Tim Maurer makes an appearance on Nightly Business Report to discuss how the proposed Republican tax plan could affect middle-income Americans, home buyers and, perhaps, even retirement savers.

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By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

The post The Proposed Tax Plan and Your Money appeared first on Sawyer Capital Management.

The holy grail for mutual fund investors is the ability to identify in advance which of the very few active mutual funds will outperform in the future.

To date, an overwhelming body of academic research has demonstrated that past performance not only fails to guarantee future performance (as the required SEC disclaimer states), but has almost no value whatsoever as a predictor—with the exception that poor performance combined with high expenses predicts future poor performance.

The research has shown that not only is there a lack of persistence beyond the randomly expected among mutual funds, but also among hedge funds and even pension plans—despite their use of high-powered consultants who advise them on identifying the future winners.

The evidence on plan sponsor performance is so strong that a 2008 study by Amit Goyal and Sunil Wahal, “The Selection and Termination of Investment Management Firms by Plan Sponsors,” found that if plan sponsors had remained with the investment managers they regularly fired, their returns would have been larger than those actually delivered by the newly hired managers.

The bottom line is that past performance’s only value seems to be in showing that poor performance tends to persist, with the likely explanation being high expenses.

Superstar Or Superdud?

Jerry Parwada and Eric K.M. Tan contribute to the literature on the predictive value of past performance through their February 2016 study, updated in October 2017, “Superstar Fund Managers: Talent Revelation or Just Glamor?”

The authors examined the performance of funds managed by the winners of Morningstar’s coveted Fund Manager of the Year (FMOY) award. Morningstar selects its FMOY winners based on an expectation of future alpha.

Here is how Morningstar presented its 2016 winners: “To be nominated for Fund Manager of the Year, the manager’s mutual fund must be among the 1,200 that receive Morningstar Analyst Ratings and earn a rating of Gold, Silver, or Bronze. The medal rating indicates that our analysts believe a fund will outperform its category peers and/or benchmark on a risk-adjusted basis over the long haul. Looking at their individual coverage lists, analysts nominate Morningstar Medalist funds that have strong recent and long-term risk-adjusted returns, excellent stewardship practices, and broad shareholder bases. Our asset-class teams whittle down the list to a group of finalists. Then the entire analyst team meets to debate the merits of the finalists in each category, and, following those discussions, analysts vote to determine the winners.”

Flows Chase Ratings

It has already been established in the literature that investors value Morningstar’s ratings, as fund flows tend to follow them. For example, the study “Morningstar Ratings and Mutual Fund Performance,” by Christopher Blake and Matthew Morey, found that an amazing 97% of fund inflows went into four- and five-star funds, while even three-star funds experienced outflows.

Parwada and Tan examined not only the effect of mutual fund managers’ superstar status (which comes with being named FMOY) on money flows, but also on their risk-taking behavior. Their study covered FMOY winners over the period 1995 through 2012 and compared their performance to the performance of the other finalist managers. Following is a summary of their findings:

• They confirmed that investors respond positively to mutual fund managers who win a prominent fund-manager-of-the-year award based on proven long-term record. FMOY winners garnered 21% more assets over the 12-month period following the award announcements.
• Award-winning managers generate positive risk-adjusted performance in the very short term. FMOY winners generated outperformance of 1.6% for the three-month period following award announcements using the Carhart four-factor (beta, size, value and momentum) model. However, that outperformance disappeared when measured during the subsequent six-, nine-, 12-, 24- and 36-month periods. The results were statistically significant at the 1% level of confidence.
• Award-winning managers do not take on increased risks or trade more actively as implied by attention-induced incentives. There was no evidence of managers becoming overconfident (which could negatively impact performance) after receiving the award.

Success A Red Flag?

An interesting finding is that winning managers generally manage smaller and younger funds when compared to finalist managers. The average fund size of award winners was less than $200 million in assets under management.

Thus, not many investors were benefiting from the winners’ success. This raises the question: Does success sow the seeds of its own destruction? To answer it, consider Parwada and Tan’s finding regarding short-term outperformance, which is consistent with the findings of prior research.

It’s also consistent with the rational expectations equilibrium argument Jonathan Berk and Jules van Binsbergen present in their paper, “Measuring Skill in the Mutual Fund Industry.”

They write that skill exists among superstar fund managers, and investors recognize this skill and reward the managers with capital inflows. The increased capital arbitrages away outperformance due to diseconomies of scale—success does contain the seeds of future erosion.

However, this isn’t the only possible explanation for the short-term outperformance that Parwada and Tan documented. Before concluding there is skill, we should consider other theories.

‘Persistent Flow’

A second theory is that mutual funds’ short-term predictability is driven by stock return momentum. A third explanation for the positive flow/performance relation is what’s called the “persistent-flow” hypothesis. Research has found that investor flow-related buying pushes up stock prices beyond the effect of stock return momentum, and that fund performance owes more to flow-related trades than to managers’ skill.

Because fund flows have been shown to be highly persistent, mutual funds with past inflows (outflows) are expected to receive additional capital (redemptions), expand (liquidate) their existing holdings, as well as drive up (down) their own performance in subsequent periods. This is a very different explanation than the “smart-money” hypothesis.

In their study “What Drives the “Smart-Money” Effect? Evidence from Investors’ Money Flow to Mutual Fund Classes,” published in the January 2017 issue of the Journal of Empirical Finance, George Jiang and H. Zafer Yuksel found that the flow/performance relationship explains the short-term outperformance.

Before concluding, I’ll review some of the other evidence on Morningstar ratings and future performance.

When You Wish Upon A Morningstar

The November 2009 issue of Morningstar’s FundInvestor provided the following evidence on its five-star funds:

• The 2004 class of five-star domestic funds had a five-year rating of just 3.2 stars, just slightly above average. The average fund underperformed its risk-adjusted benchmark by more than 1%.
•  The 2005 group of five-star funds turned in a three-year rating of just 3.1 stars.
• The 2006 group had a three-year rating of just 2.9 stars.

