknowns. Investopedia even admits in reference to ETFs, ‘the perceived increase in volatility needs further research.’ In its current state of affairs, the ETF market is simply not reliable enough to recommend as a vehicle for a person’s life savings. There seems to be increasing support for research and regulation surrounding ETFs so the issue is certainly not over-with, perhaps we could even end up recommending ETFs to all of our investors in the future, but for now, stick with some good old mutual funds.

 

Sources:

Financial Times: The $5tn ETF market balances precariously on outdated rules

Financial Times: Market turbulence revives fears over ETF structural issues

Evanson Asset Management® – Are DFA Strategies Superior?

What’s going on inside your investment portfolio?

Part of my job is to analyze customer portfolios. The gist is that we dig into the different investments, usually contained within different mutual funds, to figure out what people actually own in their portfolios. For many of us, it’s tough to know what’s going on behind the scenes in our portfolio because the quarterly statements only show pie charts and weird mutual fund names. So, I help to figure out what the actual stock holdings are, then organize the information by asset classes to see how many different asset classes people are invested in and what percentage of their money is allocated to each. Essentially it’s a determination of diversification, which, as we know, is the single most important component of a portfolio (check out Where do returns come from?). It’s a fun exercise, and helpful for clients. The results tend to be a little more sobering.

I estimate that about 95% of portfolios we analyze are not diversified like they should be, and about 75% of portfolios are heavily bent toward one asset class: US Large Growth (S&P 500). Those are estimates, the point is that the large majority of portfolios we see are diversified poorly or hardly at all. There are two problems here: 1) diversification is lacking, 2) the most popular asset class to load up in is US Large Growth.

The first problem has to do with the Modern Portfolio Theory. Lacking diversification means that the portfolio is subject to more risk (volatility) and will expect less return over time than an efficiently diversified portfolio. Many people think that they’re pretty well diversified because of the number of mutual fund names they see on their statement. However, we find that those mutual funds typically have significant overlap with each other. The large majority of portfolios are loaded up in US Large Growth companies because the mutual funds they own are loaded up in US Large Growth companies. Just because there are a bunch of different mutual funds doesn’t mean there are a bunch of different asset classes represented within them. Seldom do we find small companies or value companies within these mutual funds, and we almost never see small value companies. These portfolios also infrequently own anything internationally, which makes up about half of the global stock market (in 2017, the US accounted for 51.3% of the global market, leaving 48.7% often untapped). These asset classes are largely ignored in favor of US Large Growth.

The second problem has to do with the US Large Growth asset class. If US Large Growth was the best performing asset class, a lack of diversification in your portfolio would have at least some defense. The risk would still be higher than it should be, but at least you could expect some decent returns. Unfortunately, that’s not the case. Going back as far as we have air-tight data on the stock market (almost 100 years), US Large Growth has been one of the worst performing asset classes in the world. That’s not to say US Large Growth a total waste, the asset class still provides good returns, and it’s valuable as a piece of a well-diversified account, but the lean towards these companies has a handicapping effect on portfolios. You simply won’t be able to expect the same level of return as you would in an efficiently diversified portfolio. Here’s a snapshot of average asset class returns over the years:

Why do most portfolios lean toward the S&P 500 despite the evidence? It seems that there are a few reasons. 1) The S&P 500 is the popular companies, the ones you’ve heard of, like Apple and Google and Amazon. They’re also all we hear about in the news. The S&P 500, the Dow Jones, and the Nasdaq are all categories of Large US companies. The news cycle is constantly spinning stories about them. They’re familiar companies, and we like to think we know them better. 2) The US Large Growth asset class is cheap to trade in. There is so much trading activity going on with these stocks, they’re always in demand, there’s always a market for them. Since much of the industry is still actively trading in an attempt to beat the market, they have to trade where the trades are cheaper. If they were actively making trades in an account with small value companies, the trading costs alone would submarine any return expectations.

When we see these disappointing results in a client’s portfolio we offer them a few things. 1) For the money they can move, we offer a well-diversified portfolio which will take advantage of returns offered from higher performing asset classes while simultaneously reducing risk. 2) If the money is locked up in a 401k with a current employer, we help them analyze their options within the 401k to get as close to an efficiently diversified portfolio as possible.