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Tinkering and Chasing Performance

Passive investors aren’t immune to the temptation to chase performance. We just do it by tinkering with our asset allocations rather than hopping between various actively managed funds.

For Example

Imagine two portfolios: Both have a 70/30 stock/bond split. Both have the same total costs. And both have identical holdings in the bond portion of the portfolio. The difference is that:

Theoretically, Portfolio B should earn slightly higher long-term returns than Portfolio A because it carries slightly higher risk. Of course, there’s no guarantee those additional returns will materialize over any particular period.

All we know with certainty is that there will be some years in which Portfolio A does better and some years in which Portfolio B does better. And that can create a temptation to tinker: “Perhaps I should be overweighting small-cap and value stocks after all.” or “Perhaps I went a little overboard with the small-cap/value idea.”

However, picking either A or B and sticking with it is likely to beat the heck out of jumping back and forth between A and B, always moving to the one that’s done well over the last couple years.

Be Wary of Tinkering

The same thing happens with your allocation to REITs. Whether you allocate 5%, 10%, or 20% of your portfolio to REITs, there will always be years in which you wish your allocation was something different from what it is.

And with your U.S. vs. international allocation: Should 20% of your stock portfolio be invested internationally? 40%? Regardless of what you choose, there will always be some other allocation that’s done better.

Be wary of the temptation to tinker with your portfolio. It may be nothing other than chasing performance.

Or to put it differently: How we invest is at least as important as what we invest in.

Principal Protecting Your Investments

The following is a guest post from Dylan Ross, CFP and founder of Swan Financial Planning.

How would you like to like to participate in the good stock market returns, but not lose any money, even if the market goes to zero? No, I’m not about to invite you to a free lunch seminar to pitch an annuity. There is actually a very simple way that just about anyone can invest some money in the stock market while guaranteeing that your starting balance will be available at a future date.

The basic idea behind this strategy is to use enough U.S. Treasuries or money in FDIC insured CDs to guarantee a future value that is equal to principal. Then, invest the difference in the stock market. Even if you are not interested in principal protecting your investments, understanding this concept can help frame your understanding of the relationship between risk and return.

How It’s Done

While there are several ways to construct such a strategy, here is an example of how to protect $20,000 and still seek some growth over a five-year period. First, you’ll need to find a CD or Treasury note with the maturity you want and a competitive yield. Let’s use a 5-year CD with a 3.5% APY for this example.

Next, you need to figure out how much to invest in that CD so that your balance will equal $20,000 at maturity. In this case, $16,840 will get you there, leaving $3,160 to be invested in the stock market using a low-cost, no-load total stock market index fund.

Possible Results

If after five years, your stock market investment is flat, your $20,000 will have grown to $23,160, about a 3% annualized rate of return.

If the market losses half its value each year for five years in a row, you’ll still have $20,098, even though the market lost about 97% of its value over half-a-decade!

If the market does well and averages 10% for the next five years, you’ll have $25,078. That’s a little more than a 5% annualized rate of return.

In fact, when the market does better than the CD’s APY, you will have done better compared to putting all of your money in the CD, but no matter how bad the market does, you won’t lose your original principal.

Keeping It Going

You can follow the same process with future contributions, buying additional CDs and adding to your total stock market fund. When a CD matures, you can repeat the process, protect your principal after adjusting for inflation, or even lock-in your stock market gains. There is no right or wrong way to do this. If you understand the trade-offs and mechanics of this strategy, you can customize it to meet your own needs.

You may be comfortable with protecting only a portion, perhaps only enough to withstand a 20% market decline over five years (with the CD from the example, a 50/50 split gets you pretty close). Also, keep in mind that when CD and Treasury rates are higher, less money is needed to principal protect, leaving more to be invested in the stock market.

Other Considerations

Of course, the best place to execute such a strategy is in a tax-advantaged account, at least for the income-producing portion. Otherwise you will need to allow room for taxes by aiming for an after-tax future value. Also when using CDs to principal protect a portfolio, keep in mind that FDIC insurance covers deposits but not any yet-to-be-credited interest.

Now, I’m certainly not suggesting everyone go out and do this. But the example should help to illustrate the relationship between risk and return. Even as you begin to deviate from the example in pursuit of greater returns, the relationship between risk and return persists. Lastly, it’s okay to be conservative with your investments as long as you are willing to make up for it in other areas, like saving more, saving longer, or planning to live on less.

How Turnover in Your Portfolio Affects Performance

I frequently mention that, when selecting mutual funds, it’s generally advantageous to look for funds with low turnover.