The paper “Mutual Fund Ratings and Future Performance” from Vanguard provides further evidence on the ability of star ratings to predict the future.

Authors Christopher Philips and Francis Kinniry Jr. examined excess returns over the three-year period following a given rating.

They chose the three-year period because Morningstar requires at least three years of performance data to generate a rating, and investment committees typically use a three-year window to evaluate the performance of their portfolio managers.

The 2010 study covered the period June 30, 1992 through August 31, 2009. Following is a brief summary of the authors’ findings:

• 39% of funds with five-star ratings outperformed their style benchmarks for the 36 months following the rating, while 46% of one-star funds did so.
• All the star-rating groups produced negative excess returns in the succeeding three years. Even worse, the four- and five-star figures were more negative than those of lower-rated groups.

No Signal Of Success

Philips and Kinniry concluded: “Higher ratings in no way ensured that an investor would increase his or her odds of outperforming a style benchmark in subsequent years.”

In fact, they found that “5-star funds showed the lowest probability of maintaining their rating, confirming that sustainable outperformance is difficult. This means that investors who focus on investing only in highly rated funds may find themselves continuously buying and selling funds as ratings change. Such turnover could lead to higher costs and lower returns as investors are continuously chasing yesterday’s winner.”

The bottom line is that using Morningstar ratings to identify future outperformers is like driving forward while looking through the rearview mirror; their ratings system does a great job of “predicting” the past. That applies to not just all rated funds, but even to FMOY winners.

This commentary originally appeared October 25, 2017 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

The post The Peril of Chasing Active Mutual Fund Performance Ratings appeared first on Sawyer Capital Management.

We have data for 91 calendar years (or 1,092 months) of U.S. investment returns over the period 1927 through 2016. The average monthly return to the S&P 500 has been 0.95%, and the average quarterly return was 3.0%. With that background, here’s a short, four-question quiz:

1. If we remove the returns from the best 91 months (an average of just one month a year and 8.5% of the entire period), what is the average return of the remaining 1,001 months?

2. What is the average return of those best-performing 91 months?

3. If we remove the returns of the best-performing 91 quarters (an average of one quarter a year and 25% of the entire time period), what is the average return of the remaining 273 quarters?

4. What is the average return of those best-performing 91 quarters?

What many investors don’t know is that most stock returns come in very short and unpredictable bursts. Which is why Charles Ellis offered this advice in his outstanding book, “Investment Policy”: “Investors would do well to learn from deer hunters and fishermen who know the importance of ‘being there’ and using patient persistence—so they are there when opportunity knocks.”

It also is likely why, in his 1991 annual report to shareholders, legendary investor Warren Buffett told investors: “We continue to make more money when snoring than when active,” and “Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.” Later, in his 1996 annual report, Buffett added: “Inactivity strikes us as intelligent behavior.”

Returning to our quiz, the answers are:

1. While the average month returned 0.95%, if we eliminate the best-performing 91 months, the remaining 1,001 months provided an average return of virtually zero (0.1%). In other words, 8.5% of the months provided almost 100% of the returns.

2. The best-performing 91 months, an average of just one month a year, earned an average return of 10.5%.

3. While the average quarter returned of 3.0%, if we eliminate the best-performing 91 quarters, the remaining 273 quarters (three-fourths of the time period) actually lost money, providing an average return of -0.8%. In other words, just 25% of the period provided more than 100% of the returns.

4. The best-performing 91 quarters, an average of just one quarter a year, earned an average return of 14.3%.

Despite this type of evidence, which makes clear how difficult market timing must be, one of the most popular beliefs held by individual investors is that timing stock markets is the winning strategy. After all, who doesn’t want to buy low, right at the end of a bear market, and sell high, just before the next bear market begins. Unfortunately, an idea is not responsible for the people who believe in it.

Pros Bad At Prediction

The evidence is very clear that professional mutual fund managers cannot predict the stock market. For example, in his famous book “A Random Walk down Wall Street,” Burton Malkiel cited a Goldman Sachs study that examined mutual funds’ cash holdings for the period 1970 through 1989.

In their efforts to time the market, fund managers raise cash holdings when they believe the market will decline and lower cash holdings when they become bullish. The study found that, over the period it examined, mutual fund managers miscalled all nine major turning points.

Legendary investor Peter Lynch offered yet another example. He pointed out that an investor who followed a passive investment strategy and stayed fully invested in the S&P 500 over the 40-year period beginning in 1954 would have achieved an 11.4% rate of return.

If that investor missed just the best 10 months (2% of them), his return fell 27%, to 8.3%. If the investor missed the best 20 months (or 4% of them), his return dropped 54%, to 6.1%. Finally, if the investor missed the best 40 months (or just 8% of them), his return declined 76%, all the way to 2.7%.

In a September 1995 interview with Worth magazine, Lynch put it this way: “Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”

Investors should keep the preceding evidence—as well as advice against trying to time the market offered by investment legends such as Ellis, Buffett and Lynch—in mind whenever they hear warnings from “gurus” that the market is overvalued and a correction is surely coming.

This wisdom is especially timely with the Shiller CAPE 10 at 31 as I write this, almost double its long-term average. However, I would note that calls for a correction are nothing new.

For example, back in February 2013, with the CAPE 10 then at 22, Jeremy Grantham, a respected market strategist at GMO, wrote that “all global assets are once again becoming overpriced” and that some securities were “brutally overpriced.”

By November of that year, with the CAPE 10 at 24.6, he wrote: “The S&P 500 is approximately 75% overvalued.” But the market ignored Grantham, as well as other pessimists such as John Hussman and Marc Faber (Dr. Doom). From February 2013 through September 2017, the S&P 500 Index returned 14.2% (well above its long-term return of 10.0%) and posted a total return of 85.6%.

Cost Of Waiting

Elm Partners provided some valuable insight into the question of whether investors should wait to buy equities because they believe valuations are too high. Looking back at 115 years of data, Elm asked: “During times when the market has been ‘expensive,’ what has been the average cost or benefit of waiting for a correction of 10% from the starting price level, rather than investing right away?” It defined “expensive” as the occasions when the stock market had a CAPE ratio more than one standard deviation above its historical average.

Elm noted that while the CAPE ratio for the U.S. market is currently hovering around two standard deviations above average, there aren’t enough equivalent periods in the historical record to construct a statistically significant data analysis.

It then focused on a comparison over a three-year period, a length of time beyond which they felt an investor was unlikely to wait for the hoped-for correction. Following are its key findings:

• From a given “expensive” starting point, there was a 56% probability that the market had a 10% correction within three years, waiting for which would result in about a 10% return benefit versus having invested right away.
• In the 44% of cases where the correction doesn’t happen, there’s an average opportunity cost of about 30%—much greater than the average benefit.
• Putting these together, the mean expected cost of choosing to wait for a correction was about 8% versus investing right away.

The takeaway is this: Even if you believe the probability of a correction is high, it’s far from certain. And when the correction doesn’t happen, the expected opportunity cost of having waited is much greater than the expected benefit.

Elm offered the following explanations for why it thought the perception exists among investors that waiting for a correction is a good strategy: “First, while a correction occurring is indeed more likely than not, investors may confuse the chance of a correction from peak-to-trough with the lower chance of a correction from a fixed price level. For example, the historical probability of a 10% correction happening any time during a 3-year window is 88%, significantly higher than the 56% occurrence of that correction from the market level at the start of the period. Second, the cost of waiting and not achieving the correction is a ‘hidden’ opportunity cost, and we humans have a well-documented bias to underweight opportunity costs relative to realized costs. Finally, investors may believe they can wait indefinitely for the correction to happen, but in practice few investors have that sort of staying power.”

Elm repeated its analysis with correction ranges from 1% to 10%, time horizons of one year and five years, and an alternate definition for what makes the market look “expensive” (specifically, waiting for a correction from times when the market was at an all-time high at the start of the period).

The firm found that “across all scenarios there has been a material cost for waiting. The longer the horizon that you’d have been willing to wait for the correction to occur … the higher the average cost.”

Summary

Noted author Peter Bernstein provided this insight: “Even the most brilliant of mathematical geniuses will never be able to tell us what the future holds. In the end, what matters is the quality of our decisions in the face of uncertainty.”

And we certainly live in uncertain times. But that’s always the case. To help stay disciplined, it’s important to keep in mind that the market already reflects whatever concerns you may have.

Finally, remember this further advice from Warren Buffett: “The most important quality for an investor is temperament, not intellect.”

The inability to control one’s emotions in the face of uncertainty, and clarion cries of overvaluation, help explain why so few investors earn market rates of return and thus fail to achieve their objectives.

This commentary originally appeared October 18 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

The post More Money Is Lost Waiting for Corrections Than in Them appeared first on Sawyer Capital Management.

Following the recent Wall Street Journal critique of Morningstar’s star rating system, Tim Maurer appears on NBR to discuss tools investors can use to investigate mutual funds and why first setting an appropriate asset allocation is so important.

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By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

The post What to Consider When Choosing a Mutual Fund appeared first on Sawyer Capital Management.

Since 2002, S&P Dow Jones Indices has published its S&P Indices Versus Active (SPIVA) scorecards, which compare the performance of actively managed equity mutual funds to their appropriate index benchmarks. The 2017 midyear scorecard includes 15 years of data.

Equity

Following are some of the highlights from the report:

• Over the five-year period, 82% of large-cap managers, 87% of midcap managers and 94% of small-cap managers lagged their respective benchmarks. Note that the performance of active managers was the worst in the very asset class they claim is the most inefficient.
• Over the 15-year investment horizon, 93% of large-cap managers, 94% of midcap managers, 94% of small-cap managers and 82% of REIT managers failed to outperform on a relative basis. Again, note the poor performance in small-caps, as just 6% of active funds outperformed their benchmark index.
• Over the 15-year horizon, on an equal-weighted (asset-weighted) basis, active large-cap managers underperformed by 1.5 percentage points (0.9 percentage points), active midcap managers underperformed by 1.9 percentage points (1.3 percentage points), active small-cap managers underperformed by 2.3 percentage points (1.6 percentage points) and active REIT managers underperformed by 0.8 percentage points (0.5 percentage points). Note that multicap managers, who have the supposed advantage of being able to move across asset classes, underperformed by 1.3 percentage points (0.4 percentage points). Again, the worst performance was in the supposedly inefficient small-cap space.
• Over the 3-, 5-, 10- and 15-year investment horizons, managers across all international equity categories underperformed their respective benchmarks. Over the 15-year horizon, 85% of active global funds underperformed, 92% of international funds underperformed, 83% of international small-cap funds underperformed and, in the supposedly inefficient emerging markets, 95% of active funds underperformed.
• Over the 15-year horizon, on an equal-weighted (asset-weighted) basis, active global funds underperformed by 0.8 percentage points (0 percentage points), active international funds underperformed by 2.0 percentage points (0.6 percentage points) and active international small funds underperformed by 1.1 percentage points (0.3 percentage points). Emerging market funds produced the worst performance, underperforming by 2.5 percentage points (1.4 percentage points).
• Highlighting the importance of taking into account survivorship bias, over the 15-year period, more than 58% of domestic equity funds, 55% of international equity funds and approximately 47% of all fixed-income funds were merged or liquidated.

While I believe the preceding data is compelling evidence of the active management industry’s failure to generate alpha, it’s important to note that all the report’s figures are based on pretax returns.

Given that actively managed funds’ higher turnover generally makes them less tax efficient, on an after-tax basis, the failure rates would likely be much higher (taxes are often the highest expense for actively managed funds).