What I’ve noticed from comments on the blog and emails I’ve received is that some investors seem to miss the fact that the same thing applies to our own portfolios. Generally speaking, increased turnover is a bad thing.

Increased Costs

Most obviously, increased turnover leads to increased transaction costs:

  • If you purchase individual stocks or bonds, each transaction comes with a cost. Even if you’re using a discount brokerage firm, those $7 trades begin to add up.
  • If you jump between funds, there may be a transaction cost (depending upon which funds you use and how quickly you sell them after buying them).
  • If you’re investing in a taxable account, turnover means incurring capital gains taxes earlier, which is harmful to returns.

Increased Risk

Less obviously, increased turnover in your portfolio creates a cost in terms of extra risk you take on.

For example, there’s a high probability that if you hold a stock-based mutual fund for a long enough period of time, you’ll enjoy a positive rate of return. However, if you constantly jump back and forth between various mutual funds, it’s no longer such a sure thing.

Increased risk and increased costs, without an increase in expected return. What’s not to love?

The alternative: “Don’t just do something, sit there!”

Is your fund manager gambling with your money?

According to Morningstar, the average annual turnover within domestic stock funds is 104%. In other words, on average, domestic equity funds hold a stock for just 351 days before selling it.

Of course, such high turnover has a negative impact on returns in that it substantially increases costs. But even leaving that issue aside for a moment, doesn’t this level of turnover strike anyone else as a bit frightening?

I’m not a stock picker, and I never have been. Nor do I want to pay anyone to pick stocks for me. That said, if I was forced to choose between:

  1. A fund manager engaging in the Warren Buffett/Ben Graham “my-favorite-holding-period-is-forever”-type of investing, or
  2. A fund manager who holds stocks for less than one year before selling…

…I’d have very little hesitation about going with option #1.

I’m not here to say that it’s impossible to be a successful short-term trader. I am, however, concerned that many fund investors think they’re using a long-term buy & hold strategy, when in reality, all they’re doing is paying somebody to engage in short-term stock picking with their money.

Giving Up on Buy and Hold Indexing

I recently saw an interview with Suze Orman discussing passive, index investing. In it, she provides us with the following insight:

“I’m not sure you can buy and hold that way and just forget about everything as if everything will be OK.”

If you look around the realm of personal finance (online or offline), you’ll be inundated with similar messages. Two quotes from recent emails I’ve received appear to be perfect examples:

“Over the last decade, we’ve learned that passive investing doesn’t always work.”

“Passive investing only works during bull markets.”

In other words, as Jason Zweig recently stated, “today, it has become trendy to declare that ‘buy and hold is dead.'”

Got a better idea?

Will buy & hold index investing ensure that you reach your goals? That depends to some extent on what your goals are, but the honest truth is that no, it probably can’t guarantee that you’ll reach them.

A more meaningful question, though, is whether there is a better alternative. Can we hope to do better by using some other strategy?

To be able to earn a return better than that provided by a long-term, buy & hold indexing strategy, we have to either:

  • get lucky, or
  • outsmart the market in some way

Outsmarting the market

All the various methods for attempting to outsmart the market can be broken down into two broad categories:

  1. picking stocks (or other individual securities), or
  2. timing the market

Picking Stocks

My rule of thumb before investing in an individual stock is to ask myself whether I have any information about the company that would not already be known to somebody whose full time job it is to stay informed about the industry the company is in. If I can’t answer in the affirmative, I don’t buy the stock.

(To date, I’ve never answered in the affirmative, though I don’t entirely rule out the possibility of it happening someday. 🙂 )

Timing the Market

The difficulty of predicting short-term market movements is analogous to that of picking individual securities: Short-term market movements are the result of new information being released. To be able to predict the market’s movements, you need to know something that the rest of the market doesn’t yet know.

It’s not perfect…

Long-term, buy & hold, index investing is far from a perfect strategy. But a declaration that “buy & hold is dead” is worthless unless coupled with a strategy for doing better.

And let’s not forget that every effort we make to “do better” puts us further behind as a group.

The downside to passive investing.

In the last few weeks, a handful of people have asked to see a greater discussion of the drawbacks to passive investing. I’ve been thinking about it a lot. So here we go…

  1. It’s boring.
  2. There’s precisely zero chance that you’ll get rich overnight.
  3. It’s difficult. (Not the mechanics of it–those are quite simple. The hard part is sticking it out through a down market.)

From my perspective, that about covers it. 🙂 Anybody have anything they want to add?

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