Fixed Income

The performance of actively managed funds in fixed-income markets was just as poor. The following results are for the 15-year period:

• The worst performance was in long-term government bond funds, long-term investment-grade bond funds and high-yield funds. In each case, just 2% of active funds beat their respective benchmarks. On an equal-weighted (asset-weighted) basis, long-term government bond funds underperformed by a shocking 3.5 percentage points (3.0 percentage points), long-term investment-grade bond funds underperformed by 2.6 percentage points (2.2 percentage points) and high-yield funds underperformed by 2.3 percentage points (1.7 percentage points).
• For domestic bond funds, the least poor performance was in intermediate- and short-term investment-grade funds, where 76% and 71% of active funds underperformed, respectively. On an equal-weighted basis, their underperformance was 0.5 percentage points and 0.7 percentage points, respectively. However, in both cases, on an asset-weighted basis, they outperformed by 0.3 percentage points. This result possibly could be explained by the funds having held longer maturities (taking more risk) than their benchmarks.
• Active municipal bond funds also fared poorly, with between 84% and 92% of them underperforming. On an equal-weighted (asset-weighted) basis, the underperformance was between 0.6 percentage points and 0.7 percentage points (0.2 percentage points and 0.4 percentage points).
•  Emerging market bond funds also fared poorly, as 67% of them underperformed. On an equal-weighted basis, the underperformance was 1.4 percentage points. On an asset-weighted basis, the underperformance was 0.4 percentage points.

Summary

The SPIVA scorecards continue to provide powerful evidence on the persistent failure of active management’s ability to generate alpha (risk-adjusted outperformance). In particular, they serve to highlight the canard that active management is successful in supposedly inefficient markets like small-cap stocks and emerging markets.

The scorecards also provide compelling support for Charles Ellis’ observation that, while it’s possible to win the game of active management, the odds of doing so are so poor that it’s not prudent to try—which is why he called it “the loser’s game.” And it’s why we continue to see a persistent flow of assets away from actively managed funds.

This commentary originally appeared September 27 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

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The Incredible Shrinking Alpha,” today the percentage of actively managed funds generating statistically significant alpha is less than 2%. We explain why this trend, in which active managers experience a persistently declining ability to generate alpha (that is, to outperform risk-adjusted benchmarks), is virtually certain to continue.

That, in turn, raises an interesting question: Why did this prospective client possess such a strong belief that active managers actually outperformed?

In Love With A Loser’s Game

One of the greatest frustrations for me, and one of the great anomalies in finance, is that, given the overwhelming amount of evidence against active management and in favor of passive investing, a majority of investors keep playing a loser’s game. I offer four explanations for this phenomenon.

First, the education system has totally failed the public. Unless they obtain an MBA in finance, it’s highly unlikely that investors have taken a single course in capital markets theory. Without the appropriate knowledge, how can investors determine whether an active or a passive strategy is the right one?

Unfortunately, many obtain their “knowledge” about investing from the very institutions—Wall Street and the financial media—that don’t have their interests at heart, because the winning strategy for them is when investors play the game of active investing.

Wall Street needs investors to trade frequently and to pay the high fees imposed by actively managed funds. The media needs investors to “tune in.” The result is that most investors are unaware of the historical evidence.

Getting Properly Educated

Second, despite the importance of the issue, the public seems unwilling to invest the time and effort to overcome the failings of the education system. Instead of exploring the appropriate resources to become informed, such as books by William Bernstein, John Bogle or myself that lay out the historical evidence on active versus passive management, they would rather watch some reality TV show or cable financial news to hear the latest guru’s forecast.

There’s an all-too-human need to believe there is someone out there who can predict the future and thus protect us from uncertainty.

The third explanation is what we might call the Lake Wobegon effect—the need and/or desire to be above average. In my long experience, this seems especially true of certain high net worth investors.

They want to feel special, particularly when it comes to investments. They want to be members of the “in crowd,” with access to products to which the hoi polloi does not. That can offer a feeling of prestige and sophistication. In other words, they want more than just returns from their investments.

Wall Street plays on that need. You hear the repeated lie that goes something like this: “Indexing is a good strategy, but it gets you average returns. You don’t want to be average. We can help you do better than that.”

The truth is that indexing doesn’t get you average returns; it gets you market returns. And because it does so with lower costs and greater tax efficiency, by definition, you earn above-average returns—as long as you maintain the discipline to stay the course. This is about the only guarantee there is in investing.

Why Do Investors Ignore The Evidence?

Why do so many investors continue to play a game that has such poor odds of winning? Kathryn Schulz, author of “Being Wrong,” provides us with some fascinating insights to help explain this phenomenon, one that allows Wall Street to transfer tens of billions of dollars every year from investors’ pockets to their own.

She explains that most of us go through life assuming we are “basically right, basically all the time, about basically everything” and that “our indiscriminate enjoyment of being right is matched by an almost equally indiscriminate feeling that we are right.” Schulz then continues: “Occasionally, this feeling spills into the foreground as we make predictions or place bets” (or make investments).

She explains that, often, this confidence is justified as we “navigate day-to-day life fairly well.” This suggests that we’re right about most things. Schulz’s book is all about the opposite of that. It’s about being wrong and what happens when our convictions collapse around us. When that happens, we often feel foolish and ashamed, as error is often associated with “ignorance, psychopathy and even moral degeneracy.”

Schulz’s observations can help us understand why that prospective client believed what she did—it would be too painful to her self-image to admit her ignorance and mistaken belief.

Mistakes Happen To Other People

Schulz noted that we tend to view mistakes as things that happen to others. Yet we feel it is implausible they’ll happen to us. She believes this is because “our beliefs are inextricable from our identities” and because “we’re so emotionally invested in our beliefs that we are unable or unwilling to recognize them as anything but the inviolate truth.”

She also notes that “we tend to fall in love with our beliefs once we have formed them” (such as the belief that active management is the winner’s game), and that explains why “being wrong can so easily wound our sense of self.” It explains why we experience cognitive dissonance—the uncomfortable feeling and/or anxiety we feel when someone disproves a long-held belief. It also explains why we ignore evidence, even when it is compelling, and why we resist change.

Schulz writes that this view—that others make errors but not us—is the greatest error of them all, as “wrongness” is a vital part of how we learn and change.

In other words, even smart people make mistakes—for instance, I used to be an active investor. However, once smart people learn that a behavior is a mistake, they revise their ideas and change their ways. This is what separates them from fools, who keep repeating the same mistakes while expecting different outcomes.

Among the many insights Schulz offers is that our ability to forget our mistakes is keener than our ability to remember them. During her research, Schulz met a lot of people who told her that she should interview them, as they make mistakes all the time. Yet when asked to provide a specific example of their mistakes, they were hard-pressed to come up with any. The inability to remember mistakes leads to overconfidence, which in turn can lead to other mistakes, especially investment mistakes—such as taking too much risk and failing to diversify—which can be very expensive.

Yet Another Explanation

The fourth and final explanation for the anomaly that most individual investors use actively managed funds comes from social psychologists Carol Tavris and Elliot Aronson, authors of the wonderful book, “Mistakes Were Made (But Not by Me).”

They write: “Most people, when directly confronted with proof that they are wrong, don’t change their point of view or course of action but justify it even more tenaciously. Politicians, of course, offer the most visible, and often tragic, examples of this practice. … We even stay in an unhappy relationship or merely one that is going nowhere because, after all, we invested so much time it making it work.”

Tavris and Aronson explain: “Self-justification has costs and benefits. By itself it’s not necessarily a bad thing. It lets us sleep at night. Without it we would prolong the awful pangs of embarrassment. We would torture ourselves with regret over the road not taken or over how badly we navigated the road we did take. We would agonize in the aftermath of almost every decision.… Yet mindless self-justification, like quicksand, can draw us deeper into disaster. It blocks our ability to even see our errors, let alone correct them. It distorts reality, keeping us from getting all the information we need and assessing issues clearly.”

Investors, both individual and institutional, who rely on the past performance of active managers, and rankings such as Morningstar’s star ratings, hire managers, eventually firing most of them, and then repeat the process.

They do so without ever asking themselves: What should I do differently in the selection process so I don’t repeat the mistake I made last time? In a triumph of self-justification, they end up behaving in a way that has been described as the definition of insanity—they repeat the same thing over and over again and expect a different outcome.

Tavris and Aronson note that “none of us can live without making blunders. But we do have the ability to say: ‘This is not working out here. This is not making sense.’ To err is human, but humans then have a choice between covering up or fessing up. The choice is crucial to what we do next. We are forever being told that we should learn from our mistakes, but how can we learn unless we first admit we make any?”

Admitting Mistakes Can Be Freeing

Unfortunately, admitting mistakes is a difficult hurdle for many. A great example of this behavioral problem is a clever insight from Lord Molson (a 20th century British politician) into his own behavior: “I will look at any additional evidence to confirm the opinion to which I have already come.” This leads to the well-documented problem of confirmation bias, which we have already discussed.

Perhaps the saddest part is that we miss out on just how freeing it can be to admit a mistake. Tavris and Aronson told a story about a friend who was sent to traffic court and heard excuse after excuse for running red lights or making illegal U-turns. This friend became so fed up with it, he stood in front of the judge when it was his turn and said, “I didn’t stop at a stop sign. I was entirely wrong and I got caught.” The entire room burst into applause.

In 1994, only about 3% of individual investor inflows into mutual funds went to index funds. By 1999, as more individual investors became aware of the evidence on the poor performance of actively managed funds, that figure had reached almost 40%.

Today the net figure (funds going into passively managed funds and out of active ones) is more than 100%. Actively managed funds are no longer just losing market share, as they have been for about 25 years, they are now losing net assets as well.

For example, in March 2017, $31.1 billion flowed into passive equity strategies, while investors pulled $18.6 billion out of actively managed equity. Most active funds are dead men walking; they just don’t know it yet.

Conclusion

If you’ve hired and fired fund managers and/or advisors who advocate active strategies, or have been using active strategies on your own and have underperformed appropriate risk-adjusted benchmarks, perhaps it’s time you fessed up and started playing the winner’s game that is passive investing.

By doing so, it’s highly likely you will increase your odds of achieving your financial goals—assuming you also have the discipline (like Warren Buffett) to stay the course, adhering to your well-thought-out plan (assuming, of course, you have one).

In fact, in his 1996 Berkshire Hathaway annual report, Buffett himself advised investors: “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”

Sadly, not enough investors have heeded his advice. But it’s never too late.

This commentary originally appeared September 1 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

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Ever since the financial crisis, when the correlation of all risky assets rose toward 1, investors have been hearing that the world has become flat and the benefits of international diversification are gone. The explanation generally is that the world market has become more integrated and financial markets more globalized.

The Power Of Mononationals

Cormac Mullen and Jenny Berrill contribute to the literature addressing the merits of international diversification with the study “Mononationals: The Diversification Benefits of Investing in Companies with No Foreign Sales,” which appeared in the second-quarter 2017 issue of Financial Analysts Journal.

Mullen and Berrill showed that one way to recover international diversification benefits is to decrease the internationalization in investors’ portfolios by lowering exposure to the stocks of foreign multinationals and focusing on what they called mononationals.

The authors concluded: “Despite the decrease in international diversification benefits documented in recent papers—and a research focus in recent years on the benefits of stocks from emerging and frontier markets—we found there is still international diversification potential in developed-market equities. We suggest that a portfolio of international stocks classified solely as domestic offers the potential for more international diversification benefits than a portfolio of more-internationalized stocks.”

While their conclusion does have the benefit of being intuitive, there’s really nothing new here. Multinationals are more likely to be large companies, and mononationals are more likely to be smaller companies. Additionally, it has long been known that the benefits of international diversification are greatest when investing in smaller companies.

For example, Rex Sinquefield’s study, “Where Are the Gains from International Diversification?”, which appeared in the January/February 1994 issue of Financial Analysts Journal, showed that international small stocks diversified U.S. portfolios more than the large stocks of the EAFE Index.

While foreign large companies do have exposure to their domestic economies, their earnings are more likely to be impacted by global conditions than the earnings of smaller companies, which tend to be more dependent on the conditions of local economies. Thus, their returns are driven more by local, idiosyncratic factors. This makes them a more effective diversifier than international large stocks.

As an example, the performance of two giant, global pharmaceutical companies (like Merck and Hoffmann-La Roche) is likely to be more highly correlated, because their products are sold around the globe, than the performance of two small-cap domestic restaurant chains whose products are sold only in their home countries.

Historical Correlations

When designing a portfolio, all else equal, investors should prefer to add asset classes that have lower correlations. With that in mind, to see which international asset classes provide the greatest diversification benefits, we will look at correlation data for various asset classes.

The table below shows the semiannual (instead of annual) correlations for the longest period for which we have data, January 1994 through June 2017.

The international indexes are provided by Dimensional Fund Advisors (DFA). (In the interest of full disclosure, my firm, Buckingham Strategic Wealth, recommends DFA funds in constructing client portfolios.)

As you can see, the benefits of international diversification are greater when investing in international small and small value stocks and in emerging markets than when investing in the international large stocks in the EAFE Index.

Because of the lower correlations of international small and small value stocks, as well as their higher forward-looking return expectations, investors should strongly consider including an allocation to them when constructing their portfolios. All too many investors include only an allocation to funds tracking the EAFE Index or the Total International Markets Index.

The bottom line is that, if you want to improve the diversification benefits of your international stocks, increase your exposure to small and small value stocks, both in developed and emerging markets.

That will provide you not only with the benefits associated with reduced correlations, but with greater exposure to the size and value premiums, which have been just as persistent and pervasive internationally as they have domestically. You can see the evidence on their returns in my latest book, co-authored with Andrew Berkin, “Your Complete Guide to Factor-Based Investing.”

We have one more point to cover. When thinking about the benefits of diversification, it’s important to understand that correlations are not the only element that matters. As long as there’s a dispersion of returns, there are diversification benefits—and in each year since 2008, there has been a wide dispersion of returns.

Dispersion Of Returns

• In 2009, we saw very wide dispersion of returns. For example, while the S&P 500 was up almost 27%, the MSCI Emerging Markets Index rose 79%. And emerging market small and value stocks produced even higher returns. In addition, international large value and small value equities, as well as international REITs, managed to outperform their domestic counterparts by wide margins. Note that while correlations were positive, as all equity asset classes produced above-average returns, the world didn’t look very flat in 2009.
• In 2010, even though the S&P 500 returned about 15%, emerging markets stocks outperformed it by about 4 percentage points. On the other hand, U.S. large, large value, small, small value and REIT funds outperformed their foreign counterparts by significant margins.
• In 2011, while the S&P 500 returned just more than 2%, in general, international stocks showed negative returns. The MSCI Emerging Markets Index lost more than 18%.
• In 2012, the relative performance of U.S. and international funds reversed; international funds outperformed their U.S. counterparts in all asset classes, although the return differences were relatively small.
• In 2013, U.S. stocks outperformed international equities by wide a margin. For example, the S&P 500 Index, which returned 32.4%, outperformed the MSCI EAFE Index by about 10 percentage points and the MSCI Emerging Markets Index by approximately 35 percentage points. The world didn’t look very flat in 2013, either.
• In 2014, domestic stocks, in general, not only far outperformed international stocks, U.S. stocks rose and developed, non-U.S. markets generally fell. Again, the world sure didn’t look flat.
• In 2015, returns were all over the place. For instance, U.S. large stocks and developed, non-U.S. stocks produced similar returns, both close to zero. On the other hand, the MSCI EAFE Small Cap Index rose about 10% while the MSCI EAFE Small Value Index rose roughly 5%. Their U.S. counterparts lost 4% and 5%, respectively. At the same time, the MSCI Emerging Markets Index lost almost 15%. Once again, the world didn’t look very flat at all.
• In 2016, the world also wasn’t totally flat. While Vanguard’s 500 Index Fund (VFINX) returned 11.8%, its Emerging Markets Index Fund (VEIEX) did return an almost identical 11.5%. DFA’s passively managed Emerging Markets Small Cap Fund (DEMSX) returned a similar 10.9%, but its Emerging Markets Value Fund (DFEVX) returned 19.8%.
• So far in 2017, we are again seeing that the world isn’t flat. For example, through July 31, while VFINX was up 11.5%, the Vanguard Developed Markets Index Fund (VDVIX) was up 17.9%, VEIEX was up 20.8%, and international small and small value stocks outperformed domestic stocks by wide margins. As one example, while the DFA U.S. Small Cap Value Fund (DFSVX) had produced a loss (-1.1%), its International Small Cap Value Fund (DISVX) returned 18.9%, an outperformance of 20.0 percentage points. This was a virtual reversal of 2016’s relative performance, when DFSVX returned 28.3% and outperformed DISVX’s return of 8.0% by 20.3 percentage points.

Conclusion

Despite markets becoming more integrated and correlations rising somewhat, there are still wide dispersions of returns—showing benefits to diversification even in a flatter world.

Hopefully, the evidence presented here demonstrates that, even though the benefits of a global equity allocation may have been reduced by market integration, they certainly have not disappeared. Thus, broad global diversification is still the prudent strategy.

A good starting point for determining how much to allocate to international markets is global market capitalization, which currently has a weighting of roughly one-half U.S. stocks, three-eighths non-U.S. developed markets, and one-eighth emerging markets. Investors more subject to the dreaded psychological risk of tracking-error regret may decide to incorporate a home-country bias.

This commentary originally appeared August 16 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

The post The World Isn’t Flat- Invest Globally appeared first on Sawyer Capital Management.

In a July 2017 Q&A with WealthManagement.com, Western Asset Management CIO Ken Leech asserts that passive investing is unlikely to play as large a role in fixed income as it does now in equities, because active managers outperform their benchmarks much more in the bond market than they do in the stock market.

While the trend toward passive/index investing has been just as strong in the bond market as it has in the stock market, with passive bond mutual funds and ETFs experiencing a net inflow of $185.8 billion during the 12 months through May, according to Morningstar data cited in the article, Leech claims we’ve “been fortunate that the record of active beating passive is strong in fixed income.”

He added: “The index is around the bottom quartile of the active community, in terms of performance. We’re hopeful that evidence is compelling, and that active management will continue to play a dominant role.”

When asked why active strategies have done better in the bond market than in the stock market, Leech responded: “Government and government-sponsored agency bonds make up more than half of indices. Most studies suggest that overweighting high-quality bonds with higher yields than Treasuries gives you a powerful advantage over time compared to indices.”

Let’s see if Leech’s claims hold up to scrutiny, or if they are—like most claims about the success of active management—nothing more than what journalist and author Jane Bryant Quinn called “investment porn.”

Checking In With SPIVA

While the poor performance of actively managed equity funds is well-known, the performance of actively managed bond funds tends to receive less attention. To check Leech’s assertions, we will look to the S&P Dow Jones Indices year-end 2016 SPIVA U.S. Scorecard, which has 15 years of performance data on actively managed bond funds.

Following is a summary of the report’s findings:

• The worst performance was in long-term government bond funds and long-term investment-grade bond funds, as just 3% of active funds in those categories beat their respective benchmarks. On an equal-weighted (asset-weighted) basis, active funds underperformed the index by a shocking 3.3 percentage points (2.7 percentage points) and 2.2 percentage points (2 percentage points), respectively. Active high-yield funds didn’t fare much better, with just 4% outperforming. On an equal-weighted (asset-weighted) basis, the outperformance was an also-shocking 2 percentage points (1.7 percentage points).
• For domestic funds, the least-poor performance was in intermediate investment-grade and short-term investment-grade bond funds. In both these cases, “only” 73% of actively managed funds underperformed. On an equal-weighted basis, the underperformance in both categories was 0.3 percentage points. However, on an asset-weighted basis, they managed to outperform by 0.7 percentage points and 0.3 percentage points, respectively. That is possibly explained by their holding longer maturities and/or holding lower-rated bonds (taking more risk) than the benchmarks. A factor regression would provide us with that evidence.
• Domestic high-yield bond funds performed almost as poorly as long-term government bond funds and long-term investment-grade bond funds, with just 4% of actively managed funds outperforming their benchmarks. On an equal-weighted basis, the underperformance was 1.9 percentage points. On an asset-weighted basis, they managed to outperform by 1.6 percentage points.
• Emerging market bond funds also fared poorly, as 76% of them underperformed. On an equal-weighted basis, the underperformance was 1.4 percentage points. On an asset-weighted basis, the underperformance was 0.2 percentage points.

Believe Vs. Evidence

Contrast the actual performance of active fund managers with Leech’s assertion that indexes were in the bottom quartile of performance: Leech was right about one thing—the evidence is compelling, just not in the direction he meant.

Even though the SPIVA scorecards clearly provide powerful evidence on the persistent failure of active management’s ability to generate alpha (risk-adjusted outperformance), active managers continue to claim otherwise.

As author Upton Sinclair noted: “It is difficult to get a man to understand something when his salary depends upon his not understanding it.” The claim that active management works in the bond markets is just as much a canard as the claim that it works in emerging markets (as I show in another recent article) or, for that matter, any other market.

The actual evidence provides compelling support for Charles Ellis’ observation that while it’s possible to win the game of active management, the odds of doing so are so poor that it’s imprudent to try—which is why he called it the “loser’s game.”

This commentary originally appeared August 7 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

The post Active Management Falls Short With Bonds, Too appeared first on Sawyer Capital Management.

In a recent article that highlighted the perils of owning individual stocks, I offered the historical evidence demonstrating how only a small percentage of stocks have accounted for all the gains provided by the market—with the vast majority earning a big, fat zero in aggregate cumulative returns, even before considering the impact of inflation or taxes.

The article included a study by Longboard Asset Management called “The Capitalism Distribution,” which covered the period 1983 through 2006. Longboard recently updated the study, so I thought I would share its findings, which serve to reinforce the risky nature of owning individual stocks.

The new study covers the period 1989 through 2015 and a total of 14,500 stocks. Over this period, the S&P 500 Index returned 10.0% and provided a cumulative return of 1,324%. The broader Russell 3000 Index produced almost identical results. It returned 10.1% per year and provided a cumulative return of 1,341%.

Key Findings

The following are some of the study’s important findings—findings that demonstrate just how risky investing in individual stocks, and a failure to diversify, really is:

• 1,120 stocks (7.7% of all active stocks) outperformed the S&P 500 Index by at least 500% during their lifetimes.
• 976 stocks (6.8% of all active stocks) lagged the S&P 500 by at least 500%, and 3,431 stocks (23.7% of all active stocks) dramatically underperformed the S&P 500 by 200% or more.
• 3,683 stocks (25% of all active stocks) lost at least 75%, even before considering the negative effects of inflation (which cumulatively was 96.3%).
• 6,398 stocks (44% of all active stocks) lost money, even before considering inflation.
• Almost two-thirds of all stocks (about 9,500 of them) provided no real return, even before considering the impact of taxes.
• The 80/20 rule works well in stocks. The best-performing 2,942 stocks (just more than 20% of the total) accounted for all the gains; the worst-performing 11,513 stocks (almost 80% of the total) provided an aggregate total return of 0%.

Despite these miserable odds—with only 20% of stocks providing 100% of the returns—investors who broadly diversified through passively managed index funds earned roughly 10% per year (less low costs) and a total return of more than 1,300%. That occurred because most indices are market capitalization weighted.

Successful companies with rising stock prices carry larger weightings in the index. Likewise, unsuccessful companies with declining stock prices receive smaller weightings. Companies showing continued declines are eventually delisted to make way for growing companies.

So, despite the fact that the average (mean) annualized return for all stocks on the S&P 500 Index is negative, the index can still deliver an overall positive rate of return.

Why Diversification Matters

The research, as cited in the aforementioned June 2017 post, shows that most common stocks (more than four out of every seven) do not outperform even virtually riskless one-month Treasury bills over their lifetimes.

The research also shows that individual stock returns exhibit a high degree of positive skewness (lotterylike distributions), meaning a very small percentage of outperforming stocks account for the large majority of returns.

For example, one study that covered the 90-year period ending in 2015 found that 96% of stocks just match the return of riskless one-month Treasury bills. The implication is striking: While there has been a large equity risk premium available to investors, a vast majority of stocks have earned negative risk premiums.

Uncompensated Risk

The study’s finding demonstrates just how great the uncompensated risk is that investors who buy individual stocks, or a small number of them, accept—risks that can be diversified away without reducing expected returns.

Such evidence highlights the important role of portfolio diversification. Diversification has been said to be the only free lunch in investing. Unfortunately, most investors fail to use the full buffet available to them.

This commentary originally appeared August 14 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

The post More Hazards of Individual Stocks appeared first on Sawyer Capital Management.

Larry Swedroe, Director of Research, The BAM ALLIANCE

Harry Markowitz received the Nobel Prize in Economic Sciences in 1990 for his contributions to the body of work known as “modern portfolio theory.” Probably his greatest contribution was to turn the focus away from analyzing the risk and expected return of individual investments to considering how its addition impacts the risk and expected return of the overall portfolio.

Markowitz showed it was possible to add risky assets (with low or negative correlation) to a portfolio, increasing the expected return without increasing overall risk. He also demonstrated the importance of diversification of risk.

Today most investment advice focuses on the development of portfolios that are on the “efficient frontier.” A portfolio that is on the efficient frontier is one in which no added diversification can lower the portfolio’s risk for a given return expectation (alternately, no additional expected return can be gained without increasing the risk of the portfolio).

Working with the efficient frontier, investment advisors tailor portfolios to the individual investor’s unique situation. Unfortunately, far too many investors and/or their advisors only focus on the risks of the investments themselves.

Managing Financial, Not Just Investment, Risks

When developing an overall financial plan, there are risks—other than investment risks—that are important to consider. Not integrating the management of these risks into an overall financial plan can cause even the most carefully considered and well-thought-out investment plans to fail. Among the other risks that should be considered are human capital (wage-earning) risk, mortality risk and longevity risk. Let’s consider how these risks should be integrated into an overall financial plan.

Human Capital Risk

We can define human capital as the present value of future income derived from labor. It’s an asset that doesn’t appear on any balance sheet. It’s also an asset that is not tradable like a stock or a bond. Thus, it’s often ignored, at potentially great risk to the individual’s financial goals. How should human capital impact investment decisions?

The first point to consider is that, when we are young, human capital is at its highest point. It’s also often the largest asset young individuals have. As we age and accumulate financial assets, and our time remaining in the labor force decreases, the amount of human capital relative to financial assets shrinks. This shift over time should be considered in terms of the asset allocation decision.

The second point is that we need to not only consider the magnitude of our human capital but also its volatility. Some people (such as tenured professors, doctors and government employees) have stable jobs, and thus their labor income is almost like an inflation-indexed annuity. In other words, it acts very much like a bond. Other people (such as commissioned salespeople and construction workers) have labor income that is more volatile, and thus acts more like equities. Financial advice should incorporate these differences.

For example, for people with safer labor income, it might be appropriate to invest more aggressively—with a higher allocation to equities overall and perhaps higher allocations to riskier small and value stocks. Those with riskier labor income should consider holding less aggressive portfolios (those with higher bond allocations).

This gets to the heart of Markowitz’s work on portfolio theory: An asset shouldn’t be considered in isolation. Note there may be times when the riskiness of one’s human capital changes (after a career change, for example). If the riskiness of the human capital increases, one should consider reducing the riskiness of the other assets in the portfolio, and vice versa.

A related issue is the significance of human capital as a percentage of total assets. If human capital is a small percentage of the total portfolio (because there are large financial assets), the volatility of the human capital and its correlation to financial assets becomes less of an issue.

Correlation, Health And Mortality

The third point we need to consider involves one of the most basic principles of investing—don’t put too many eggs in one basket. Individuals should avoid investing in assets that have a high correlation with their human capital. Unfortunately, far too many people follow Peter Lynch’s advice to “buy what you know.” The result is that they invest heavily in the stocks of their employers.

This is a mistake on two fronts. The first is that it’s a highly undiversified investment. The second is that the investment is likely to have a high correlation with the person’s human capital. Employees of such companies as Enron and WorldCom found out how costly a mistake that can be.

The fourth point to consider is that human capital can be lost due to two risks that need to be addressed by means other than through investments. The first is the risk of disability. This risk can be addressed by the purchase of disability insurance. Thus, the risk of disability and how to address it should be part of the overall financial plan. The other risk is that of mortality. That issue can be addressed by the purchase of life insurance (we will discuss that in more detail).

There are still other points to consider. All else being equal, people with a high earning capability have a greater ability to take more financial risk because they can more easily recover from losses. However, they also have a lower need to take risk. All else being equal, the higher their earnings, the lower the rate of return they need from their investment portfolio to achieve their financial goals—they can choose less risky investments and still achieve them.

Risk Tolerance And Adaptability

Another factor is investors’ willingness to take risk—their risk tolerance. It’s important that investors don’t take more financial risk than their stomachs can handle. The reason is that, when the inevitable bear markets arrive, they might be more inclined to panic-sell, and the best laid plans would end up in the trash heap of emotions.

Even if they were not driven to panic, life is just too short not to enjoy it. One should be able to “sleep well” with his or her investments. Thus, a high earnings capability, or even a high need to take risk, shouldn’t necessarily result in an aggressive investment portfolio.

Yet another factor to consider is the ability to adjust your “supply” of human capital. Consider the following: You develop a financial plan that allows you to retire at age 65. However, the market’s rate of return falls below the expected return you built into your plan, or you weren’t able to save as much as you had expected. Now you will need to work longer.

Can you continue in the labor force? What level of income can you generate? Will the market allow you to sell your skills, and at what price? Younger workers typically have more ability to adjust their supply of human capital. In addition, those with a variety of skill sets also have a greater ability to adjust their supply to economic conditions.

We’ll revisit this discussion later in the week to consider additional risk factors, including mortality and longevity risk, and using “tax alpha” strategies to improve the odds of achieving your financial goals.

This commentary originally appeared April 12 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

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